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By the Casey
Research Energy Team
There’s more than one price of oil… and
lately one of the followers has become the far-and-away leader.
It’s almost funny, how people talk about
“the price of oil” as though it is a singular thing. In reality
it is far from singular, and in fact events over the past few years have
created further complications in what is already a complex game.
Crude oils can display a wide range of characteristics,
the most important of which are density and sulfur content. Light crudes have
an API gravity rating of 38 degrees or more, while heavy crudes have an API
gravity of 22 degrees or less. As for sulfur, sweet crude is commonly defined
as oil with a sulfur content of less than 0.5%, while sour crude has more
than 0.5% sulfur.
Those characteristics differentiate the approximately
160 types of crude oil – including Alaska North Slope, Bonny Light, Es Sider, and Palanca Blend
– traded on exchanges around the world. The names usually refer to
geographic locations, as oils from a certain area share similar properties.
Of those 160+ types of crude, two are the most
important. Brent North Sea crude, also known as Brent Blend, is a light, sweet crude that is comprised of oil from 15
fields in the North Sea. Brent is traded on the London ICE exchange and can
be easily loaded onto tankers and shipped around the world. The other key
crude is West Texas Intermediate (WTI), which has traditionally been the U.S.
benchmark crude oil. WTI is a slightly lighter,
sweeter crude than Brent that is piped from the northern United States and
from Canada’s oil sands to the delivery point at Cushing, Oklahoma and
is traded on the New York Mercantile Exchange.
Lighter, sweeter crudes are usually more expensive than
their heavier, sourer counterparts because they require less processing and
produce more higher-value products, such as aviation fuel. For that reason,
WTI crude has historically commanded a price premium over Brent crude, and
for years WTI was the world’s benchmark oil price, with its price
movements mimicked almost instantaneously by other crudes on other exchanges.
However, in the last year we have seen that longtime relationship flip. Brent
prices are now roughly 25% higher than WTI prices, an historic difference and
one that invites some investigation.
There are several issues behind the reversal, but the
main one is a glut of crude supplies at Cushing. Over the last 15 or so
years, two unconventional sources of crude oil materialized in North America:
shale oil and bitumen. Shale oil is trapped in formations of sedimentary rock
with low porosity and permeability, and bitumen is the tar-like heavy oil
from the oil sands. The technology to recover and refine these oils was
developed recently.
By chance, it turns out that these new, major oil
sources are located in the northern United States and in Canada, and almost
all of the oil from shale plays and from the oil sands is sent to Cushing.
The chart below shows crude production in the PADD 2 district, which is the
name given to the Midwest region. The Bakken Shale
in North Dakota – one of the most significant shale plays in the world
– now accounts for almost half of the region’s crude production.
Source: US Department of Energy; Midwest (PADD 2) Field
Production of Crude Oil (Thousand Barrels); data are from January 1981
through September 2010
All of this crude from the shales
and the oil sands needs to be refined. Only one pipeline connects the oil sands
to the west coast, which means the rest of the bitumen has to go to Cushing;
within the last year two new pipelines increased the flow of bitumen into
Cushing by one million barrels of oil a day. Shale oil from the Bakken only adds to the supply problem.
It is a problem because Cushing is landlocked –
it is in the middle of Oklahoma. And there is now simply more oil flowing
into the PADD 2 region than its refinery system can handle. The next chart
shows how crude stocks at Cushing have been rising steadily and are now
approaching total capacity. That forces producers to sell into the cheaper
spot market, pushing the average price down.
Source: US Department of Energy; Weekly Cushing, OK
Ending Stocks excluding SPR of Crude Oil (Thousand Barrels); current
effective storage capacity as of September 2010; all other data are from
April 9, 2004 through March 4, 2011
Two things would relieve the supply glut at Cushing:
much stronger demand for petroleum products in the United States; and
increased transport capacity out of Cushing. While oil demand will continue
to increase in the United States, it will rise only slowly. And the biggest
capacity addition on the horizon is the hotly contested Keystone XL pipeline
expansion, which would add a line from Cushing to the Gulf Coast. Initially
targeted for start-up in 2013, the pipeline was recently delayed because of
permitting issues.
That means it will be some time before the supply glut
at Cushing is relieved. In the meantime, WTI prices will continue to suffer.
The WTI price depression prompted a few changes that
will help Brent’s supremacy persist. The big one is that Saudi Arabia,
Kuwait, and Iraq all ditched WTI as their official pricing benchmark in favor
of a new benchmark known as the Argus Crude Oil Index. The Argus Index is a
volume-weighted average price index of deals done for three types of crude
– Mars, Poseidon, and Southern Green Canyon – all of which are
U.S. Gulf Coast medium sour crudes. And here’s where things get a bit confusing:
Even though Gulf Coast crudes are American, they have always been priced
according to Brent, not WTI. Brent is more applicable for the Gulf Coast
oils, both in terms of quality and because Gulf crudes are seaborne.
So, by switching to Argus, the big Middle Eastern producers
essentially switched to Brent, adding to its supremacy.
This year, while supplies climbed at Cushing, supplies
of Brent tightened. Production from the North Sea is on the decline. At the
same time unrest in the Middle East – civil war in Libya, nigh on civil
war in Syria, a revolution in Egypt, and the threat of contagion to other
important oil producers – has pushed Brent prices up, while slowing
economic recovery (and now the possibility of a return to recession) is
reducing oil demand in the United States. Essentially the forces on Brent are
exactly the opposite of those acting on WTI.
The take-home is this: The WTI-Brent price disparity
will persist for the foreseeable future, as the only real solution to
oversupply at Cushing – the Keystone XL expansion – is still
sitting on Hilary Clinton’s desk awaiting approval. She, it turns out,
is a bit busy these days, so we don’t expect progress on that front to
come quickly. Until capacity develops to move crude from Cushing to the Gulf
Coast, Brent will remain the crude price that best reflects supply, demand,
and sentiment in the global oil market.
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