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The "spread" between Brent
and West Texas Intermediate (WTI) crude recently hit record levels. Here is
why it could go further.
Crude oil has been on a wild ride in recent months.
The current chart for West Texas
Intermediate (WTI) crude is in a downtrend, below its 200-day moving average,
as supply builds up in Cushing, Okla. (The point where WTI crude is
delivered.)
What some investors do not realize,
however, is that not all "crude oil" is the same. There are
different types of crude oil, trading on different price drivers.
The standard oil futures contract that
most of us know is based on WTI crude -- the stuff that flows into
Oklahoma. One might think of this as "American" oil, because WTI
crude delivery is centered in the United States.
But there is also "Brent"
crude, which represents the light, sweet stuff delivered to Europe and Asia.
And then there is "Dubai" crude, which is heavy and sour (harder to
refine) in comparison to other grades.
These crude types make a difference as
the "spread" between prices has been widening. It used to be that
Brent crude, which is largely delivered to Europe and Asia, only traded at a
small differential to WTI crude (focused on the USA).
Over the past year, though, the gap
between Brent crude and WTI crude has been getting larger and larger. With
WTI crude at $100 per barrel, Brent might be at $118 per barrel and so on.
The Brent-WTI oil spread -- representing that gap -- recently hit record
levels.
Above we can see how the Brent-WTI oil
spread has performed over the past year, by proxy of two ETFs, BNO and USO.
Via the descriptive website, the U.S.
Brent Oil Fund (BNO:NYSE)
is "a domestic exchange-traded security designed to track the movements
of Brent crude oil."
Meanwhile the U.S. Oil Fund (USO:NYSE)
is designed to "reflect the changes in percentage terms of the spot
price of light, sweet crude oil delivered to Cushing, Okla., as measured by
the changes in the price of the futures contract on light, sweet crude oil
traded on the New York Mercantile Exchange (the NYMEX)."
It should be noted that crude oil ETFs
have their own issues, and do not always track the spot oil price precisely.
But the general movements are faithful enough for BNO/USO to represent the
Brent-WTI spread.
What this means is that an investor
could buy BNO (the Brent ETF), sell USO (the WTI ETF), and effectively be
"long" the spread -- or go vice versa.
Why has the Brent-WTI spread widened
so much in the past year? We can look to three basic reasons:
·
Supply tightness in Europe and Asia
·
Greater global demand relative to U.S.
demand
·
The Middle East fear premium
Remember that Brent crude primarily
serves the rest of the world (Europe, Asia etc.), while WTI crude is more
focused on the United States.
Even though crude oil is a global commodity that can
be shipped across oceans, this makes for a difference in how the various
grades are priced. With greater supply tightness in Asia and parts of Europe,
even as supply at Cushing builds up, it makes sense for the price
differential to spread.
Another key element of the story is
greater global oil demand in general. A key feature of the
"decoupling" story is the United States slowing or stalling as
developing world nations power ahead. That story is
naturally bullish for Brent, more global in its delivery scope, and less so
for WTI (which is more U.S.-centric).
Finally, consider who gets hit hardest
by a major disruption in the flow of Middle East crude -- the "fireball
in the desert" scenario.
In the event that the Arab Spring
leads to heavy clashing, or the simmering Saudi Arabia/Iran conflict boils
over and leads to open military strikes, the price of Brent and Dubai crude
would skyrocket, as the primary consumers of Brent crude supply would find themselves in a panic.
The price of WTI crude would shoot
higher too, of course, as crude oil is a global commodity. But WTI
would likely not rise as much, causing the spread to widen further.
The upshot is that buying the
Brent-WTI oil spread is a bet on emerging market decoupling (particularly
Asia) and an insurance hedge against the Middle East fear premium.
Those who expect Asia's growth to slow
down relative to the U.S., on the other hand, or who think Middle East
concerns are overblown, might look to sell the Brent-WTI spread rather than
buy it (on expectations the spread will narrow).
Such would
be a risky play, though, as "headline risk" -- the possibility of a
terrorist attack on a major Middle East oil facility for example -- points in
the other direction. A wider Brent-WTI spread may be with us for a while, and
is worth keeping an eye on.
Justice
Litle
Taipan
Publishing Group
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