Feature Stories | Feb 23 2011
(This story was first published on February 15, 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).
– Egypt is not responsible for the spread between WTI crude oil and European Brent
– West Texan Intermediate has lost its relevance because of specific circumstances
– Crude oil in most other price benchmarks is priced around US$100 per barrel
By Greg Peel
Why do we care about the price of oil? Well the obvious answer is that the price of oil impacts what it costs me to fill my car with petrol, and that's a fundamental element in my weekly household budget. The global cost of energy is, nevertheless, of vital importance to the performance of the global economy given the extent of consumption of fossil fuels in everything from transport to factory power to chemicals and plastics. A strong oil price implies a strong economy, but the higher the price of oil rises, the greater is the cost-drag on economic growth.
So we all know that the price of oil is important. Indeed, oil is far and away the world's most heavily traded commodity. And if asked the price of oil right now, the response would be “about US$85 per barrel”. Most appreciate that the “price of oil” is taken as that of West Texas Intermediate (WTI) crude as traded on the New York Mercantile Exchange (Nymex) in the form of futures contracts.
Why a futures contract price and not a physical price? Well that's because oil is heavily traded by producers, refiners, speculators and hedgers alike. Not all of these parties have the odd supertanker at hand to transport physical oil nor the capacity to store it. Physical oil might be the world's most heavily traded commodity, but the dollar value of oil traded as “paper” on the Nymex far, far exceeds the value of traded physical oil on any given day. Note that the same is true for gold and, increasingly more these days, metals and grains.
But when gold is traded on international markets the underlying commodity is a near 100% pure element. Gold is gold – end of story. Oils, on the other hand, ain't oils, as those old enough to remember know was once the iconic catch-cry of Castrol ads in Australia. The crude oil pumped from different locations around the globe is a blend of hydrocarbons and various impurities which vary from place to place. There is no one “oil”. There are in fact many.
I was recently listening to a discussion about the petrol price on the radio when a listener rang in and posed an angry and impassioned query as to why the price of oil in Texas should have anything at all to do with what's going on in Australia. The ingenuous implication was that we were all paying through the nose at the pump locally just because of those “bloody Yanks”. While misguided, it's still a fair question.
Australia does produce its own crude oil – out of Bass Strait in the Gippsland Basin which is known as Gippsland crude. But like America, Australia consumes a lot more oil than it produces. That's why, for example, the nightly ABC News broadcast will highlight the price of Tapis crude. The bulk of oil purchased by local refiners in recent times has come from Singapore, and in Singapore the “local” oil is Malaysian Tapis.
Which begs the question, if Australia is using Tapis why do we still accept that the “price of oil” is that of WTI in New York?
Well New York is where the futures exchange is, but the physical price of WTI is set at a place called Cushing in Oklahoma. It is here where pipelines from all across the American midwest – Oklahoma, Texas, Arizona etc – reach a storage hub. The price of WTI and its related futures contract is then determined in relation to the rise and fall of inventories at Cushing, juxtaposed with global demand. Of course, it's misleading to think that all of the world's oil is stored at Cushing, as we have discussed, because it's not. But while oils may not be oils, different crudes are sufficiently substitutable such that were the price of any one type of crude to get out of line with the others, substitution would ensure that price would quickly come back into line.
Some oils are nevertheless “light” and some are “heavy”, and some are “sweet” (low sulphur content) and some are “sour”. The global oil industry to a great extent was born in the American midwest, where the oil is sweet and light. This makes it a high quality oil compared to, say, some of the heavier Middle Eastern oils. But we note (a) that America imports the great bulk of its oil from the Middle east and (b) the US oil industry long ago shifted focus to the Gulf of Mexico where Light Lousiana Sweet crude (LLS) is found.
WTI was the first oil benchmark, and New York the world's financial hub. So we can basically blame history, convention, convenience, and a lack of significant variation among global crude oil prices as to why WTI futures traded on the Nymex provide the world's “price of oil”.
But there is a problem. WTI might currently be trading at around US$85/bbl but Brent crude is trading at over US$100/bbl. Brent is basically the world's “second benchmark” oil given it comes from the North Sea which is Europe's major source. Brent futures are also heavily traded, this time on the International Commodity Exchange (ICE). The pricing point for Brent is at Sullom Voe in the Shetland Islands, while ICE is headquartered in London.
Brent oil is not as light and sweet as WTI, so throughout history it has typically traded at a slight discount to WTI. But rarely do the two prices become anymore than a couple of dollars out of whack. Yet suddenly now they are around US$15 out of whack. That gap has grown rapidly from late 2010 and into 2011 and at present looks like blowing out even further. So unusual is this price differential that there is blood on the floors of trading houses which have assumed, as has always been the case in the past, that the gap must quickly close and a profit can be made from “arbitraging” the prices. Traders have quite simply been blown away.
What's happened? Well the first conclusion one might jump to is that Egypt has happened.
Egypt does produce its own oil, but its production is insignificant globally and compared to that of neighbours such as Libya and Algeria. Egypt is where the Suez Canal is located – the passage built by Europeans which allows cargoes, including oil, to be transported quickly from the Mediterranean to the Red Sea or vice versa without having to go the long way around South Africa's Cape of Good Hope. Egypt now controls the Suez Canal and charges a hefty toll for its use. Indeed, Suez Canal tolls are Egypt's largest contributor to GDP after tourism.
