Written for Newsbase’s Euroil in June 2015
Brent-WTI spread turns negative again; set to stay tighter
The premium that Brent has held over West Texas Intermediate (WTI) – the world’s two most important crude oil benchmarks – reversed briefly on June 19th, for the second time this year, reinforcing expectations of a much narrower average spread than has been seen over the last five years. The change is largely a consequence of Opec’s price strategy, which has slowed US output growth while boosting flow from the Mideast Gulf, but it also highlights WTI’s improved physical connection with the international market, which could enable it to challenge Brent as the preeminent global crude benchmark.
Over the last five years, ballooning U.S. domestic and Canadian crude production, combined with transport bottlenecks to the coast, caused the gap between US benchmark, WTI, and Brent, the established international oil marker, to stay strongly positive, peaking at over $28 a barrel in 2011. That premium has now softened, indicating that the growth in supply from within continental North America has slowed – as a result of reduced drilling due to lower crude prices – leaving the US domestic market balanced with the international one for the first time in years. This has been underpinned by new rail, barge and pipeline capacity – the development of which was driven by WTI’s heavy discount – allowing a more extensive and stable physical connection between WTI and wider global oil markets.
The narrowing spread is being reinforced by sellers of Atlantic basin physical oil, who are struggling to offload cargoes of North Sea and West African crudes, which is keeping downward pressure on Brent futures. These crude grades are being displaced from Asian markets by ample supply from the Mideast Gulf, which is mopping up demand there as part of Opec’s strategy to maintain market share. With Asian demand covered and European demand still weak, sellers have been forced to offer the biggest discounts on physical Atlantic basin cargoes to Dated Brent since 2008 to clear the surplus, leaving U.S. strength to drive price discovery over recent weeks and close the spread.
A narrower WTI–Brent spread is positive for U.S. inland oil producers, which will be able to earn values closer to the international market price. However, the opposite is true for refiners, which have benefited for years from weak WTI, especially as international product prices tend to be benchmarked to Brent crude. On the other hand, a weak physical market around Brent in Europe, benefits European refiners, and is a factor behind the recent high refining margins.
Prior to the rise of US shale oil production in 2010-11, the spread between WTI and Brent had moved in a far tighter range of four or five dollars a barrel either way, standing on average at a slight premium for WTI – reflecting its lower sulphur content. After five years of strong Brent premiums, markets may now revert to earlier fundamentals, when WTI traded on average at a slight premium to Brent, especially if the U.S. crude export ban is removed, as anticipated.
Fighting over the top spot
WTI’s re-established international connection, combined with improved flexibility in trading physical WTI and ample physical volumes – as inland production continues at a high level – is beginning to provide a more robust competitor to Brent as the leading global benchmark. With the U.S. hailed as the new global swing producer, this may well be appropriate, and the market is already reflecting a degree of change in the form of sharply higher WTI futures liquidity.
While WTI’s logistics problem has been largely addressed through increased rail shipments and pipeline capacity, Brent has more fundamental issues related to adequate supply, which is less easily dealt with. Before recent investment, a long-term decline in production of the four North Sea Dated grades — Brent, Forties, Oseberg and Ekofisk — had led to concerns that the benchmark would see the physical liquidity upon which it is based dry up. Between 2008 and 2013, loadings of the four grades declined by an average of 9% each year, dropping to a low of 864,000 bl/d in 2013 from 1.4 million bl/d in 2008.
However, in 2014 new start-ups began to offset the declines at existing Brent grade fields, and measures were taken to increase the effectiveness of the benchmark. This lifted loadings to 870,000 bl/d in 2014, and it is hoped that North Sea production should now remain relatively stable for several years. Beyond that, there are concerns that the fall in oil prices since last summer will put an end to new field development in the region, or even lead to abandonment of mature fields where the cost of extraction is high – illustrated by Shell’s decision to decommission Its Brent platforms early – causing a resumption in the long term decline in production. These are not concerns that affect WTI, which is expected to be amply supplied for decades to come.
Further efforts are being made to bolster Brent, including recent proposals to expand the date range for physical dated Brent cargoes, in order to further increase its liquidity. They focus on extending the window for assessing individual grades to include cargoes loading up to a month ahead of the day assessment. Presently, only cargoes loading 10-25 days ahead of the day of assessment are used in establishing prices. The move would allow more cargoes to be included in the price assessment, especially Oseberg, which currently trades further ahead than Forties or Ekofisk, and so rarely affects the benchmark.
As high cost U.S. shale oil production is more sensitive to price in the short term than conventional production – reacting more quickly due to its shorter investment cycle – WTI may, in turn, respond more quickly in physical terms to changes in the global supply-demand balance in future years, making it a better global benchmark.