Investors Refine?Bets on Crude Price Gap
Forget the sharp slide in oil prices. What’s really concentrating minds in oil markets is the huge sums at stake in a bet on the direction of Brent and WTI — the world’s most heavily traded crude benchmarks.
Here the debate is about more than the prospect of rising Saudi oil output or a jump in US stock. It is not so much about the actual price of oil, but the huge differences in the cost of the two crude streams.
For nearly two years oil extracted from the middle of the US and Canada has traded at steep discounts to oil delivered in ocean tankers as North American drillers pump more than pipelines can take to refineries.
Now investors including Pimco and Goldman Sachs , the Wall Street bank with the biggest commodities business by revenues, say these discounts will narrow. Others including PBF Energy, a company chaired by refinery investor Tom O’Malley, and oil transport company Magellan Midstream Partners see the discounts lasting for years.
This debate matters. At stake are hundreds of millions of dollars worth of trades and investments as well as fees for commodities exchange operators CME Group and IntercontinentalExchange.
The discount is most visible in futures markets, where $92-a-barrel West Texas Intermediate, the US benchmark crude, sells for $16 less than Brent, the North Sea benchmark. Changes in pipeline flows and the use of rail routes to carry crude produced inland to the coast have led to bets that the discount will diminish.
Goldman argues that a recent change in direction of oil flow along the Seaway pipeline is draining 150,000 barrels a day from the glutted WTI delivery and pricing point of Cushing. The pipeline’s capacity is due to rise 400,000 b/d in 2013.
New rail infrastructure will carry more barrels from inland fields, reconnecting Cushing with the waterborne market. This should in turn shrink the WTI discount to $4, or the Seaway tariff, says David Greely, Goldman’s head of energy research. The bank is recommending clients buy WTI and sell Brent for delivery next June.
“In the second quarter of next year we think that spread has to come in pretty sharply,” says Mr Greely.
Mihir Worah, who oversees a $30bn commodities portfolio at Pimco, says the fund has bought WTI and sold Brent futures for delivery in December 2013.
“Late 2013 is when the physical oil offtake is going to grow dramatically. But clearly, if this becomes a certainty, which we expect, the market will start to narrow well before that,” Mr Worah says.
The difference between the December 2013 contracts was $10.50 on Wednesday. “We think it should be trading $5 to $6,” Mr Worah says. There is a feeling, too, among traders that the glut at Cushing could soon ease.
“Volume in WTI-Brent has been massive over the last few weeks. Many people anticipate the pipeline logjam is about to clear up,” says a dealer in swaps that track both oil benchmarks.
The market has flashed false signals before. After hitting a record $28 last October, the spread contracted to $8 after Seaway’s owners announced the pipeline reversal, only to expand again. HollyFrontier, a central US refiner that has enjoyed fat profit margins largely thanks to stranded inland crude markets, believes the wide spread is here to stay as production keeps outpacing pipeline projects.
“Our best guess is we are going to see it higher longer,” says Neale Hickerson, vice-president.
Magellan is spending $375m to reverse a pipeline to carry 225,000 b/d from west Texas to coastal Houston and is contemplating another 278,000 b/d line in the same direction. Both projects would steer rising production away from Cushing.
Mike Mears, chief executive, nevertheless says it will take years for pipeline capacity to shrink WTI’s discount to tariff levels. “The four-year, five-year timeframe is probably the right timeframe for that to happen,” he says.
At its refinery in the east coast state of Delaware, PBF is investing $60m to build a rail terminal to offload more than 100,000 b/d from trains loaded in North Dakota and Canada. “We believe crude differentials are sustainable for the foreseeable future, it’s going to continue to be a volatile, disconnected, regionalised market,” says Neil Wizel, director at private equity firm First Reserve, which co-owns PBF.
This week Brent has fallen faster than WTI, narrowing the spread by more than $1. But Mr Greely warns: “It’s a buy-and-hold trade. It could be a bumpy ride.”