From the October 01, 2011 issue of Futures Magazine • Subscribe!

A tale of two crude oil markets

On the other hand, oil inventories in the rest of the world slowly have been moving toward normal to even below normal levels in some regions. Consequently the market has looked to Brent as a more valid marker for crude that is representative of the global crude oil supply and demand balance. On top of this evolution the world lost Libyan crude oil production because of the civil war, at the same time as unrest heated up in Nigeria resulting in further losses of high-quality crude oil. In addition, the normal maintenance season in the North Sea over the last several months has resulted in an underperformance of North Sea production. As a result, the premium in Brent has gone pretty much viral (see "Premium vs. regular).

As we entered September, the October Brent/WTI spread traded at an all-time high of around $27 premium of Brent over WTI. The spread has been in a relatively steep uptrend since late spring/early summer when Libya, Nigeria and North Sea issues started to work into the equation. Prior to that the spread was settling into a trading range of between $8 to $12 premium to Brent predominately driven by the growing surplus of crude oil in PADD 2. So the last $15 or so is related mostly to the non-WTI factors mentioned above. Interestingly, since early April crude oil inventories in PADD 2 have been in a destocking pattern and actually have declined by about 10 million barrels. They now are back to about where they were toward the end of 2010 when the Brent/WTI spread was trading between $4 to $6 premium to Brent (before Libya).

So how do we trade this spread going forward? With extreme caution. The spread may look toppy and trading at a very overvalued and unrealistic level, but it remains in an uptrend, and as such you can only respect the trend until proven otherwise. There was a temptation to sell the spreads at the end of August when the Gaddafi regime was toppled, but as you can see there was no massive convergence in the spread as some had suspected. The fundamental factors to watch are: A return of a substantial amount of Libyan oil, stability in Nigeria and a return to normal production levels in the North Sea. Some combination of these will be the trigger to send the spread into a downward corrective move.

Dominick A. Chirichella is president and founder of Energy Management Institute: www.energyinstitution.org. He can be reached at dchirichella@mailaec.com.

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Dominick A. Chirichella

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