The world's two most important oil benchmarks are on two different tracks, and may see a larger divergence in the months ahead.
WTI has typically traded at a discount to Brent, although the differential widens and narrows depending on specific dynamics affecting the two benchmarks. Back in 2012, when the shale bonanza really began to explode, the midstream sector was ill-prepared for such a dramatic ramp up. The result was a bottleneck that forced WTI to trade at a discount in excess of $20 per barrel for a short period of time. New pipelines resolved the backlog and the discount narrowed in the ensuing years.
In 2018, however, surging production in the Permian has resulted in yet another midstream bottleneck. As a result, the WTI discount has bounced around between $3 and $8 per barrel relative to Brent. In September, the differential jumped to $9.
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In fact, the two benchmarks may very well continue to diverge in the months ahead as they experience different market pressures.
U.S. shale output continues to grow, albeit at a slower pace than in months past. Permian takeaway capacity is all but tapped out, which could result in localized glut of supply. Oil located in Midland, Texas in the heart of the Permian has already been trading at a double-digit discount to WTI in Houston, and that dynamic will only magnify as we head into 2019.
Meanwhile, Brent, which more closely reflects the international market, is suffering from the opposite problem. As Iranian supply continues to plunge - Iranian oil exports are down some 1 million barrels per day from the April peak - the global oil market has tightened to its greatest extent since 2014. Now, there are questions about Saudi Arabia's spare capacity and its ability to offset the outages in Iran.
The result is that WTI and Brent are on diverging paths, which could widen the differential to as much as $15 per barrel, according to Citigroup, roughly twice as high as today. As Permian production continues to grind higher, more oil could end up in storage in Cushing. As inventories climb, WTI will suffer downward pressure. Related: Underwhelming OPEC Fuels Oil Price Rally
"As U.S. production grows, the likelihood is overwhelming that a lot of the valves to get into the Gulf Coast are going to close," Morse said in a Bloomberg interview during the Asia Pacific Petroleum Conference (APPEC) in Singapore last week. "It's bottlenecked getting to the Gulf Coast but it's not as bottlenecked getting into Cushing."
That could result in the widest discount in about five years. "We expect that Permian production is going to continue to grow," Morse said. "We have production from Colorado to Oklahoma, even from North Dakota and Canada, that has to go to Cushing before getting to the Gulf Coast."
A differential as large as $15 per barrel would have knock on effects. It would supercharge the business case for new pipelines coming out of the Permian, although some analysts think that the midstream market in Texas is getting pretty crowded with several pipelines under construction. Such a heavy discount could also incrementally slow drilling in the shale patch. At the same time, new modes of transit could open up, with an expansion of trucks and rail moving oil from West Texas to the Gulf Coast (although trucks and rail are also facing their own constraints).
A more obvious effect of a $15-per-barrel discount for WTI would be an acceleration of U.S. crude oil exports. U.S. crude discounted by that much would be very attractive to buyers around the world, so U.S. exports would likely rise even higher than today's levels. If WTI were discounted by $15 per barrel relative to Brent, the limiting factor for exports would be inadequate export infrastructure, not willing buyers. Related: How Much Spare Capacity Does Saudi Arabia Really Have?
Gulf Coast refiners would also enjoy buying up crude and churning out gasoline and diesel, which they could export at much higher prices that are more closely linked with Brent. Even better, refiners inland would have a better chance of buying the heavily discounted oil trapped behind the pipeline. WTI may be discounted to Brent by $15 per barrel, but Midland crude would be discounted by at least as much relative to WTI in Houston. The result would be a windfall for mid-Continent refiners.
However, this is a temporary story. There are several reasons why the discount would not last long. The biggest and most obvious reason is that the Permian pipeline bottleneck is expected to be fleeting. By late next year, new capacity will start coming online to ease the backlog. That will allow more oil to reach the Gulf Coast either for refining or for export, narrowing the price differentials.
A second reason would be that a surge in exports would help force WTI and Brent back together, although the degree to which this matters is up for debate. More U.S. crude oil exports will help even out the imbalances in what are essentially different markets for crude oil, just as any arbitrage eventually closes.
By Nick Cunningham of Oilprice.com
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Nick Cunningham is an independent journalist, covering oil and gas, energy and environmental policy, and international politics. He is based in Portland, Oregon. More