Why natural gas prices rose while oil and liquids prices fell (Part 4 of 4)
WTI and Brent used to trade in line, but prices had diverged over the past few years
The spread between West Texas Intermediate (WTI) and Brent crude represents the difference between two crude benchmarks, with WTI more representing the price that U.S. oil producers receive and Brent more representing the prices received internationally. The two crudes are of similar quality and theoretically should price very closely to each other. However, the prices had differed greatly between the two crudes because a recent surge in production in the United States has caused a buildup of crude oil inventories at Cushing, Oklahoma, where WTI is priced. This created a supply and demand imbalance at the hub, causing WTI to trade lower than Brent. Before this increase in U.S. oil production, the two crudes had historically traded in line with each other.
The above graph shows the WTI-Brent spread over the past few years. Note that when the spread moves wider, it generally means crude producers based in the United States receive relatively less money for their oil production compared to their counterparts producing internationally.
The spread moved narrower last week as refineries upped demand for WTI
The WTI-Brent spread moved narrower last week, from $13.96 per barrel to $12.35 per barrel. A report from the U.S. Energy Information Administration showed that refineries operated at 92.6% of capacity last week, which was the highest level since July. Also, stocks of crude oil in the U.S. fell by 10.6 million barrels, the largest decline in nearly a year, and far exceeding expectations (see Why oil traded lower despite a large draw in crude oil inventories for more analysis).
Background: The WTI-Brent spread over 2013
WTI had been trading as low as $23 per barrel under Brent in February of 2013. Over the course of the year, the spread narrowed due to several factors. Firstly, increased midstream infrastructure has come online, facilitating the movement of crude from inland to refiners on the coast. One notable example is the expansion of the Seaway Pipeline in January 2013, which allows more crude to flow from the Oklahoma crude hub at Cushing to the Gulf Coast, where a great amount of refining capacity sits. Also, Sunoco’s Permian Express Pipeline and the reversal of Magellan Midstream Partners’ Longhorn Pipeline are allowing more crude from the Permian Basin in West Texas to flow directly to the Gulf Coast. Increased pipeline capacity and crude transportation by rail have allowed inland domestic crude to more efficiently travel to refiners on the East and West coasts, which has also backed out Brent-like imports.
Lastly, U.S. refineries began running at higher rates earlier in the year, which increased demand for crude. Since spring 2013, many U.S. refineries started to come back online from performing routine maintenance, and the EIA reported that in July, domestic refineries were running crude through their facilities at a rate of ~16.3 million barrels per day through June 2013. This is a ~2.1 million-barrel-a-day increase over the first week of March. Also, new refining capacity opened up in the Gulf Coast, helping increase refiners’ demand for crude.
So the spread between WTI and Brent closed in through the year until the two crudes traded nearly at par in mid-July. Since then, the spread gradually widened to levels as wide as ~$19 per barrel in late November before closing into current levels of ~$12 per barrel. In late August and early September, the spread widened to nearly $8 per barrel. This was partly because supply from Libya had dropped sharply due to unrest. Also, the escalation of tensions in Syria had caused traders to take bullish bets on the international oil benchmark of Brent crude and has also possibly driven the price differential between WTI and Brent. Since then, fears about Syria eased somewhat, and production from Libya started to recover, so that spreads closed in again to ~$3 per barrel in mid-September.
After that, data continued to show growing U.S. crude production—particularly from areas like the Bakken in North Dakota and the Permian in West Texas. Accompanying the crude production growth were increasing stocks of crude inventories, particularly at Cushing, a major crude hub in Oklahoma. Cushing inventories rose for seven weeks straight, after several months of steep declines. This is a signal that inland crude production flowing into Cushing was starting to potentially overtake the existing takeaway capacity, which would depress WTI crude oil prices in comparison to Brent prices.
Recently, the gap between WTI and Brent began closing with the news of increased takeaway infrastructure coming online (see Why the WTI-Brent oil spread closed in sharply), as well as increased refinery demand, as we discussed this week.
The future of the Brent-WTI spread
As we’ve seen, WTI and Brent had historically traded at near par and reached near par at points earlier this year. However, given the structural change of significantly more oil being produced from the U.S. (with projections of continued future growth), many market participants expect WTI to continue to trade under Brent. The U.S. Energy Information Administration, for example, notes in its monthly report titled “Short Term Energy Outlook” that it expects a spread of ~$9 per barrel in 2014 (recently increased from $8 per barrel).
The EIA also noted in an article in June, “The future of the Brent-WTI price spread will be determined, in part, by the balance between future growth in U.S. crude production and the capacity of crude oil infrastructure to move that crude to U.S. refiners.” For example, since TransCanada’s recent news to start up the Keystone XL pipeline, the spread has tightened.
The spread’s effect on oil companies
When WTI trades below Brent, this generally means companies with oil production concentrated in the United States will realize lower prices compared to their international counterparts, as WTI is the de facto U.S. benchmark and Brent is the international benchmark.
For example, see the table below for a comparison of oil prices realized by U.S.-concentrated companies versus companies with a global production profile.
|3Q13 Average Price Per Barrel|
|BENCHMARK OIL PRICES|
|West Texas Intermediate||$109.65|
|3Q13 Realized Oil Prices Per Barrel (excluding hedge gains/losses)|
|Chesapeake Energy (CHK)||$101.08|
|Concho Resources (CXO)||$102.10|
|Range Resources (RRC)||$91.82|
|Oasis Petroleum (OAS)||$100.75|
|Total Corp. (TOT)||$107.20|
From an investment point of view, if Brent is expected to continue to trade significantly above WTI, one might favor buying oil names that receive crude prices closer to the Brent benchmark than the WTI benchmark. Generally, this would represent oil names with more international production relative to domestic (U.S.) production.
Investors may want to monitor the spread, as a wider spread may make international producers more attractive relative to domestic producers. The difference between Brent and WTI has caused domestic producers like those mentioned in the above table (CHK, CXO, RRC, and OAS) to realize lower prices on oil compared to international producers. Over the medium term, the spread has experienced volatility lately, and the U.S. Energy Information Administration expects the spread to persist into 2014. Investors should note that many international names are in the XLE ETF (SPDR Energy Select Sector), an ETF whose holdings are primarily large-cap energy stocks with significant international exposure. In comparison, the XOP ETF (SPDR Oil & Gas Exploration & Production ETF) is weighted towards domestic-only names.
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