The fear has been that whoever assumes power in Egypt might block the Suez. This would cease the passage of oil cargoes from/to Europe and as such a supply disruption risk factor has been built into the European oil price – Brent – thus pushing that price well above WTI which never leaves America.
It seems a fair conclusion, but it's very wrong.
It is a fair assumption that unrest in Egypt and neighbouring nations has helped to push up the price of oil in general. But in terms of why Brent should suddenly be so much more expensive than WTI, this unrest is not the culprit. Firstly we note, as Barclays Capital points out, that (a) whoever claims power in Egypt would never be silly enough to close the Suez given its considerable cashflow generation; and (b) even if they were, the Suez has become a bit of an antique: today's oil supertankers are too big to squeeze through and as such most oil does actually go the long way around these days and very little goes through Egypt. Suez tolls actually make the freight cost comparable despite the greater distance and time required.
So the blow-out of the Brent-WTI spread is not a Suez effect. Indeed, it's got nothing to with Egypt nor anything to do with the supply of Brent. Realistically, Brent has not shot up to a premium over WTI, WTI has collapsed to a discount below Brent. Because it's not just Brent crude trading at US$100 while WTI trades at US$85. Tapis is also above US$100 and most tellingly, so is LLS crude from the Gulf of Mexico. All the world's major oils are trading above US$100 – the odd one out is WTI.
The irony is, it's all to do with Canada.
Back in the good ol' days when the midwest was America's primary source of oil, the oil mostly flowed north from Cushing – to Chicago and points beyond. But currently under construction is a pipeline that will bring oil all the way down from Canada and into the Cushing storage facilities. The tanks at Cushing rarely ever reach full capacity but rather ebb and flow with demand and supply. But as far as the market is concerned, when the Keystone pipeline starts pumping Canadian oil into the tanks, they'll be full to the brim.
Now recall that while there is an obvious geographical reference in the name “West Texas Intermediate”, the WTI price is that of oil at Cushing, Oklahoma, no matter from whence it hails. Gulf of Mexico oil is not sent to Oklahoma but to Louisiana which is why it's LLS. So even though the Canadian oil in question might be derived from shale or tar sands, once it's at Cushing it is WTI oil. And the price of any oil is deemed to be its price at that storage point.
And storage costs money. Indeed, the price of oil at any storage point represents the sum of the underlying value of that oil and its cost of storage. When inventories are low, the cost of storage falls. When inventories are high, the cost of storage rises. But given substitutability, once the oil leaves storage no one will pay too high a premium for one oil over another just because it had a high storage cost. So something has to give.
What gives is the underlying price of the oil. If the storage cost at Cushing has risen to high levels in anticipation that there will be little storage space left when the pipeline arrives, then the price of WTI crude, which is any oil at Cushing, must fall to compensate. And so it has. The discount in the WTI price does not mean there is an abundance of WTI, it just means there is a relative abundance (or will be it) at its particular storage location based on finite storage capacity.
So the simple reality is that the market is looking ahead to the Keystone pipeline's arrival, which is still a-ways off, and determining that WTI will be in oversupply in comparison to other oils. And that is why WTI is trading at an unprecedented discount to Brent, LLS, Tapis and other crudes.
Is the price discrepancy nevertheless justifiable? Well the jury's still out on that one. The bottom line is of course that were the price of different oils all about geography despite substitutability, then one could easily justify any variation in prices across the globe. A Dutch oil refinery, for example, can buy Brent crude from “up the road” but its a long slog to get oil delivered from the American midwest. So one might assume that US$100/bbl coming from the Shetlands can still be cheaper after freight cost than US$85/bbl coming from Cushing. But if that were the case, different crudes would always have traded with occasionally wide differentials.
They haven't. Between supertankers and pipelines and canals, there will always be another oil not too far away to buy if one particular crude is undersupplied and expensive, and production would soon be stepped up or reduced accordingly (look at OPEC's production quotas for example) to ensure that global oil prices can never get too distorted. And let's not forget that America imports the bulk of the oil it consumes each year from the Middle East, much to its chagrin, because local production cannot meet local demand. So no one will be buying WTI but Americans, thank you very much, and Cushing is centrally located for ease of national distribution.
So even if the current Brent-WTI spread does soon begin to contract once more, global oil analysts have largely reached the same conclusion – it is misleading to consider the WTI benchmark as the global “price of oil”. West Texas Intermediate is simply no longer relevant beyond the midwest of America and on the trading floor at Nymex where WTI futures have reigned for decades. Clearly the better choice for the global benchmark “price of oil” is Brent crude, given that is now also heavily traded as a futures contract and all other oils are trading in a tight price differential around Brent.
Indeed, Brent is far more relevant than WTI from Australia's perspective. Lack of availability of Tapis crude has meant more deliveries of Brent crude to Singapore in recent times which means Australian refiners are actually using Brent as well as Tapis.
The aforementioned caller to the radio who wondered what Texas oil has to do with Australia can now be silenced in the knowledge North Sea oil has everything to do with Australia.
So there you have it – WTI is dead. The current “price of oil” is not about US$85/bbl, it's about US$100/bbl and that cost is quickly impacting on global economic growth.
[Note: FNArena will continue to publish the overnight price of WTI futures in its price tables but will shortly publish the equivalent Brent price as the new benchmark, albeit we'll leave WTI there for the time being as a comparison.]
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.
