Streetwise Professor

November 30, 2013

It’s Not Your Retro Brent-WTI Spread

Filed under: Commodities,Derivatives — The Professor @ 5:47 pm

The Brent-WTI spread reached a record level last week, defying predictions that the gap would continue to close.  But this isn’t the retro spread of the last couple of years.

When Brent-WTI was at its earlier record wides, the spread between Brent and Gulf Coast crude prices (e.g., LLS) was not that anomalous.  Instead, WTI was at a huge discount to LLS. This reflected a bottleneck in getting crude from the Midcontinent to the Gulf.

Now that bottleneck is largely eliminated: LLS is only at a $4 premium to WTI, which is pretty close to marginal transportation costs.  The current price structure is that the LLS-WTI spread has normalized, but the LLS-Brent spread has cratered.

So where’s the bottleneck now?  Part of it is legal: it is impossible to export crude from the US, except in a limited way to Canada.  It is possible to export products, and US refined product exports are at all time highs, nearly 3 times larger than the level of only 8 years ago.  (Interestingly, US product exports started their upward trend in 2005, well before the splurge in US oil production.)  However, refinery capacity is insufficient to close the gap, and there are logistical constraints that limit the amount of products that can be shipped out.   Some simple distillation units are being built to refine crude into products (including fuel oil) that can be exported.

Meanwhile, production issues in Libya and Nigeria are supporting Brent prices.

If the differential persists, it will be interesting to see whether there is pressure to eliminate, or at least relax, the constraints on exports of US crude.  I would presume that even if pressure begins to build, there will be a political battle in the US that will likely long delay any such relaxation or elimination.  So in the meantime this will be a boon for domestic refiners, and a roller coaster ride for traders.  The political, infrastructure, and refining bottlenecks that separate Brent and WTI will not close anytime soon, and the supply shocks on either side of the divide will cause prices to move with considerable independence.  A continued spike in US production will weigh on US prices, but can’t be communicated efficiently to Brent prices because of the bottlenecks; similarly, another shock to Nigerian or Libyan production will primarily move Brent.

In some ways, the world oil market, which is conventionally considered a “world” market due to the relative ease of shipping the stuff around the world, is becoming more like the natural gas market, with regional markets separated due to various bottlenecks, and the prices in these markets driven by idiosyncratic supply and demand shocks in those regional markets.  The adjustments necessary to ease the bottlenecks in crude are likely cheaper than those in gas, but they won’t take place overnight.  And until they do, Brent-WTI will remain a major speculative play.

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  1. A key difference versus gas is, as you note, that the restraints on arbing crude out of the USA are political, whereas those that constrain the arbing of gas around the world arise from the physical properties of gas. Can’t compress it, costs the earth to liquefy it, GTL never quite pays, etc etc etc.

    So the regionality of WTI is essentially a choice, arrived at through having the wrong people making the choice.

    What’s odder still is that US shale gas has displaced much coal, which is now being exported. I struggle with this a bit. It’s OK to export your surplus coal, and your refined products, but not your crude oil?

    If you were allowed to export US crude, could you get to a place where the Brent price falls (because the offered price of export WTI is lower), while the spread returns to the TI = Brent + $2 we had for so long?

    Comment by Green as Grass — December 2, 2013 @ 3:47 am

  2. Small quibble on the whole “record” thing. Brent-WTI isn’t at a record. It was a bigger spread 9 months ago, and still a long way off the $30/bl spread back in 2011. And while LLS-Brent is at a record, it’s been setting records almost daily for the last month and a half.

    The real question is the future relevance of the Brent-WTI, or LLS-Brent, spreads to the way that physical oil actually flows. Brent-WTI’s function in physical markets was to determine how much Atlantic basin crude went to US refineries. That’s much less the case now, and will stay that way as long as the US bans crude exports.

    The Brent-Dubai spread is becoming the more relevant spread to physical flows, and it works pretty well. More than 2mn b/d of west African crude is going to Asia right now. East and south Asian refiners need to know whether it’s more economic to get Angolan or Iraqi cargoes, and that’s where the real arbitrages are in the oil system now. Even Latin American crudes – barring those from Mexico and Venezuela – are mostly priced against Ice Brent. It makes the comparison with Asian demand easier through Brent-Dubai, although the producers are mostly trying to avoid the WTI discount creeping into their revenues.

    @Green as Grass: If the US lifted its ban on exports, I expect you’d still see Brent at a premium. There used to be a slight quality differential in favour of WTI, although Forties (lighter, but sourer than Brent) now sets Dated Brent, which makes old assumptions about quality less certain. Still, most of the WTI premium was about transport costs across the Atlantic and, more notionally, up the pipelines to Cushing. I imagine if the US were a crude exporter, the spread would have to account for transport costs the other way.

    Comment by Down With This Sort Of Thing — December 2, 2013 @ 5:16 am

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