At first glance, Cushing, Oklahoma and SullumVoe, Scotland appear to have nothing in common. The landlocked town of Cushing – perpetually bathed by bright sunshine and a dry southwestern heat – stands in complete contrast to the dark, cold and rainy port of SullumVoe in the Shetland Islands. Despite their differences, the two locations share a similarity: they act as the respective pricing points for the world’s two most heavily traded crude oils –Brent Blend crude (SullumVoe) from the North Sea and West Texas Intermediate crude (Cushing).
The dynamics of the WTI-Brent spread – or “Atlantic Arb” – have shifted dramatically over the past several years in the wake of the US shale revolution. Aging American infrastructure has not been able to keep up with the massive production increase, creating large bottlenecks in the system, most famously at the storage facility in Cushing where inventories remain elevated (Exhibit 1) as crude continues to flow south from the large Bakken field in North Dakota. Crude is struggling to find its way to the ports and refineries (8 mm b/d capacity) of the Gulf Coast, resulting in a reduced global relevance. Consequently, some traders now use Light Louisiana Sweet (LLS), a waterborne crude, to calculate Atlantic arbitrage, believing it to be more linked to oil market fundamentals than WTI. Since May 17, 2012, the 670-mile Seaway Pipeline has been reversed to ship oil southward to Texas and the Gulf to address this concern. Meanwhile, the Gulf Coast Pipeline Project, a 485-mile pipeline with a capacity of 830,000 b/d, is expected to be completed by mid-to-late 2013 and will connect Cushing to the coastal town of Nederland, Texas. These actions suggest that the infrastructural effort to unblock Cushing is well underway.
In March 2013, trading volumes for Brent on the ICE and NYMEX exchanges overtook WTI for the first time – a historic development considering that five years prior, traded Brent volumes were less than a third of WTI volumes. This means that hedge funds, institutional investors, and other buy-side firms have adopted the ICE-listed Brent Blend contract to speculate on future movements in the oil market. The widely-held belief that waterborne crudes like Brent are more reflective of the global markets than landlocked crudes, though, is highly questionable – pipelines benefit from a flexibility in delivery quantity that is impossible for ocean tankers. Today, Brent is almost universally recognized as the global benchmark for oil prices.
This reversal was not entirely unexpected. In 2009, Saudi Arabia – the world’s largest producer of crude oil – stopped using WTI as a reference price for its exports to the United States. Late the following year began a significant price divergence between the world’s two reference crudes, with Brent trading at a notable premium to WTI for the first time (Exhibit 2). More recently, the US government’s Energy Information Agency (EIA) also decided to eschew WTI in favor of Brent as for reference pricing purposes.
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Historically, WTI crude has traded at premium to Brent and served as the global benchmark. Though both are “sweet” crudes (sulfur content < 0.5%), WTI’s sulfur content of 0.24% is slightly lower than Brent’s 0.37%. A high sulfur content lowers the value of crude, as sulfur is a pollutant which reduces total energy output and can corrode metal in pipelines and tankers. Additionally, WTI has an API gravity (a measure of oil’s density) of 39.6 degrees compared to 38.3 degrees for Brent. A higher API means the oil is less dense, and thus, more valuable. The Brent contract traded on the ICE is, in actuality, a blend of different crudes (most notably Brent, Forties, Oseberg, and Ekofisk) from fifteen different North Sea fields. For example, the Buzzard field – a massive offshore elephant field located 100 kilometers northeast of Aberdeen – produces a medium sour grade crude with a sulfur content of 1.44% and an API of 32.6 degrees.
The WTI-Brent spread is much more than a favorite speculative play of major commodity trading houses like Glencore, Trafigura, Vitol and Mercuria, however. Morgan Downey, a New York-based crude trader and author of Oil 101, explains that the spread plays a major role in determining the directional flow of crude exports. Based on a combination of transatlantic freight rates (using the Baltic Dry Index as reference) and the WTI-Brent spread, large Middle-Eastern and African producers will decide whether to ship their crude to Asia or North America and Europe. The far-reaching consequences of the shale revolution in the United States can be seen here: as the US gradually moves toward energy independence, West African and Middle-Eastern producers will no longer have the luxury of choosing their market. Indeed, OPEC-member nation Nigeria has seen its oil exports to the United States drop to a 25-year low, causing somewhat of a national panic. Nigeria is particularly vulnerable as it produces a grade of crude (Nigerian Bonny Light) which is physically similar to many American-based sweet crudes (Exhibit 3) in terms of sulfur content and API gravity.
The dynamics of the Brent-WTI spread strongly point toward the return of WTI as the world's reference crude. The current spread, though narrowing, is still misaligned with market fundamentals. Production declines in the North Sea (Exhibit 4) have also played a role in the increased price of Brent, though it is paradoxical that lower output levels would cause Brent to become the world’s reference oil. Additionally, European demand for oil has recently dipped to a 20-year low, a development which should jeopardize its status as the global reference crude.
The following are six primary reasons why WTI should regain its mantle:
1. WTI is a higher-grade crude than Brent
2. Infrastructural constraints in the United States are only temporary and easily fixable
3. Waterborne crudes are not intrinsically better benchmarks
4. Oil demand in Europe is in a long and steady decline
5. North Sea production declines should lessen, not increase, Brent's global relevance
6.Recent North Sea production disruptions and outages undermine Brent's reliability as a benchmark
The case for price convergence and eventual reversal, then, becomes rather simple. As long as the necessary infrastructural investment to unblock Cushing materializes – and all signs indicate that it will – then the higher grade crude in a higher demand market should trade at a premium to its counterparty.
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By. Phil Casey