Brent-WTI Oil Spread Collapse Spooks Refiners, Railways

Getty Images

After almost three years of churning bumper profits from the massive price gap between the world's two most actively traded crude oil contracts, traders, refiners, railways and investors are all asking the same question: Is the game finally coming to a close?

The near $20 premium North Sea Brent held for much of 2012 over U.S. benchmark West Texas Intermediate (WTI) has fallen to less than $8 a barrel, the lowest since the crude-by-rail boom began to gather steam in early 2011.

The collapse in what oil traders call the Brent-WTI spread could now threaten the vast investments made by rail and refining companies to try and move lower priced crudes to higher priced markets, as the key spread trades far below the $10-$15 a barrel level many based their business plans on.

The spread has narrowed as traders bet increased pipeline capacity will help move crude to the Gulf Coast in the second half of this year.

In earning calls over the last three weeks, analysts and investors have hounded refining and rail executives with questions about what a collapse in Brent-WTI could mean for their bottom line. Most executives were unbowed, arguing a "short-term" move in the spread wasn't going to slow them down, even as oil future prices suggest it could stay below $10 a barrel for the rest of the year.

(Read More: Key Levels to Watch for Crude Oil)

The issue, they say, is not that the game is over, but that the rules have changed. As the pipeline bottleneck that separated WTI's delivery point in Cushing, Oklahoma, from the Brent-dominated global marketplace starts to ease, the Brent-WTI spread is no longer a particularly accurate reflection of the cost of moving crude to the coasts.

Instead, the oil industry now has dozens of new rail terminals and thousands of tank rail cars that can carry more than 1 million barrels a day of crude to every corner of the United States. It costs more to ship oil by rail than by pipeline and each rail route has its own costs and potential profits. For traders and investors, however, the opaque nature of the crude-by-rail business makes it difficult to know who is still on the winning side of the trade.

"At the moment, the publicly available prices we can see suggest that sending crude from the Bakken to the East Coast isn't particularly profitable for refiners," said David Kennedy, co-founder of Rail Solutions LLC in Jacksonville Beach, Florida, who has advised a number of rail and refining companies on how best to move crude from the Midwest to the coasts.

"What we can't see, of course, is the kind of long-term supply deals the refiners have in place, which probably ensure that these deals are still more attractive than they first look. Every deal is different."

Some major oil producers are already ringing alarm bells for the rail companies though. Continental Resources, the biggest oil producer in the Bakken, who ships 80 percent of its crude by rail, said on its first quarter earnings call on Thursday that "we will need to see rail carriers reduce their costs to stay competitive".

Trains Keep on Running

So far, the evidence indicates that the trains will keep running, at least in the medium-term. Rail traffic data from the Association of American railroads show U.S. oil shipments in the week to May 4 were up more than 50 percent on the same time last year.

Energy industry intelligence service Genscape, which monitors almost 90 percent of all rail loadings from North Dakota's Bakken shale fields, said crude-by-rail shipments from the state increased to near 550,000 barrels per day in the week ended May 3, a 20 percent increase from the previous week.

Part of the reason is that firms have signed up to long-term "take or pay" agreements to get quick access to the rail network, which mean they must continue to pay the transport costs whether they decide to ship the oil or not.

The lighter quality of many U.S. shale crudes also provide further incentives for refiners on the East and West coasts, as basic plants can produce more gasoline and diesel than from imported crudes like Brent.

"Even if the spreads get to some narrow low single-digit numbers, there are still value propositions for crude-by-rail," said Eric L. Butler, Executive Vice President of Marketing and Sales for Union Pacific on the firm's first quarter earnings call in April.

While existing projects may keep running, new proposals for expanding the crude-by-rail infrastructure could now be put on hold, analysts said.

"There's no panic, but the crude-by-rail build out that we've seen is probably in a later stage of its development than many investors realize," said Bradley Olsen, director of midstream research at Tudor, Pickering, Holt & Co. in Houston.

"You could shut the majority of crude-by-rail projects down tomorrow and they still would have been good investments. They were designed to make their money back in a very short time frame."

The projects most at risk could be those that will still rely on water-borne barges to ship crude the final few miles into a refinery, adding additional costs of around $2-$3 a barrel.

Hunter Harrison, CEO of Canadian Pacific, Canada's second largest rail company, said on the firm's quarterly earnings call at the end of the April that the firm was now proceeding "cautiously" with crude-by-rail infrastructure projects.

"We're not going to go out and spend capital and build infrastructure that's going to last 40 or 45 years, when we're not so sure about the markets for five or six," Harrison said.

Trading Places

While many refining executives say they expect to continue to have access to cheap crude, oil future prices stretching all the way to next summer suggest a sub-$10 a barrel Brent-WTI spread could be here to stay. On Thursday afternoon in New York, the spread for May 2014 was near $8 a barrel, having traded above $14 a barrel as recently as February.

If WTI prices continue to move back toward Brent as pipelines come onstream, other inland crudes that remain reliant on rail to get to market will increasing trade at a discount to WTI, traders and analysts said.

Already Bakken crude prices at Clearbrook, Minnesota, which aren't traded on an exchange, have slipped to about $90 a barrel or around $5.50 below WTI and $13 below Brent, and could have further to fall. At the start of May Bakken crude was just $1 below WTI.

"Bakken crudes should start to price at bigger differentials to make crude-by-rail to the coasts economically viable, said Sandy Fielden, an analyst at RBN Energy in Austin, Texas.

"Ultimately, the competition is occurring at the refinery gate. Refiners will push the price of Bakken lower if taking it isn't worth their while."

(Read More: Refiners Gain From Energy Rally at Consumers' Expense)

Speaking on Wednesday, the Chief Executive of independent refiner Phillips 66, which owns 11 refineries in the United States, said that the narrower spread wouldn't alter the company's strategy of expanding crude-by-rail to the East and West coasts.

"As long as you have an oversupply of crude, as long as we're over-drilling our infrastructure, you're going to see a lot of volatility," CEO Greg Garland told reporters ahead of the company's annual meeting.

The company's share price has doubled since it was first spun off from oil major ConocoPhillips last spring, as it has increased the amount of cheaper North American crudes it runs in its plants to almost 70 percent, with plans to run even more.

Kennedy at Rail Solutions LLC in Florida said that while the sharp movements in crude oil spreads would continue to foster uncertainty in the coming weeks for the crude-by-rail and refining business, he didn't think it was necessarily a bad thing.

"It calms everybody down a little, and should put a stop to some of the crazier suggestions that were starting to emerge," Kennedy said.

"We don't want to end up with too much capacity in the long run."