The West Texas Intermediate’s (WTI) discount to Brent has held steady as of late around $4-$5 per barrel, and remains around that level far out on both futures curves. But shifting dynamics in the U.S. market, mostly declining output and strong demand growth, are likely to lift WTI back to a premium over European marker Brent.
Shifting dynamics in the U.S. market, mostly declining output and strong demand growth, are likely to lift WTI back to a premium over European marker Brent.
Until the beginning of this decade, U.S. benchmark NYMEX WTI, for the most part, enjoyed roughly a $1.50-$3 premium to Brent, largely the result of the U.S. needing to trade higher than international prices in order to pull in the marginal barrel. This was necessary to meet demand for the world’s largest oil importer and demand growth market.
A string of changes in the global, and U.S., oil market altered the relationship between the two markers, giving Brent the price advantage. At times, the spread between the benchmarks has ballooned to more than $20.
There are a number of reasons why the premium flipped. First, the U.S. used to be the world’s biggest importer of crude, but it has been superseded by Asia, which is now the outlet for the marginal barrel, or the last barrel of oil needed to meet immediate demand. This shift is partly due to demand growth being strongest in the Asia-Pacific region, where Brent is used as a pricing benchmark, but also U.S. crude oil output increases slicing the need for imports in that market.
Second, WTI is a mid-continent crude, meaning it is “land-locked” and not easily transported to refineries. It also can’t be exported, for both logistical and legal reasons. Moreover, the spurt of shale growth in the U.S. Midwest has caused stock levels at Cushing, Oklahoma (where WTI is priced) to soar to almost 58 million barrels, or 30 million bbl above this time last year. This is keeping the U.S. benchmark depressed versus international prices, including Brent.
Third, Brent, closely linked to fundamentals in the North Sea and the wider global market, has also become a magnet for speculative investors and a barometer for geopolitical risk, trends that have overinflated the price at times.
U.S. supply to tighten as OPEC’s soars
Both WTI and Brent futures have bounced sharply off their lows of around $38 and $43, respectively, since middle of last week as a result of speculative plays and (questionably) bullish headlines, with the spread between the two remaining at $5. WTI, which traded at a premium very briefly earlier this year, has kept relatively close to Brent throughout 2015. Going forward, the overall direction of the oil market is very uncertain, but there’s more upside risk for WTI, setting the stage for the U.S. benchmark to overtake Brent again.
The main factor behind WTI’s resurgence will be underinvestment in the shale patch and declines in overall U.S. production. This is already occurring. Although U.S. shale producers have adjusted to the low oil price environment by cutting costs, becoming more efficient, and refracking wells, output is on the decline. And given the cost barriers for new participants and fracking new wells, underinvestment is a large risk going forward, undercutting expectations for supply growth.
In a note published this week, the Energy Information Administration (EIA) said that U.S. crude oil production averaged 9.3 million barrels per day in June, down .1 mbd versus May, while also revising estimates from earlier this year. For 2015, the agency pegs crude oil output at 9.36 mbd, with 2016 some .4 mbd lower as a result of weak prices.
With production trending downward, inventories will inevitably decline. While crude stocks should rise by almost 40 million barrels in 2015, next year will see a draw of about 16 million bbl. The inventory decline could even be sharper depending on U.S. fuel demand, which is currently on the rise. Besides the price outlook, there’s another big wild card for shale—interest rates. A Federal Reserve hike in interest rates could cut off producers’ access to capital and also make it more expensive to hold storage. In other words, the EIA’s supply and inventory outlooks could be too optimistic.
As the U.S. supply picture tightens into next year, the rest of the international market should stay the same, or loosen.
The tighter U.S. market could very well coincide with the global market becoming looser, also creating havoc with the spread between the two benchmarks. While U.S. output is set to fall by more than 4 percent, OPEC’s output is expected to hold steady—and may even increase depending on events in Iran and Iraq—and non-OPEC supply (excluding the U.S.) should continue to grow. And as U.S. inventories decline, OECD commercial stocks for crude and products are set to rise—for instance, the EIA says they will grow by 97 million barrels in 2016. In other words, as the U.S. supply picture tightens into next year, the rest of the international market should stay the same, or loosen.
A tighter U.S. market is already reflected in spot prices. Light Louisiana Sweet, a waterborne crude produced on the Gulf Coast, is trading only slightly under Brent futures, and more than $1 above the spot price for Dated Brent.
U.S. demand grows, while Asia takes a hit
The U.S. is one region that has seen a clear impact on the demand side from low prices. This trend is likely to continue, another factor tightening the U.S. market. Total refined product consumption is set to rise by .4 mbd this year, and another .2 mbd next, according to the EIA. The EIA’s forecast could end up being too conservative, given that an extended period of low pump prices and firm economic growth may lift demand to higher levels.
Other markets may not see the same reactions to lower prices. European demand remains on a steady decline amid stronger fuel efficiency and stagnant economic growth. Moreover, continued high fuel taxes give motorists less incentive to drive more, even when pump prices trend downward. Many consumers in emerging markets remain less exposed to changes in crude prices because of widespread subsidies—although some countries have taken steps to scrap them.
Against this backdrop, China will be key. Demand growth was an impressive .6 mbd in the second quarter, but it is certain to slow. With the country undergoing economic turmoil, demand growth could end up coming in lower than the expected 3-4 percent for this year and next. Any setbacks in Chinese demand would have more of a negative impact on Brent than WTI.
Geopolitical factors make no price impact
Tensions in oil-producing countries issues have made Brent an indicator of geopolitical risk and a more enticing investment vehicle for speculators. But geopolitical threats are not currently having an impact on prices.
One major factor lifting Brent over WTI in the past five years or so has been taken out of the market amid the current oversupply. Tensions in oil-producing countries issues have made Brent an indicator of geopolitical risk and a more enticing investment vehicle for speculators. But geopolitical threats are not currently having an impact on prices. When Libya’s 1.6 mbd of production went offline in early 2011 during the Arab Spring, Brent soared, eventually passing $120, lifting the premium to more than $20. This occurred again in 2012, when international sanctions against Iran isolated Tehran and limited its exports, sharpening the disparity between the two markets and again lifting the differential to more than $20. Last year, when ISIS took over large areas in Iraq, Brent shot up to $115 and held a solid $8 premium to WTI.
Physical fundamentals have now trumped geopolitical risk. Bloated inventories, an ongoing large surplus, the expected return of Iranian volumes, Iraq’s ability to keep production rising despite the war with Islamic State, and the Saudi strategy of favoring market share over higher prices will hold down Brent as the U.S. market tightens.