West Texas Intermediate versus Brent Crude Oil Prices: Why is There a Disproportionate Difference?

Brent vs. WTI Chart 2000-2012

(Editor’s note: I originally wrote this article as an academic report for my Technical Writing class for the Fall 2012 semester. I have modified it slightly to fit the format of this website, as some information was not relevant to the article. Since it pertains to every driver out there, I felt that it was important to have my readers aware of what’s going on in the oil industry.)

 

In February 2011, a price anomaly occurred on the oil futures contracts market that changed the course for the foreseeable future: the price difference between two different grades of crude oil, the West Texas Intermediate (also referred to as Texas light sweet, indicating the type of crude oil, as well as WTI) and Brent Crude (also known as London Brent or Brent Blend; both will be referred to as WTI and Brent Crude throughout the course of this report, respectively) began to increase. Normally, the price difference between the two markets will be around 1-2 USD (United States Dollar(s)/barrel: other times, the prices will essentially mirror each other. However, since February of last year, the price difference has continued to grow, and has been in favour of Brent Crude.

The WTI is used as a benchmark in determining the future oil prices in the Midwest and Gulf regions of the United States. It is also the underlying commodity of the Chicago Mercantile Exchange’s oil futures contracts, and trades on the NYSE (New York Stock Exchange). Because of its relatively low density (it has an API gravity of 39.6, and a specific gravity of .0827), as well as containing a sulfur content of .24%, it is classified as a light sweet grade of crude oil (also making it a high quality fuel). WTI is also refined primarily in the Midwest and Gulf regions.

Its contemporary on the oil futures contracts market, Brent Crude, is a major trading classification of light, sweet crude oil comprising of the following crudes: Brent Blend, Forties Blend, Oseberg, and Ekofisk crudes (this is also known as the BFOE Quotation). This particular type is produced primarily from the North Sea. Originally, this was being produced from the Brent oilfield. The name itself, Brent, was derived from the naming policy of the Shell UK Exploration and Production, which operated on the behalf of the ExxonMobil and Royal Dutch Shell energy companies, which would name its fields after different types of birds: in this case, this field was named after the brent goose. Moreover, it is also an acronym that indicates the formation layers of the field: Broom, Rannoch, Etieve, Ness and Tarbat. Brent Crude trades on the Intercontinental Exchange (also known as ICE). Although it is also known as a high quality fuel, its sulfur content is slightly higher than WTI (.37%), but still lower than many of the crudes on the market.

As stated before, the difference in trading oil prices between WTI and Brent Crude are usually very close to each other. However, in February 2011, the closing oil prices of both futures contracts differed greatly. More specifically, on Monday, February 21, 2011, the WTI closed at 95.40 USD/barrel, while the Brent Crude closed at 102.52 USD/barrel. This date is significant in the fact that this was the first time that the price difference between the two indexes was greater than 10.00 USD (this occurred during intra-day trading). This price difference has continued to this day. The main reasons that have been cited was because of the Arab Spring, increasing demand, transportation bottlenecks, debt crisis, strategic petroleum increases, and a supply surplus. The following paragraphs will to break down each reason, citing specific facts.

Arab Spring: This affected the closing price of the Brent Crude, more so that the WTI . The Arab Spring and the civil war in Libya joined forces to cause volatility in the oil futures markets during the first half of the year. Closing prices for Brent Crude quickly escalated when protests in Libya intensified in late February. The spot price of Brent increased $15 per barrel afterwards, as the market attempted to adjust to the loss of 1.5 million barrels per day (bbl/d) of exports from Libya. Coupled with the low spare production capacity, this sudden supply loss challenged the ability of the Organization of the Petroleum Exporting Countries (OPEC) producers to provide incremental supplies to an already tight market. As it stood then, OPEC was already satisfying contracts for existing customers, with little room to adjust (due to keeping an oil supply that was barely above the minimum).

