Brent-WTI Crude Oil Premium - Strangers In The Night

By: Andrew_McKillop

STRANGERS IN THE NIGHT
'Oil & Gas Journal' in an article by RBN Energy in its July 23, 2013 edition, when the premium or differential for Brent grade oil against US West Texas Intermediate collapsed to nearly zero from highs above $25 in 2011 and 2012, and a 2013 peak of $23 to date, said that despite the rebounds and recoveries, the premium has to decline. Its fundamentals are bad, the logic is bad, and the premium has strong headwinds. For oil brokers and traders, however, the heavily traded “premium trade” is still good for a flutter on the markets. Brent's premium shook itself out of bed and jumped from $14.64 to $16.21 in the week ending Nov  22, in two days trading but fell back the following week. 

GOOD BEDFELLOWS
Normal times and their normal premium values – when they existed at all – date to the 1990s and early 2000s. As Dominick Chirichilla of the US Energy Management Institute noted in a May 2013 review of the premium and how it developed over time, noted that normalcy for the premium of Brent against WTI is no premium at all, but a small discount for lower-quality Brent against WTI.

He said: “In the 1990s, WTI had an average premium of about $1.30/bbl above Brent (and) from 2000-2009, WTI’s premium averaged $0.55/bbl”. Pennies on the barrel difference in WTI and Brent prices, and no disputes. Brent was nearly always slightly cheaper.

As Chirichilla and most other analysts say, some  oil fundamentals can be used to explain the yawning gap of Brent oil prices against WTI. In 2011 and 2012 the Brent premium could be attributed to the North American (US and Canadian) shale oil and gas revolution. The growing amounts of new crude oil available in North America meant that the only way to move the increased supply of crude entering the price-critical US PADD-2 region (Midwest), where the Nymex oil market basing point of Cushing is located, was through the conversion of this crude into refined products. In other words, there was (and still is) a transport problem for the new crude which is being fixed, slowly. Through 2011 and 2012, crude supply was running, and still is running (but less so), above US refined product demand, capacity and production. Crude oil inventories in the region inevitably surge on a regular basis.

Brent crude oil supply in the eastern hemisphere of the world, with its price determination highly focused on Europe but also influenced by Asian supply-demand, faces a very different context. Especially in Europe, there is a large surplus capacity of refining. Crude backups are rare and Brent prices can therefore 'stick' while WTI prices are driven down, widening the premium for Brent.

The geopolitical risk premium – essentially a Middle East political crisis premium – loads to Brent not WTI, but by ricochet lifts WTI. This further spikes Brent against WTI whenever MENA region politics heat up, but the process has fundamental limits on how much oil export supply can be squeezed in the eastern hemisphere. This fundamental is ultra basic – all the major MENA region oil producers need oil export revenues to pay for the food imports they entirely depend on.

PROVISIONAL VICTORY FOR COMMODITIZATION
As many analysts and commentators will also say, the “fundamentals” of global oil resources, production, supply and demand in no way explains why Brent grade oil, of lower quality than WTI is able to be priced at double-digit-dollar levels above WTI.

Oil market trading, which grew from the early 1980s and became dominant in oil price setting by about 1987, started in the early 1980s when the U.S. government's decontrol of oil prices changed trading mechanics, with the commoditization of WTI. At that time, US domestic oil production was running at a rate of 8.6 million barrels per day, with about 30% of that oil coming from Texas, but this was heavily cut back by the sharp decline of world oil prices from 1985. The price decline, of around 66% in 1985-86 set a 13-year trend of very low oil prices, and coincided with the growth of eastern hemisphere crude output, notably the European North Sea, on the supply side, and the start of the takeoff in Chinese and Indian oil demand and oil imports, on the demand side.

Through a period we can date at around 1987-2005, US oil import demand was either high or very high and European and Asian import demand was steady or strong, always at a high level. No basic rational base however existed for the commoditized play on European oil prices versus US oil prices, but trading of the premium has gained its own place in financial market lore and action.

Not at all without risks, as Reuters reported Nov 25, 2013:
“One of the most popular trading bets in oil markets, based on attempts to predict price differences between European and U.S. oil benchmarks, is proving to be one of the trickiest as funds suffer losses after sky-high gains earlier this year'.

In other words its easier make gains when the premium is high, and vice versa. Rightly called “a widow maker” by some seasoned oil market analysts and traders, the premium is hard to play-trade when it shrinks near zero and when volatility increases.

One thing is sure and certain. US WTI, unlike Brent has major tailwinds for significant price decline, but to what level few analysts want to say – some put the figure around $70 per barrel based on elevated shale oil production costs. In pure theory this would or should pull down the Brent price, rather than high Brent prices pulling up US WTI. The now intrinsic and basic high volatility of the premium indicates major adjustment is likely – and on a rational basis, this should be an adjustment to reality meaning a shift to very low premiums for Brent against WTI in coming weeks.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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