Commodities | Oct 25 2012
By Greg Peel
When the price of Brent crude futures started to blow out over the price of West Texas Intermediate (WTI) crude futures in 2010, much money was lost by traders used to wide spreads lasting only briefly before slamming shut again. For a long time Brent tended to trade at around a US$2/bbl discount to the lighter, sweeter WTI. So when the spread switched around, and the Brent price gradually started moving above the WTI price, traders punted on the spread soon closing again. By the time the spread hit US$10, they were down but not out. By the time it reached US$20, there was blood on the floor. Yet still the spread kept widening, out to about US$26-27.
What these punters failed to realise is that this time, it really was different. This time the Brent-WTI spread was not about oil quality but about delivery points, storage capacities and transport costs. It was about the new Keystone pipeline which would pump oil down to Oklahoma from Canada. It was about most of the US oil refineries no longer being in Oklahoma but down on the Gulf, as well as on the highly populated east coast. It was about transporting oil from one place to another. And what the punters most blatantly missed was the fact it was not Brent price which was “out of line”, it was the WTI price, due to limited storage capacity in Oklahoma. All other crudes – such as Malaysian Tapis and even America's own Light Louisiana Sweet (LLS) – were trading in a close range to Brent. WTI was the odd one out.
A couple of years on, the reasons for the now longstanding spread, which has closed in to no less than about US$12 in the interim and is currently back out at US$26, are well understood. FNArena explained the reasons fully in February 2010's The Death In West Texas. But there are new developments afoot in the US with regard to oil transport which will finally provide downward pressure on the spread by some time next year.
Note that all this time Americans have fervently hung on to WTI as “the price of oil” while screaming blue murder at the seemingly high cost of gasoline. US gasoline is not priced off WTI, it's priced off LLS, which is in line with Brent.
The bulk of WTI is now crude piped down the Keystone pipeline from Canada's Brakken and Western Canada oil fields to the Cushing, Oklahoma storage point. Forget the “West Texas” idea, that's just an historic reference. Amazingly, there is a further pipeline from Cushing to the Gulf, but it flows the other way. That historical oversight is now being addressed, such that next year one million barrels of oil will be pumped from Oklahoma to the Gulf refineries. Presently, most of the oil is trucked or transported by rail to the Gulf.
Indeed, despite the Keystone pipeline (which has suffered from environmental protest risks and occasional shutdowns) being in place, at lot of Canadian oil still travels the long haul from Canada to the Gulf by rail. The bulk of oil arriving at the US east coast refineries also travels from Canada by rail. Outside of storage cost differences, which are determined by available capacity, transport costs ensure the Brent-WTI spread remains intact.
Rail transport costs from Canada to either the US east or Gulf coasts vary by US$10-20/bbl, notes JP Morgan. The variation is not a factor of distance, given the distance from western Canada to either coastal refinery centre is roughly equivalent. The difference relates to cost variations for “manifest” and “unit” cargoes. Manifest cargoes refer to oil tanker rail cars being hitched up with all other manner of goods cars in a mixed cargo delivery. Unit cargoes refer to oil tanker-only trains. Unit cargoes are half the transport cost but require sufficient facilities at the destination to handle such a bulk delivery. Such expanded receiving capabilities are rapidly being constructed at the coastal centres which implies the average cost of oil transport to the US refineries should now tend towards US$10 rather than US$20.
It will be in the second half of the year that the reversed pipeline to the Gulf from Cushing will be ready, and that should provide for lower transport prices still. JP Morgan calculates that a rail cost of US$16/bbl translates to a Brent-WTI spread of US$12/bbl, and a marginal cost of US$10/bbl, netting out with a cheaper pipeline cost, would imply a US$6/bbl spread.
Thus JP Morgan expects the Brent-WTI spread to contract through 2013 from today's US$26 to potentially US$6.
But before we all get too excited about cheap oil, ceteris paribus this likely means WTI will rise to meet Brent, rather than the other way around. The pipeline will clear out the Cushing storage tanks much quicker, reducing the storage premium cost which forms the bulk of the price spread at present.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
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