WTI/Brent convergence?

US production may change energy landscape

The United States has become the world’s top oil producer, passing Saudi Arabia and Russia to take the title. Owing in large part to the surge in hydraulic fracking production out of Texas and North Dakota, the United States is extracting 8.5 million barrels of oil per day. Taken together, the two states are equivalent to the world’s fifth largest oil producer.

Perhaps a bit of an understatement but this added production capacity is directly relevant to the WTI and Brent crude oil futures contracts. To date, supply-side changes such as the ones that we are currently seeing in the U.S. oil industry have presented market participants with valuable trading opportunities in the WTI/Brent spread. Since this will continue to be the case in the future, understanding some of the factors that tend to move the spread is important for anyone looking to capitalize on changing energy prices.

Source: AEI

U.S. Public Policy

Last month, there was buzz going around that the United States would be lifting its ban on exporting crude oil. If realized, this policy change would produce ripple effects that could be felt throughout the world. The availability of cheap, high-quality U.S. crude oil globally would have a leveling effect on oil prices around the world. On a side note, as matters stand right now, gas prices at domestic gas stations are not exclusively tied to what happens in the domestic crude oil markets because the United States both imports and exports gasoline. It is cheaper to import surplus gasoline from Europe than to ship it from Texas by tanker. So gasoline prices here are not only driven by the domestic crude oil markets but global gasoline prices also. Instead of lifting the crude oil export ban outright, the U.S. Commerce Department gave two companies: Pioneer Natural Resources Co. and Enterprise Products Partners LP, permission to export a type of ultra-light oil known as condensate to foreign buyers who, in turn, can convert the product into gasoline, jet fuel and diesel. While this leaves the ban in place, the Obama administration still set an important precedent with this decision, allowing energy companies to start chipping away at the long-time ban on selling U.S. oil abroad.

On a related note, the explosion of energy production in North Dakota and Canada’s Alberta oil sands has the potential to support U.S. energy consumption in a significant way. It is difficult to overstate the project’s importance. Despite the U.S. current status as the world’s leading oil producer, the country’s insatiable appetite for energy means that the country is still forced to import some 7,500 million barrels of crude oil per day, including Mexico and Venezuela. A successful implementation of the Alberta oil sands project might mean less reliance on less stable countries such as Venezuela and Saudi Arabia, intensifying ties instead with our Canadian friends to the north. For now, the project remains stalled as policy makers weigh up economic benefits with environmental damage, as they have been for the past seven years. There’s news also of Canada exploring other ways of shipping its oil: a project known as the Northern Gateway is focused on exploring how oil could be sent to British Columbia from Alberta, and eventually on to Asia. While this is not a done deal, it certainly is something to keep an eye on.

Bullish Factors

There was a time when a disruption in a key oil-producing state like Iraq such as the one we have seen recently would have sent crude oil prices through the metaphorical roof. This time around, crude oil surged by $5 to reach an interim top of $107 when ISIS attacked key targets in Iraq. While the situation in Iraq remains fluid to say the least, the markets have kept their calm by and large. On July 10, WTI’s August contract(NYMEX:CLQ14) returned to a low of $101.55. Certainly geography has something to do with this; most of Iraq’s oil fields are located in the country’s south, remaining untouched thus far. While extremely volatile and unpredictable, geopolitical disruptions in oil-producing regions can present trading opportunities if managed properly in terms of risk. Brent has a tendency to outperform WTI in reaction to geopolitical conflict since it is purchased more widely around the world.

Bearish Factors

On the flip side, Libya is going through the process of re-opening two of its oil fields. Sharana, Libya’s largest oil field, re-opened on July 9 and may reach full capacity by the time this article is published. The impact of these two ports coming back online will put downside pressure on both Brent and WTI Crude oil prices, with Brent poised to drop in value faster than WTI. Once the markets have priced in this increase in supply, attention will shift to the questions of how long Libya will be able to keep these fields open and at what level of production they will operate.

For the next two years, I believe there will be a leveling of WTI and Brent, and we may see the two products re-visit parity. With the forces of globalization still firmly in place and U.S. production capacity increasing, I think it is only a matter of time before this spread reverts back to zero like it did in 2000. Should the U.S. government decide to go ahead with the Keystone Pipeline, we may see this happen sooner rather than later. While there is no way of knowing for sure and the energy markets notoriously volatile and unpredictable, I believe the overall trend is down.

Source: Bloomberg

 

This chart shows the historical relationship between WTI and Brent crude oil on a 1,000 to 1,000 barrel basis. The current spread is sitting at $5.46. A drop in the spread from $5.46 to zero would represent a $5,460 move. As time progresses, I believe the overall trend is down. However, the move will not unfold in a straight line, so there will be opportunities on both sides of the trade depending on current events.

 

 

About the Author

Jack Malone is a Futures and Options Advisor at RCM Asset Management with a focus on the metals and energy markets. Jack can be reached at jmalone@rcmam.com