Increasing Global Demand/Decreasing Local (American) Demand: As emerging countries such as China and India began to socially accept spending their wealth on automobiles, and to work on their transportation infrastructure respectively, the demand for gasoline increased dramatically. Conversely, due to the combination of what economists have called the worst recession since the Great Depression, as well as the increase in gasoline prices, contributed to a lower demand from the United States, the leading consumer in the Organization of Economic Cooperation and Development (OECD). In addition, the prices of other high-quality international crudes, like Nigerian Bonny Light and Algerian Sahara Blend, have aligned themselves more with Brent as they pulled away from the WTI. The result of these opposing forces has created a disproportionate difference in daily closing oil prices.

Transportation Bottlenecks: Brent’s price strength was not matched by WTI, which became isolated from the global crude oil market due to oil companies, in conjunction with the American government, being unable to successfully find a viable solution to their ongoing transportation bottleneck issues in the U.S. Midwest. Despite the ever-increasing crude oil production from the Bakken Shale formation and Canadian oil sands, prices for U.S. inland crude benchmark WTI weakened relative to those of broadly traded coastal or imported crude oil grades. The companies’ ability to revisit previously unattainable oil reservoirs in places such as South and West Texas have not positively contributed to this ongoing issue. As a result of these factors, a surplus in the oil supply was created in the WTI’s holding area, located in Cushing, Oklahoma. This surplus continues to grow daily, as data shows that stocks at Cushing remain 37% above their 5-year average at 37 million barrels. At the same time, refineries are processing crude at only 88% utilization rate (1.4% below their historic average), as they await new pipelines to export crude out of the region. American politics has delayed construction of the needed additional refineries and pipelines to export the crude oil to other markets.

Debt Crisis: The (still ongoing) European debt crisis loomed large over the global economy, and expectations for economic growth globally, especially in the OECD economies (as mentioned in the Increasing Global Demand/Decreasing Local (American) Demand section), were not realized over the course of the year. This resulted in a lower-than-expected growth in demand for petroleum products for both markets. This is another major contributor to the ongoing price difference.

Speculative Reasons: As much as supply and demand issues play a huge part in the spot and closing oil prices for WTI and Brent Crude, the stock market plays an equally important role. Investors seeking out any potential opportunities to increase their investment on returns have flocked to the oil futures market, which suddenly became popular as an investment class in Europe. This also became popular in the United States as well

What has led to the increased price/price difference is when the U.S. Commodities Future Trading Commission (CFTC) started enforcing wash sales rules. In the futures world, a wash sale is a sale where the buyer and seller are essentially the same entity. This has been going on for many years, with numerous countries with national (re: government owned) oil companies also set up sovereign (also government owned) investment funds in the US. What do they invest in? Oil futures.

The Commodity Futures Trading Commission publishes a weekly activity report on oil trading that occurs on exchanges (e.g., NYMEX), the Commitment of Traders Report. In this report, the activities of multiple trading categories are detailed, including physical participants (producers, merchants, processors, and end users), money managers (usually hedge funds or other sophisticated traders), and swap dealers (traditionally investment banks or commodity broker/dealers). This allows them to keep tabs on the futures market consistently, and they are able to adjust the amount of money invested accordingly.

The reasons why there is a disproportionate difference in the daily closing oil price between the WTI and Brent Crude are many, from numerous conflicts in Africa and the Middle East, to increased global demand and concurrent decreasing demand in America. Combined with the ongoing debt crisis that has afflicted the United States and Europe, America’s inability to export their oil supply surplus out of Cushing, Oklahoma, and investors manipulating the stock market, have led to, and keep the price difference going today. Unfortunately for the end consumer, this price difference continues to increase, causing among other things, a premium in gasoline prices

So, what’s keeping this price difference going? Despite the fact that more oil is being produced at a lower price, and then sold and delivered (exported) at a higher price, despite the aforementioned reasons, is not an adequate explanation for the price discrepancy. There is a very sound fundamental economic principle that most industries tend to adhere to, in that goods that are similar in nature, or in this case, almost exactly the same grade of crude oil, and easily transported should sell for a similar price, even if the fundamentals of local supply and demand differ across regions. The economic force that ensures this is arbitrage.

Whenever price differentials emerge, there are very powerful monetary incentives for anyone to buy in the market where the price is low in order to sell in the market where price is high. Generally speaking, the motives behind maintaining this are negative in nature: the consequences of such actions may devastate the global market.

Leave a Reply

Your email address will not be published. Required fields are marked *