Key releases and bullish inventories boost oil and gas prices (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 (or “WTI”) and Brent crude represents the difference between two crude benchmarks, with WTI more representing the price oil producers receive in the U.S. and Brent more representing the prices received internationally. The two crude oils 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 production surge in the U.S. 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 oil producers based in the U.S. receive relatively less money for their oil production compared to their counterparts that are producing internationally.
The WTI-Brent spread traded narrower last week
The spread between WTI and Brent crudes closed at $6.37 per barrel on March 28, compared to the spread of $9.53 per barrel for the week ended March 21, 2014. Markets may have bet that the spread would close, as Enterprise Products Partners (EPD) said it would more than double the capacity of its Seaway pipeline in mid-2014. The Seaway pipeline currently brings crude oil from the inland U.S. oil hub of Cushing, Oklahoma, to the Gulf Coast. The increased transportation capacity from inland U.S. crude production regions to demand centers (such as refineries on the Gulf Coast) is bullish for WTI crude oil prices. The expanded pipeline is reported to be able to move more than 850,000 barrels per day of crude oil. Plus, the U.S. Energy Information Administration reported that stocks at the inland U.S. crude hub of Cushing continued to decrease, which also could indicate that U.S. crude produced inland is having an easier time getting to demand centers such as refineries, which would bring WTI and Brent prices closer together.
The EIA expects a wider average spread
The U.S. Energy Information Association in its latest “Short Term Energy Outlook” report noted that it expects the spread between WTI and Brent to average ~$9.60 per barrel over 2014 and ~$11.15 per barrel over 2015—higher than current levels. The forecast takes into account increasing uncertainty for existing refinery infrastructure to process an increase in light sweet crude production in North America, pushing WTI prices down relative to Brent. The EIA stated that its forecast reflects “the economics of transporting and processing the growing production of light sweet crude oil in U.S. and Canadian refineries.”
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. First, 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. Second, 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. Read about the latest pipeline development in Why the new Keystone XL pipeline helps narrow the WTI-Brent spread.
U.S. refineries began running at higher rates earlier in 2013, which caused increasing demand for crude oil. Since spring 2013, many U.S. refineries started to come back online from performing routine maintenance. The EIA reported that in July, domestic refineries were running crude oil 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. Plus, new refining capacity opened up in the Gulf Coast, helping increase refiners’ demand for crude.
So, the spread between WTI and Brent closed in throughout 2013, until the two crude oils traded nearly at par in mid-July. 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. Plus, the escalation of tensions in Syria had caused traders to take bullish bets on the international oil benchmark of Brent crude and perhaps also drove 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 oil production—particularly from areas such as 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. In 4Q13, Cushing inventories rose for seven weeks straight after several months of steep declines. This was a signal that inland crude production flowing into Cushing may have started to overtake the existing takeaway capacity, which would have depressed WTI crude oil prices compared to Brent prices. During this period, the spread gradually widened to levels as wide as ~$19 per barrel in late November before closing 2013 at ~$12 per barrel. The spread narrowed on account of the opening of the southern portion of TransCanada’s Keystone XL pipeline and stabilizing tensions in the Middle East.
The most recent widening of the WTI-Brent spread was primarily the result of geopolitical tension from the Ukraine-Russia standoff. Globally, we have a situation where oil inventories are increasing amid rising supplies from outside the Organization of Petroleum Exporting Countries (the OPEC). So, if the fear of a large-scale disruption in oil supply subsides, the spread would decrease in the medium term.
The spread’s effect on oil companies
When WTI trades below Brent, this generally means companies with oil production concentrated in the U.S. 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.
4Q13 Average Price Per Barrel
BENCHMARK OIL PRICES
West Texas Intermediate $97.61
4Q13 Realized Oil Prices Per Barrel (excluding hedge gains/losses)
Chesapeake Energy (CHK) $91.46
Concho Resources (CXO) $91.40
Range Resources (RRC) $83.43
Oasis Petroleum (OAS) $85.87
Total Corp. (TOT) $102.50
Exxon Mobil (XOM) $99.77
Chevron Corp. (CVX) $95.85
From an investment point of view, if Brent is expected to continue to trade significantly above WTI, investors 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 such as those mentioned in the above table (CHK, CXO, RRC, and OAS) to realize lower prices on oil compared to international producers. But over the medium term, the spread over 1Q14 has been significantly lower on average than over 4Q13.
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 toward domestic-only names.
To learn more about investing in the energy and power space, check out Market Realist’s Energy & Power page.
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