How to Profit as the WTI-Brent Spread Widens

Brent and WTI have been on a downward trajectory recently. Brent had declined for seven consecutive trading sessions before yesterday, while WTI had been down for five.

Brent and WTI (West Texas Intermediate) are the two principal crude oil benchmark prices of global trade. Brent is set in London, WTI on the NYMEX in New York.

Given the importance these have in pricing crude worldwide, it may be useful to review what they are before talking about what has happened with them recently.

As I have observed in OEI on a number of occasions, neither benchmark has actually reflected the quality of oil traded worldwide. On average, 85% of the oil in the international market on any given day is sourer (having a higher sulfur content) than either of these benchmarks.

That means the actual trades are done at a discount to the price of one or the other of these standards.

Both are denominated in dollars, the currency in which virtually all oil consignments internationally are priced. That certainly is one primary reason for their use. In addition, the daily liquidity of futures contracts traded in the world’s two largest investment locations is also a reason for their use.

Finally, with more than 200 benchmark rates for crude existing throughout the world, most having insufficient volume to constitute a basis for pricing, there needs to be yardsticks to determine pricing differentials and swaps. Those common yardsticks should be the most liquid and highest volume trading contracts.

Brent and WTI fit the bill in all of these aspects, despite not actually reflecting the lower quality of most oil traded.

There have been several sour crude rate benchmarks introduced in an attempt to provide more representative pricing. But the predominance of London and New York as trading centers has maintained the dominance of Brent and WTI.

Still, the interesting development since mid-August 2010 has been the following. Despite representing lower quality oil, Brent has been trading at a premium to WTI. Of the two, Brent (which actually comprises a benchmark for oil coming out of designated North Sea offshore fields) has more sulfur content. That should result in a lower price rather than higher comparative price.

Global Markets Favor Brent Crude

Actual trading conditions prompt a spread in favor of Brent for several reasons. In addition to Europe experiencing a more immediate reaction to current geopolitical pressure, there are two primary issues at hand.

First, Brent is used as the basis for more actual daily trades worldwide than WTI is. Brent is the preferred standard for determining discounted prices in many global markets where even lower quality volume is offered.

Second, Brent represents a crude standard that does not have significant supply glut concerns. WTI, on the other hand, may be traded in New York, but the daily spot price is set at Cushing, Okla.

Cushing is the main pipeline hub in the United States, but the city has experienced a surplus backlog for some time.

New pipeline projects and the construction of additional storage capacity are addressing this problem. These moves include the use of existing lines in reverse mode to move volume away from Cushing to Gulf Coast refineries and the construction of the next Keystone Pipeline project stage south out of Cushing.

The Keystone XL from Canada is mired in partisan political squabbling inside the Beltway. That is because it requires Congressional approval (since it crosses an international border). On the other hand, those sections located completely within the U.S. do not.

But until the network to move oil from Cushing improves, the glut will continue to have a suppressing impact on WTI pricing. That finally allows us to segue into the subject matter of today’s OEI.

The WTI-Brent Spread Widens

The price difference or spread between Brent and WTI is an indicator of overall global oil market conditions. It widened lately, closing yesterday at the highest difference since mid-October of last year.

The nominal difference in price (the one determined by simply subtracting the WTI rate from Brent) was $23.32 a barrel. The better way to express the spread, and my preferred approach, is to treat that difference as a percentage of WTI.

By using this figure, we obtain a thumbnail indicator of the real effect the spread has on prices in the U.S.

Yesterday, that spread rate hit 27.1%.

Refineries Set to Advance

The consequences have two results that investors in the energy sector need to consider.

The first is the obvious one. Given its more dominant use as a global benchmark, a higher Brent price translates into higher import pricing in the American market.

The advent of increasing U.S. domestic unconventional production (shale and tight oil) is resulting in less dependence on imports. Five years ago, the U.S. imported nearly two-thirds of its daily oil consumption. By the end of 2012, that figure may fall to less than 50%.

This is a remarkable transformation.

In a similar development, U.S. production will register this year at a daily level higher than at any point in more than a decade. This has led to much discussion about self-sufficiency being a realistic future goal.

And it is possible.

A few decades down the road, if current projections of unconventional reserves are accurate, the U.S. will need to import only about 30% of daily requirements. Virtually all of that would be provided by the huge Canadian oil sands deposits.

But for the next 20 years or so, those higher Brent prices will affect U.S. prices, even if we rely on fewer imports. Even after that, given the global nature of oil pricing, the spread will affect the American market.

The second major result of the Brent premium to WTI is less apparent.

Still, it has a bigger impact on U.S. energy investment prospects. When the spread increases, so do margins (and thereby profitability) at American-based refineries.

A spike in the spread often leads to a decline in refinery share prices at the outset, but quickly prompts a recovery and improvement thereafter. This is because the single largest cost component in refining remains crude oil.

Still, if a refinery can balance consignment sourcing and stockpiles supply in advance of the spike, a later increase in Brent over WTI allows an improved margin. This is why increasing inventory figures in weekly EIA reports need to be read with care. They may have less to say about retail demand levels and more to say about the massaging of refinery margins.

One conclusion, however, is beyond dispute.

The rise in the spread between Brent and WTI provides an element investors need to watch.

But it is also an indicator of where to profit when investing.