While $100 crude oil is the main focus of investors, a structural phenomenon has emerged within the overall petroleum complex. Brent crude oil, which has historically traded at a discount to the Nymex's West Texas Intermediate (WTI) crude oil grade, has been trading at a premium of over $10 for the past several weeks. It has lead many to ask: why?
To understand the situation, it is necessary to understand how futures contracts work. Unlike stocks, where you acquire an ownership stake in a company, a futures contract is a commitment to make or take delivery of a certain grade of commodity, at a certain time, at a particular place. It is the last element that is at work with the Brent-WTI spread. It matters not that a small percentage of futures contracts actually go through the delivery process. The mere ability to do so keeps the markets honest.
Nymex crude oil is deliverable into Cushing, Oklahoma. It is centrally located in the United States, and the oil is transported there via pipeline mostly from Canada. Due to the increase in Canadian output, more and more crude oil has found its way to Cushing, and there have been periods, recently, where Cushing storage was filled to capacity—even after recent storage increases. These crude oil inventories have also run head long into a depressed refinery operating environment in the United States, with respect to refinery operating levels. Not to say that refinery profit margins are not spectacular—they are—it's that the overall operating rates in the United States have hovered in the low 80 percent level for an extended period.
As a result, due to the extremely high local supply levels, Cushing oil has remained depressed relative to all other grades of crude oil, not just Brent crude. Grades of crude oil along the Gulf Coast region have been trading at premiums of over $20 to WTI, exceeding the Brent-WTI premium. They are not as readily traded, so the disconnect is less obvious.
Brent crude, on the other hand, is primarily consumed in Europe and Asia—the key, swing demand center. Rates of consumption and importation of oil into China continues to grow, putting a greater and greater call on Brent crude oil. So, as a more international grade, fungible regarding location, Brent is more valuable to the global markets for now.
This situation is a lesson of futures markets that work. While WTI continues to be an important part of the global energy markets, it will not completely disconnect from its local market dynamics, nor should it.
Finally, as the Middle East oil producers get ensnared in the freedom fever sweeping the region, I would expect the spread to narrow because every barrel of oil, regardless of its location, will become dear to the markets. As the situation calms down, the spread could actually widen, again, as the Cushing supply element re-enters the calculus.
John P. Kilduff is Partner at Again Capital LLC Ltd. He's also a CNBC contributor.