Middle East Economic Survey
VOL. L
No 38
17-
OIL PRICES
WTI-Brent Decoupling: A Different Perspective
By Mohammad Sadegh Memarian
The author is Head of the Petroleum Market Analysis Department, OPEC Affairs & International Relations, Iranian Ministry of Petroleum. This analysis is based upon the personal opinion of the author and does not represent the official view of the Ministry. The author is contactable at msmemarian@yahoo.com.
The recent riddle regarding temporary distortion of WTI, a leading crude oil benchmark, which not only affected the US oil market but also the world oil market, has drawn the attention of oil market analysts. This kind of temporary distortion, which resulted in reversing the relative value of a crude oil price compared with its normal position in the international oil market is not a new phenomenon. Market participants have experienced in several occasions such unusual price movements. But, what is interesting in the case of the WTI-Brent reversal was its duration, starting at the beginning of 2006 and intensifying through April 2007 on the back of supportive refinery outages in the Cushing hub, before the usual WTI-Brent relationship was re-established.
Several articles have addressed WTI-Brent decoupling, and arrived at similar conclusions about its causes:
The logistics bottleneck at
the Cushing, Oklahoma hub or more generally in PADD II.
Reversal of the Enbridge
Spearhead pipeline since March 2006. Historically the direction was
south-north, but now delivery is from Chicago to Cushing.
A flood of Canadian crude oil via the Enbridge pipeline to Cushing, amid recent refinery outages (of Valero’s 170,000 b/d Mckee and Conoco Phillips’ 145,000 b/d Borger), resulted in excessive stockpiling at Cushing, and consequently downward pressure on the WTI price.
Before proceeding a number of issues need to be discussed:
First, the shut-in of nearly
500,000 b/d of Shell’s light-sweet Nigerian Forcados crude would not
normally weaken the WTI respective position to Brent, and instead efforts to
keep open the transatlantic arbitrage window would see WTI strengthened.
Generally speaking from a global light-heavy balance (GLHB) point of view,
light crudes (including WTI) would be better off compared to heavy grades,
since the overall position of light crudes had been strengthened compared to
other grades.
Secondly, it is argued that
by reversal of the Enbridge pipeline, the flood of Canadian crude oil to the
Cushing hub caused stockpiling, which the early inventory data by the EIA
also supported. But the dominant Canadian crude stream to Cushing is mainly
Western Canada Select (WCS), a heavy grade; its differential to the lighter
Canadian crude Edmonton (which is similar grade to WTI) before the pipeline
reversal was as wide as $35/B in February 2006.
Interestingly, after the reversal, the differential narrowed again to an
average of $23/B for 2006, compared to $25/B in 2005. Needless to say a
fluctuation of one cent in its price amounts to millions of dollars in
income fluctuations. Given that WCS is priced with respect to WTI, this flow
should transfer the said differential to the Cushing hub or alternatively,
based on the GLHB principle, result in WTI strengthening. But according to
available data, the WTI-WCS differential for 1Q07 was $16.46/B, compared to
$28.76/B in 1Q06. This clearly indicates that WTI was under-priced with
respect to WCS.1
Thirdly, there is the status
of the Cushing refineries which are mainly designed for light crude similar
in grade to WTI. Because of this, the substitution of heavy WCS during
outages would be more expensive due to higher refining costs and naturally
lower margins compared to WTI. Therefore, based on this reasoning, the
aforesaid refinery outages not only should not weaken WTI but also should
support its price. The counter argument for the above statement is that the
persistent steep contango in WTI has caused inventories to be built up in
anticipation of higher prices in the future. This reasoning ignores the
different patterns normally associated with futures markets, and the fact
that the WTI contango occurred after the inventory build-up in the region.
This phenomenon will be discussed later on.
Fourth, the higher refinery
margins of WTI for the second quarter, which hiked to $24.68/B, is
comparable to a similar crude like Light Louisiana Sweet (LLS) which showed
margins of $16.61/B.2 This contradicts the normal oil market
pricing system, because it should lead to higher WTI prices in order to
compensate for higher margins in the product market.
