The Fuse

Brent-WTI Spread Narrows, For Now at Least, as North American Supply Tightens

by Nick Cunningham | July 05, 2018

The wide discount between WTI and Brent suddenly has collapsed after a confluence of events forced the two benchmarks to converge.

WTI had dropped to a discount of nearly $10 per barrel in May, the steepest differential in years. The different fortunes of the two benchmarks largely reflected a handful of factors that left North America with ample supplies of oil while the rest of the world saw significantly tighter fundamentals. Abundant shale supply dragged down WTI, while OPEC cuts, emerging market growth, and geopolitical unrest put upward pressure on Brent.

But recently, the fundamentals of both markets shifted, cutting the spread between the two.

Margin narrows again

Since the shale boom earlier this decade, WTI has typically traded at a discount to Brent, but for the past few years, the difference has been relatively minor. Yet, the two crude oil markers diverged considerably in the summer of 2017 after Hurricane Harvey, which led to widespread damage along the U.S. Gulf Coast, the shutting down of refineries, and crude oil unable to reach the Gulf Coast for processing and export. The buildup of crude at the time caused WTI to plunge while Brent remained stable.

The latest twist occurred in late June, with the WTI discount narrowing sharply to just $3 per barrel. The forces that helped drive WTI and Brent apart have suddenly reversed course.

OPEC and its non-OPEC partners agreed to increase production by around 1 million barrels per day (Mbd), adding supplies back onto the market. Around the same time, news surfaced that Syncrude Canada suffered an equipment problem at an oil sands project in Canada, which could sideline around 360,000 barrels per day (b/d) through July at least. The sudden disruption led to a “sharp repricing of North American crudes with sharply stronger WTI timespreads and tighter differentials,” Goldman Sachs wrote in a note. In a sign of how worried the market has become, WTI contracts for August delivery are trading at a more than $2-per-barrel premium to WTI for September, a very significant differential for futures that are only a month apart. Meanwhile, the November contract is some $5 under August. The strong backwardation reflects growing concerns about near-term supply.

“A sharp repricing of North American crudes with sharply stronger WTI timespreads and tighter differentials.”

Moreover, the widely publicized pipeline bottlenecks in the Permian are threatening to significantly slow the shale production growth rate, further underpinning prices for some North American crudes. “We will reach capacity in the next 3 to 4 months,” Scott Sheffield, chairman of Pioneer Natural Resources Co. told Bloomberg in June. “Some companies will have to shut in production, some companies will move rigs away, and some companies will be able to continue growing because they have firm transportation.” He sees Permian production flattening for the next year due to inadequate pipeline capacity.

The latest data from the EIA show that the slowdown probably already began a few months ago. U.S. oil production was essentially flat in April compared to March—Permian production grew only modestly, while offshore Gulf of Mexico dipped.

“Some companies will have to shut in production, some companies will move rigs away, and some companies will be able to continue growing because they have firm transportation.”

These trends—a sudden slowdown in supply in North America at a time when OPEC+ is adding barrels back onto the market to offset geopolitical outages—have reshuffled the outlook for both WTI and Brent, leading to the narrowest price discount in nearly three months.

U.S. exports hit record

The widening of the WTI discount in April and May sowed the seeds of an export boom. U.S. crude exports have trended upward since early 2017, but accelerated in the last few months, culminating in a record high 3 Mbd of exports for the week ending on June 22. The nearly double-digit WTI discount made American crude highly attractive to foreign buyers.

However, exports at such elevated levels will likely be temporary with WTI and Brent prices closer together. After factoring in the cost of transportation, U.S. crude at just a few dollars cheaper than Brent may not garner as much interest from refiners in Asia, or elsewhere. U.S. export volumes will likely dip a bit in the coming weeks even if the long-term trend still points to volumes remaining high.

Crude exports at such elevated levels will likely be temporary with WTI and Brent prices closer together.

The price differential between WTI and Brent, however, is not static, and could widen once again. For instance, the WTI September-Brent October spread is now around $6 per barrel. Supply outages are multiplying in the international market, which will likely push Brent upward. Venezuela’s production continues to fall. Major supply outages loom in Iran, and recent comments from the U.S. State Department suggested that the Trump administration will press governments to “zero” out their purchases of Iranian oil. Market participants will continually recalibrate expected losses from Iran. The most recent outage came from Libya where the National Oil Corp. (NOC) said that it might have to declare force majeure on several export terminals, and the NOC said that Libya could see as much as 850,000 b/d of supply disrupted. Nigeria and Angola have also suffered from production and export issues.

If U.S. shale production resumes on its upward trajectory—particularly after new pipeline capacity comes online in 2019—and the disruptions in various parts of the globe are sustained, there will be a wedge driving WTI and Brent apart. But for now, the two oil benchmarks are trading at their closest point in months.

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