INSIGHT: Brent-WTI gap could persist until 2012

21 January 2011 18:05  [Source: ICIS news]

By Giovanni Coiro

LONDON (ICIS)--The price gap between Brent and WTI crude front-month contracts, now at more than $7/bbl, will persist through 2011 and possibly into 2012, analysts believe, because of the structural differences between the two markets.

Only minimal tightness on some grades in the North Sea cannot explain the differential and there are clearly other factors at work, both structural and physical.

While WTI is closely linked to the US economy it cannot be shipped out of Cushing, Oklahoma, the price point for the marker crude.

By contrast, Brent can be moved to Asia or the US, which reduces the influence of the European economy on the market.

“The persistence of several factors contribute to making a Brent premium over WTI more the norm rather than the exception, at least for 2011 and potentially 2012,” BNP Paribas analyst Harry Tchilinguirian said in a research note on 18 January.

Persistent oversupply at Cushing, and the differences in supply and demand dynamics compared to the Brent market, have resulted not only in a drop in the WTI futures curve relative to Brent but a clear difference in the steepness of the contango structure between the two markets.

While the Brent forward curve remains flat, the WTI curve is much steeper.

Currently, the front month March contract for Brent is trading around $0.07/bbl lower than the April contract, while on WTI the March contract is $1.45/bbl lower than April.

In the futures markets, an oversupply of the underlying commodity leads to a widening contango of the futures curve: the oversupply of WTI at Cushing is causing this scenario in WTI futures.

“While US crude oil inventories have regularly declined, mainly on the Gulf Coast, those at Cushing bucked the trend in December and climbed higher,” Tchilinguirian says.

Because storage capacity at Cushing is constrained and because crude at the hub is landlocked any surplus material translates into a steeper contango.

And the situation has been exacerbated in the past couple of years by upgrades that have given refineries a greater ability to refine heavier crudes.

The Keystone pipeline being built by TransCanada and set for first half 2011 start up will be another factor in keeping Cushing oversupplied.

TransCanada is set to build a pipeline to take crude from Cushing to the Gulf Coast which could solve the oversupply situation, but that will take time.

“The second phase of TransCanada’s Keystone pipeline expansion is reportedly to begin service this quarter, delivering more Canadian oil directly to Cushing. A further extension of the pipeline to the Gulf Coast is still some time away, so without geographic ‘optionality’, the potential for episodic supply surpluses remains intact, as does the contango and/or weakness relative to Brent,” Tchilinguirian says.

Another factor that can explain the price diversion is the higher demand for North Sea crude from outside Europe, particularly from Asia, as opposed to landlocked demand for WTI.

At the same time the different contango structures have led investors away from WTI to Brent to reduce their negative roll-yield.

A negative-roll-yield is the loss an investor incurs in a contango market when selling the expiring front-month and buying the next month's contract.

As the forward months in the WTI market are much higher than the front-month when compared with the Brent market, investors lose more money rolling their contracts when the front-month expires than would otherwise occur in the Brent market, which is less steep.

The difference in the two markets could prompt investment flows to shift away from WTI to Brent, resulting in the Brent front-month contract trading higher.

But in contrast to the WTI structure, the Brent forward curve is structurally relatively flat.

This can be explained by the difference in demand dynamics in the Brent physical market and the decrease in oil production in the North Sea.

A physical trader in the North Sea market this week noted that there is no shortage of crude to explain such a difference between WTI and Brent.

In its monthly oil market report in January, OPEC forecast oil supply from Norway down 80,000 bbl/day compared with last year to an average of 2.06m bbl/day.

UK total oil production has been estimated by the International Energy Agency at 1.35m bbl/day in the fourth quarter of 2010. It forecasts average output of 1.37m bbl/day in 2010 and 1.32m bbl/day in 2011.

With changes in supply in WTI and Brent crudes expected to continue for the foreseeable future, coupled with investment money flows adjusting to these changes, the differential between the WTI and Brent futures markets is expected to persist.

Read Paul Hodges’ Chemicals and the Economy blog
Read John Richardson and Malini Hariharan’s blog - Asian Chemical Connections
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By: Giovanni Coiro
+44 20 8652 3214

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