Last but not least is the historical full integration of the crude oil market. The evidence of a smooth functioning of WTI since its adaptation as marker crude by Nymex in 1983 is a good example. Full integration of the oil market, based on its transparency and transitivity, likens it to the well known Pascalian law of “communicating vessels”. It is correct that any shortfall in Nigerian light crudes should support the Brent prices, but such distortion should quickly be covered by adjustment in the physical market. Because, if the transatlantic arbitrage window is closed for WTI-Brent trade, the Canadian western refineries could act as intermediary point for Brent exports, with Canadian crudes instead being exported (to the US). In this way corrections in the international oil pricing system and consequently in the physical market should take place. Since prices of different crudes in different regions dictate to which destinations crude oils should be exported, unless and until, there is a problem of strong manipulation. The recent situation of discounting WTI to Brent implied the flow of crudes to be reversed in the Atlantic Basin, if not for WTI, since it is a land-locked crude, but for related or importing crudes to the US, eg LLS. Of course this situation has been corrected by the LLS pricing system, which has overpriced with respect to WTI, and acted as a gauge for US crude oil imports instead.
The riddle still persists, even though all evidence is in favor of WTI. But during the course of distortion, the oil market was faced with a weaker WTI compared to Brent, a situation which is exactly opposite to its normal quality setting in the international oil market. This was in spite of the fact that Brent’s real value has been questioned by market participants due to the inclusion of a relatively inferior grade-Buzzard in its pricing formula, and because of diminishing production of WTI. While WTI is in a steep Contango, and only recently flattened out, the strong rise in prompt ICE Brent also led to the futures price curve flipping toward backwardation. At this stage, it may be concluded that under the current circumstances the oil market was in turmoil with relatively high prices. Hence there may be no choice but to resort to non-fundamental factors for a possible solution (see Graph).
Equilibrium Condition
Non-fundamental (geopolitical) factors reflect the political circumstances (PCs) under which the oil market operates. Of course any escalation or de-escalation of ongoing PCs will create an oil crisis and consequently destabilize the oil market. As a result, the existing market equilibrium will be affected: any changes of the PCs will affect the oil market equilibrium in two ways:
First, where a physical disruption in the supply stream has occurred there will be a need for physical excess supply to fill the gap. This excess supply can only be obtained through the existing inventories. One assumes that existing oil streams have been fully allocated; for if there was excess capacity, then there would not be a crisis. The 1991 Gulf War was a good example: some 2mn b/d released from the SPR helped to calm the situation.3
Second, when there is a possibility of interruption in the oil stream, the dilemma is to decide what level of strategic inventories feels comfortable, and also compatible with the ongoing international political order. In other words, if the ongoing condition is going to change, the required level of strategic inventories will change accordingly. The best example is the condition of the post-Cold War Era. In the early 1990s, the huge strategic inventories flooded the market, the climax of which was the price collapse of 1994.4 Therefore, a second type of crisis implies that under the given market equilibrium with fundamental factors intact, any relaxation or escalation of the ongoing PCs, will result in either stock overhangs or signals for further stockpiling, otherwise the prices will start to drop or increase, as the case may be.
Contango/Backwardation
The movement of prices based on Con/Bac conditions differs more under normal conditions than during crises. In normal conditions, the effect of Con/Bac on the inventories is based on the level of prices. In backwardation where current prices are higher than future ones, everybody sells inventories to gain higher prices. In contrast, market expectation in contango implies that future prices will be higher than present ones, so everybody tries to stockpile for future gain. In this way both conditions will lead to an adjustment of the market and restore the equilibrium. But you have an inventory levels overhang, irrespective of the price level, then all things being equal, this will put downward pressure on the prices. Not surprisingly, inventory overhangs can be created in either condition, when a semi-relaxation or a downward revision in the existing political tension takes place. The new compatibility of the existing precautionary inventories, in spite of a downward shift in equilibrium price, will result in an idle stock. The phenomenon is akin to "just-in-time" management.5
Conclusion
After recent events it may be concluded that the price of WTI appears to be determined independently of the existing market fundamentals. If so, then what does the price of WTI indicate? It becomes clear that in the price structure of marker crudes, two sources of influences can be recognized; first, the fundamental factors, the effects of which stem mainly from supply/demand issues. Second, the non-fundamental factors, the effect of which stem from geopolitics.
