It is commonly understood that West Texas Intermediate (WTI) and Brent are grades of crude oil used as benchmarks in oil pricing. Historically, WTI and Brent have traded close to each other, with the price of WTI slightly higher; Brent crude is considered inferior to WTI and is therefore usually slightly cheaper. In 2011, however, this relationship became distorted and even reversed. Back in June 2011, the International Energy Agency (IEA) pointed out that while between 1994 and 2010 WTI futures have on average traded 5% higher than Brent futures, in 2011 Brent stood an average 13% higher. At the onset of the third quarter of this year, the Brent-WTI spread is still near all-time highs, with Brent futures currently trading over $23 per barrel higher than WTI.
This years price anomalies in crude futures can to a large extent be attributed to the geographical location of the respective oil fields, refineries and storage facilities. Stemming from this distinction is also the various degrees to which turmoil in the Middle East and North Africa--most recently in oil-rich Libya--has impacted demand for the two classes of oil.
WTI Price Distortions
WTI, also known as West Texas light crude, as the name implies, is extracted in North America. WTI is the underlying commodity for oil futures traded at the Chicago Mercantile Exchange. Importantly, the main delivery facility for WTI is a land-locked facility in Cushing, Oklahoma.
These characteristics can subject WTI to distinctly different price pressures than Brent crude, which is sourced from the North Sea and stored within easy access of both pipelines and waterways. In contrast, the overreliance of WTI crude on the Cushing storage space has historically shown a tendency to lead to occasional bottlenecks and excessive supply of oil piled in Oklahoma. This tendency is the basis for the so-called Cushing syndrome.
The term Cushing syndrome refers to a situation in which the oil stored at approaches the full capacity, which in turn sends a signal to markets that oil supply exceeds demand and, subsequently, prices drop. When it is swayed by such regional dynamics, the price of WTI becomes less useful as a barometer for global oil prices. Or as the FT’s Izabella Kaminska put it, “in terms of being a reflection of general market conditions, WTI has become about as useful as a chocolate oven-glove.”
The dependency of WTI on the Cushing facility also makes this crude partial to price curve distortions and prone to contango trading. Contango trading can be defined in a number of ways but at its core it refers to a situation whereby expected future oil prices are significantly higher than current spot prices. This also leads to a situation in which the price of oil futures can be higher than the expected spot prices at the time of futures maturity. Because the futures price must converge on the expected future spot price, contango implies that futures prices are falling over time. As bottlenecks in Cushing depress WTI spot prices, contango is often observed.
Beyond Cushing
The sustained WTI-Brent spread in 2011 has prompted an increasing number of market observers to question whether it is solely about high oil reserves in Cushing.
"This is no longer a situation of WTI's relative weakness due to large crude inventories in Cushing, for the inventories there are no longer historically large. Indeed, the inventories at Cushing are actually declining, as indicated by the rather sharp narrowing of WTI's once huge contango," observed Dennis Gartman in the Gartman Letter, a daily market commentary popular on Wall Street.
It is important to recognise that both Brent and WTI crude are subject to not only local production dynamics and the local economic climate, but also the demand outlook further afield. Because it is costly and time consuming to substitute one type of crude for the other, changes to European or U.S. growth expectations can tilt the WTI-Brent balance.
Most recently, for example, we have seen several distinct pressures on the Brent price originating in Europe or the broader EMEA region. On the one hand, the eurozone’s debt troubles and need for fiscal tightening are eroding the economic growth and energy demand outlook in Europe and putting downward pressure on Brent prices. On the other, maintenance problems and delays in the North Sea Fortis platform recently limited Brent supply and contributed to prices going back up. In addition, Libyan oil has in the past been deemed a substitute for Brent and thus turmoil in Tripoli translates into Brent price volatility.
Picking Benchmarks
One conclusion that can be derived from the 2011 WTI-Brent price diversion is that the utility of either type of crude as benchmark is subject to investors’ broader considerations. That is, while following WTI dynamics might be useful for U.S. investors, Brent futures better reflect dynamics on this side of the Atlantic as well as in the wider global energy markets. Translating this notion to an investment strategy would mean that an investor might chose to capitalise on the super-contango which WTI is prone to, on the spread between WTI-Brent or on the upward gallop of Brent prices. Neither of these strategies is a simple one and the outcome can get even more complicated if investors use commodity trackers to get exposure to energy markets. The most succinct insight to offer here is that, as with other exchange-traded products, it’s paramount that investors understand what it is that they’re buying, how it is constructed, and what role it will take in their broader portfolio.
