Streetwise Professor

July 12, 2012

Pick Your Poison, or, He Who Laughs Last, Laughs Best

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — The Professor @ 7:00 am

During all the whinging about WTI, and the claims that it was inferior to Brent as a benchmark, I pointed out that although the former was subject to short term issues that could be fixed by investment in infrastructure, the latter was plagued by far more intractable problems that would compromise its viability over the medium-to-long term.  Indeed, WTI’s problems reflected an unexpected supply surge that actually bodes well for its long term viability, whereas Brent’s inexorable production decline would be virtually impossible to fix.

That reality is now becoming more widely recognized, pace Javier Blas’s piece in the FT:

The drop in production is putting the Brent benchmark in danger. Platts, the pricing agency that acts as the de facto regulator of the Brent physical market, is looking for solutions. It will need to work closely with ICE Europe, the exchange home of Brent futures and options, and the UK’s Financial Services Authority, which has an interest in the Brent derivatives market running smoothly.

The usefulness of West Texas Intermediate, the US crude oil, as a global benchmark has suffered over the past two years due to the so-called ‘Cushing syndrome’ – a glut at the Oklahoma town that serves as the delivery point of the contract. This glut is due to surging production and limited pipeline offtake capacity, and pushed WTI prices below what global fundamentals suggested.

Brent is now suffering from the opposite problem. The ‘North Sea syndrome’ – falling regional output combined with unlimited seaborne offtake capacity. The problem could push Brent prices above what global fundamentals suggest.

It is a lot easier to build pipelines than develop vast offshore oilfields. (Well, it is if administrations I won’t bother to mention let pipeline development proceed.)  This means that WTI’s “problems” can be fixed-and indeed, that its problem (a surge in supply in regions tributary to the delivery point) is a feature not a bug.  Brent’s.  Not so much.  Meaning that before very long CME/NYMEX is likely to be laughing, and Platts and ICE will be sobbing.

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  1. “Well, it is if administrations I won’t bother to mention let pipeline development proceed.”

    I laughed after I read this. Then, I thought about crying.

    Comment by Highgamma — July 12, 2012 @ 9:16 am

  2. Even if Keystone XL and other pipelines get built/extended to Houston, the US will still have a glut of light sweet oil, it will just have moved from Cushing to the Texas coast. WTI won’t become a truly global benchmark again until the US gets over its anti-market opposition to crude exports.

    Comment by Down With This Sort Of Thing — July 13, 2012 @ 6:07 am

  3. @Down-In the absence of any constraint on shipping oil to the Gulf, Midcon/Canadian barrels will compete with imported barrels at the margin. As long as the marginal barrel is imported, in this no-constraint scenario the light sweet crude price will be equal to (adjusting for quality, etc.) the price of the imported barrel, meaning that WTI will no longer be landlocked and disconnected from the value of seaborne crude. The potential arb will be open again.

    The scenario you posit re crude exports would be relevant only if the surge in production in North America (and the investment in transport capacity to transport it to the Gulf) was so large as to displace imports completely. In this scenario, an export ban would lead to market segmentation, with (a) domestic barrels at the Gulf selling at a discount to seaborne crude, even after adjusting for ocean transportation costs, and (b) domestic barrels at the Gulf selling at a premium to Midcon, but a high correlation between Gulf and Midcon prices (which would differ by the cost of transportation). Yes, this would be a disconnect, but a different kind of disconnect than is currently taking place.

    Even this impact can be limited by product exports. However, if Gulf refineries operate near capacity (because they are drowning in domestic crude) product exports would not restore the connection between foreign and domestic crude prices.

    The ProfessorComment by The Professor — July 13, 2012 @ 10:07 am

  4. Yes, the system works as long as there are marginal import barrels to compete against. Problem is, that tipping point is very close. It needn’t involve a total halt in crude imports, just a halt to light sweet crude imports at the Gulf coast that triggers another disconnection. This might happen anytime between later this year and mid-2013.

    Comment by Down With This Sort Of Thing — July 17, 2012 @ 8:55 am

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