It has been shown that the price movements of WTI were totally opposite to the most influencing fundamental factors in the oil market, especially in the first half of 2007. It means there should be some powerful non-fundamental factors that not only have neutralized the supportive effects of the fundamentals, but also have pushed the price of WTI down such as its price fall in a discount to the Brent. This process began in early 2006. The prolonged discrepancy of WTI prices with its historical normal setting obviously is an indicator of changes in the non-fundamental factors.
It was discussed before that with given fundamentals, any relaxation or downward revision in real political circumstances will change the status of the oil market equilibrium. The change will be brought about by a shift in the market equilibrium price and the creation of stock overhangs. In turn, the created stock overhangs will reinforce the downward pressure on the oil prices. The continuity and extent of the pressure depend on the degree of political relaxation and the respective stock overhangs. The required stock overhangs to keep the WTI price at the current levels for the intended period should amount to at least 300mn barrels. This is comparable with 4-5mn barrels quoted by analysts for the excess inventory built up at Cushing, where inventories reached 27mn barrels in the first week of April, based on the EIA information.6 The secrecy of the actual figures of the strategic inventories, which in the past has been addressed by the OPEC as missing barrels, leads to this kind of confusion in the marketplace.
However, the second relevant question would be why this pressure on WTI with a flattened forward curve does not transfer to the Brent price structure, which currently has been deeply backward dated. With an answer to this key question, the pieces of the puzzle begin to fall into place. If it is true that any distortion in the oil market equilibrium prices could be brought about by distortion in the geopolitics, then theoretically, the reverse should be true as well. As a plausible answer, it means that the differentiation in the political setting on both sides of the Atlantic Basin, has resulted in differentiation of the oil market equilibrium prices on both sides.
Then, the third relevant question would be: why is the Brent price regarded as more transparent than WTI, with all the market players following it? It is simply because consumers in the east of the Atlantic Basin value Brent at that price, and naturally producers also will follow the higher priced benchmark. Now, in spite of all external price pressures, not only through US local crudes like LLS, but also through international crudes like WCS, WTI is still surviving and will continue to do so, at least in near future, which shows its power as a marker crude, with proper price structure, reflecting both fundamental and non-fundamental factors as well. The linear forward curve of WTI and Brent shows that the WTI forward curve dominated that of ICE Brent, whether in backwardation or contango (see Graph).
However, the normal differential between WTI and Brent and consequently normal oil market conditions, could be restored if a homogenous geopolitical order was restored. In this case, as happened very recently, either Brent should follow the new WTI price structure or, vice versa. Otherwise, this differential will persist as a monthly survey of 34 analysts predicted.
1. EDGAR Online – ENCANA Corp Form: 6-k- Filling Date: 30 April 2007.
2. The Oil Spot News, “Marathon eyes Jump in Q2 Refining Margins- Switches to LLS”, 31 July 2007.
3. MS Memarian, “The Crude Oil Market Mechanism In The Light Of 1990-91 Price Crisis, OPEC Review, Winter 1992.
4. MS Memarian, “Geopolitics And The Oil Market: Post Cold War Era”, IAEE Prague Conference June 2003.
5. MS Memarian, “How Just-In-Time Management Of Crude Oil Stocks Can Affect The Markets”, MEES, February 2001.
6. Bassam Fattouh – “WTI Benchmark Temporarily Down – Is It really a Big Deal?”, MEES, 14 May 2007.
WTI 2nd Minus 1st Month Versus Brent 2nd Minus 1st Month