The spread between Brent and WTI, two leading crude oil benchmarks, has widened recently, a reflection of a sharp increase in U.S. shale production this year at a time when OPEC is cutting back.
After trading close to parity for the past couple of years, WTI and Brent have started to diverge once again, a modest but noticeable price difference emerging between the two main crude oil benchmarks. At the end of August and into early September, the spread exceeded $5 per barrel, the largest disparity in about two years, giving the incentive for the U.S. to export more volumes.
At the end of August and into early September, the spread exceeded $5 per barrel, the largest disparity in about two years, giving the incentive for the U.S. to export more volumes.
There are a few reasons for the wider differential. First, U.S. shale continues to add new production, keeping a lid on WTI. Total U.S. oil production topped 9.5 million barrels per day (mbd) in late August, up from 8.5 mbd a year ago. The rapid comeback of U.S. shale has undercut OPEC’s efforts at balancing the market, and led to a period of meager inventory declines—inventories started to substantially dip only this past summer. Abundant supply in the U.S. has prevented WTI from staging a rally.
Higher output in the U.S. has come at the same time that OPEC has restrained its own production. OPEC pledged to cut production by 1.2 mbd last November, along with a group of non-OPEC countries pulling an additional 0.558 mbd off the market. The cutbacks have led to a tighter market internationally—fewer barrels from the Middle East are making their way to Asia and Europe.
In the early part of 2017, rising supply in North America combined with curtailed output in the Middle East did not lead to observable discrepancies in Brent and WTI prices. There was simply too much inventory backed up for the shifting supply dynamic to have a noticeable impact. But as the year has dragged on and OPEC has maintained compliance, ongoing production gains in the U.S. started to cause a divergence.
By August, the differences became visible in the futures market. The Brent futures curve began to shift into backwardation, in which near-term contracts trade at a premium to longer-dated futures, a situation widely regarded as a reflection of market tightness. However, WTI did not follow suit. It remained in contango, in which contracts for immediately delivery trade at a discount to futures further out—a bearish sign. The shift in sentiment showed up in positioning by hedge funds and other money managers, which staked out more bullish positions on Brent while reducing net length in NYMEX WTI.
A rash of hedging by shale producers has also prevented 2018 WTI prices from rising. Shale producers scrambled to lock in hedges when WTI approached $50 per barrel, likely foreshadowing more production gains ahead.
Not always so close
Prior to 2015, the two benchmarks didn’t track so closely together. The U.S. market was dealing with different fundamental dynamics than the rest of the world. The disparity was most pronounced during the Arab Spring uprisings in 2011, when instability rocked the Middle East and a substantial volume of supply was knocked offline in Libya. Brent, the benchmark that better reflects global fundamentals, spiked in the years after the Arab Spring, a symptom of tight supply and persistent geopolitical concerns in the Middle East and North Africa.
Prior to 2015, the two benchmarks didn’t track so closely together. The U.S. market was dealing with different fundamental dynamics than the rest of the world.
WTI, a land-locked crude, closely tracks conditions in the U.S., where supplies have been anything but tight. When Brent prices routinely traded above $100 per barrel between 2011 and 2014, surging U.S. shale production kept WTI in check. At its most dramatic point in 2011, the spread between the two benchmarks approached $30 per barrel.
Two factors forced the benchmarks to finally converge. When WTI and Brent both collapsed, the disparities between the two benchmarks essentially melted away as the whole world suffered from oversupply. Even more crucially, the elimination of the U.S. crude oil export ban in late 2015 removed barriers to trade, smoothing out the differences between the U.S. and the rest of the world. From 2015 through the first half of this year, WTI and Brent moved in lockstep with one another, with the European marker selling at a slight premium.
Hurricane Harvey laid waste to the U.S. Gulf Coast in late August, knocking more than a dozen major oil refineries offline. At the worst point, more than 4 mbd of refining capacity was knocked offline. With the recovery in its initial stages, that figure has been cut in half. Goldman Sachs predicts that 1.4 mbd of refining capacity will remain offline until at least mid-September.
While the refinery disruptions were occurring in the U.S., the international market found support from ongoing OPEC cuts and robust demand, keeping the gap wide between WTI and Brent.
While the lack of refinery demand was slightly offset by outages at offshore facilities and in shale fields in the Eagle Ford, the huge refinery disruptions have exacerbated the differences in WTI and Brent. With a severe cutback in refinery runs, crude oil produced in the Eagle Ford and the Permian have had limited outlets. The interruptions at the ports of Houston and Corpus Christi, among others, also curtailed the export of crude and refined products for a while. Gasoline futures spiked due to fears of shortages, but WTI fell back on concerns about a rapid buildup in inventories. While the refinery disruptions were occurring in the U.S., the international market found support from ongoing OPEC cuts and robust demand, keeping the gap wide between WTI and Brent.
Exports keep window from opening too much
While around a third of U.S. exports go to Canada, China has actually emerged as a relatively large buyer of American crude.
Unlike past years, however, the Brent-WTI spread will probably not expand to the extraordinary heights seen in 2011. The difference between then and now is that the U.S. has emerged as a substantial crude oil exporter. Before the U.S. Congress scrapped the crude oil export ban, the U.S. exported negligible volumes. Exports have jumped this year, at times surpassing 1 mbd in a given week. U.S. sellers are taking advantage of openings in markets all over the world as demand rises and OPEC cuts back.
While around a third of U.S. exports go to Canada, China has actually emerged as a relatively large buyer of American crude. In June, for example, China bought 140,000 bpd from the U.S.
Consequently, if the WTI discount relative to Brent becomes large enough, refiners around the world will buy American barrels, ensuring that the benchmarks converge once again. More U.S. exports will simultaneously reduce the pressure on Brent, and also push up WTI and prevent American storage from increasing too much. In short, there is a limit to how wide the Brent-WTI spread can possibly get, at least for any lengthy period of time. The spread won’t grow beyond whatever extra transport costs are associated with shipping U.S. crude to Asia, for example.
More U.S. exports will simultaneously reduce the pressure on Brent, and also push up WTI and prevent American storage from increasing too much.
There are already signs that the Asian buyers are stepping up efforts to buy U.S. crude in the wake of Hurricane Harvey and the wide Brent-WTI spread. “One good piece of news is that the WTI-Brent spread has blown out so much that means excess U.S. crude is going to be exported,” Tony Nunan, oil risk manager at Mitsubishi Corp in Tokyo, told Reuters.