As WTI Surges, Is This the “New Normal” for Oil Prices?
After 735 consecutive daily trading sessions, one of the market’s longest streaks ended on Friday.
For the first time since August 16, 2010, West Texas Intermediate (the daily benchmark crude rate on the NYMEX) priced slightly higher than North Sea Brent (the equivalent benchmark in London).
The spread that existed for so long between the two had finally disappeared.
Admittedly, this “new normal” didn’t come as a shock. The spread between the two had been narrowing and the inevitable onset of parity – and even a slight premium for WTI – had been expected.
And yes, you can be sure there will be fluctuations moving forward, like yesterday when Brent traded at a slightly more expensive price.
But absent any major outside (i.e., exogenous as it is often termed in the business) event, the closing of this long-time spread has created one important outcome: a more favorable pricing environment for the U.S. benchmark.
In these conditions, the price of WTI should continue to climb.
Let me explain why the situation has suddenly changed…
The Battle Between WTI and Brent
Traditionally, a better pricing environment for WTI would have been expected (at least prior to August 2010). Because while both WTI and Brent are “sweeter” (that is, having less sulfur content) than almost 80% of all oil traded globally, WTI is actually a slightly better grade of crude.
That would mean, while most of the world’s oil would trade at a discount to both benchmarks, WTI should be priced higher than Brent.
However, of the two, Brent is clearly a more global standard than WTI. More trades internationally are discounted to Brent than any other benchmark.
And that combined with inventory problems in the U.S. are the primary reasons why the spread in favor of Brent lasted as long as it did. The well-publicized oil glut in Cushing, OK was as the “poster child” for these supply-side problems.
Cushing is the primary crude oil pipeline hub in the states. It is the location where the price of WTI is actually determined each day for NYMEX-traded futures contracts.
The ongoing problem was more oil was being produced than could be moved. As a result, the storage facilities at Cushing maxed out causing pipeline capacity to be used for stockpiling oil rather than transporting it.
When these sorts of conditions occur in an environment of stagnant demand, the result is downward pressure on oil prices.
Some of the Brent-WTI spread, therefore, was not a result of either benchmark’s usage so much as it was a reflection on a backup in the transiting of U.S.-based production.
The Sudden Surge in WTI
In the absence of this glut, WTI has been surging of late, outdistancing the increases in Brent.
By July 19, WTI was $108.47 a barrel, higher than for any daily trading session since March 1. Meanwhile, Brent hit $109.04 a few days earlier (July 16), higher than any day since March 28.
As the spread now straddles parity, market dynamics themselves will continue the movement of prices in favor of WTI.
Of course, rising tensions in the MENA states (Middle East and North Africa) could change that in short order. Hiccups in crude exports from the MENA region tend to put almost immediate pressures on Western Europe. That would accelerate Brent prices.
Nonetheless, the vanishing of the spread has some direct impacts on oil markets.
One will be to put a new upward direction on WTI. Assuming the glut at Cushing continues to diminish (and remember that very reduction in stockpiles is itself a reason for the narrowing of the spread), the price of WTI will be rising.
Demand, though, is certainly another aspect of the situation. But even here we have yet another wrinkle. It has to do with the price of gasoline.
As of the close on Friday (July 19), RBOB futures had risen 14.3% for the month. RBOB stands for “Reformulated Blendstock for Oxygenate Blending,” the NYMEX traded high-octane gasoline futures contract.
This double-digit move occurred despite an overall leveling off of domestic demand.
Now, I have explained the factors converging in a rise of gasoline prices at the refinery level in OEI before (“A Big Time Squeeze for Refineries is About to Begin“). The “four whammies” I discussed there continue to place renewed pressure on refinery margins.
In addition, the federal requirement that 10% of retail gasoline include ethanol (slated for an increase to 15% without Congressional intervention) has also prompted a gas price spike. This is due to higher prices for corn (a major result of the pronounced drought in the U.S. midlands), from which the American market obtains most of its ethanol production.
Those rising prices, however, are also a reflection of the genuinely global market for oil products. More and more U.S. production is now being exported to developing markets where both demand and prevailing retail prices are much higher.
The current rise in WTI, therefore, is in large measure simply a reflection of what the pricing levels ought to be in a market not beset with a glut at Cushing. Higher refinery prices for oil products sent abroad are still below pricing levels elsewhere.
In other words, rising domestic prices in the U.S. are offset by rising exports. This is the starkest reality of how the retail end is impacted by parity between WTI and Brent.
Investing in the “New Normal” for Oil Prices
So how does an investor play this newfound parity?…
The added element is the fact that a narrow differential between the two primary oil benchmarks may now be the “new normal” in crude pricing.
Initially, the onset of ongoing parity will provide profit opportunities in two distinct categories of companies that I have mentioned before.
First, while U.S. oil production will benefit from any nod to WTI, some companies will fare better than others. They include well-managed, mid-sized operators working in selected basins. Companies like this will simply provide better profits.
For example, there are producing fields in East Texas, Oklahoma, and Alaska where the crude lifted is actually priced higher than WTI.
Many of them are operated by small companies that have lifting rates below the threshold larger companies require. Larger producers often require higher daily volume figures to justify higher levels of overhead.
On the other hand well-run, focused, smaller companies do not. It’s a case where bigger is not always better in the oil business.
The second opportunity is in U.S.-based midstream companies that provide gathering, initial treatment, terminal, storage, and transit services to upstream producers.
As the spread disappears and the premium falls upon WTI, you can expect well-positioned midstreams to realize added profits from all of these pass-through elements.
These services are the essential lynchpins in the upstream (wellhead) to downstream (refining and distribution) movement of oil.
So while the streak may have ended, the opportunities in the oil markets have only just begun. The bull market in energy is still just warming up.