Probably the most closely watched spread in the commodity universe is that between Cushing, OK-based West Texas Intermediate (WTI) crude oil, and the North Sea-based Brent crude oil. The relationship between the two largest benchmark prices for global crude oil was historically very tight, with Brent typically trading a few dollars below WTI. In 2010 the balance shifted dramatically, Brent crude skyrocketed relative the WTI, and what was once a sleepy spread market became extremely volatile (Chart 1). It is important to note that this was not a case of European or world oil prices rising relative to U.S. crude, as most benchmark prices, both globally as well as in the U.S., kept pace with Brent. The widening of the WTI-Brent spread was the direct result of a large buildup of supplies in landlocked Cushing, OK, which was unable to reach the global market, and therefore began to trade at a discount.
Supplies in Cushing may have been the cause behind the expanding spread differential. However, the supplies themselves were merely a symptom of a much larger structural shift in the U.S. crude market that will most likely have a pronounced effect on domestic supply and by extension on world prices for years to come. Technological advances that were initially developed to extract natural gas from shale deposits (and have since depressed domestic gas prices, Chart 2), were applied to so-called “tight oil,” allowing domestic production to surge over the past few years.
The greatest successes have been found in the Bakken Shale in North Dakota, where only five years ago, crude oil production was hovering around 100,000 bpd and was on the decline. It has since grown to more than 715,000 bpd, which is roughly equal to the production of OPEC member Qatar. Altogether, domestic production of crude oil in the U.S. has soared, reaching levels not seen since the early 1990s (Chart 3).
Since the beginning of February, the discount of WTI to global prices has fallen quickly, primarily because of changes in pipeline infrastructure that has brought cheaper mid-continent crude oil to the U.S. Gulf coast. The Seaway pipeline was reversed in May 2012, and now moves crude oil out of Cushing into the Houston area. However, the volume was expanded only in January of this year, and in February it transported an average of 272,000 bpd. By this time next year, they expect the pipeline to be moving 800,000 bpd. Despite U.S. crude inventories reaching record highs, supplies in Cushing have been on the decline since the Seaway reversal. Balance is slowly being restored to the crude market, and the WTI-Brent spread looks set to return to its historical equilibrium. But that is unlikely to last for very long.
Similar to the exponential growth of tight oil production in the Bakken shale, the Eagle Ford shale in Texas has experienced tremendous growth over the past few years. Even in 2009, production from this unconventional source of crude was virtually non-existent. By 2012, though, more than 350,000 barrels per day were being extracted. This has displaced much of the remaining light crude imports into the Gulf. As of the end of 2012, the U.S. was importing only about 500,000 bpd of light crude (many of the refineries invested substantially to process heavier grades) into Gulf Coast refineries, and imports are falling fast.
Assuming trend-line growth in Eagle Ford production, and an increase in flows from the Seaway pipeline, WTI may be escaping one oversupplied market into another. This time, however, the differential will be spread across a wider base, and the adjustment to higher supply will have a broader effect.
Until now, the discount to Brent has been confined to WTI and a handful of other local markets that lack sufficient transport capacity. But with the glut of supplies spreading to the Gulf, benchmark Louisiana Light Crude (LLS) may soon start trading at a discount to Brent as well, which until now has not happened (Chart 4). This would be significant, as it would be an arbitrageable link between inland tight oil production and the world market.
We have held a long-term bearish view on crude oil, inspired in part by the large-scale exploitation of unconventional sources. Shorts should be cautious, however, because of the constant risk of a military standoff with Iran, which could disrupt as much as 40% of the world’s seaborne crude that passes through the Strait of Hormuz. There are several strategies to protect yourself from temporary disruptions, including options and spreads.