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January 26, 2009 4:16 pm
Oil prices may be more than $100 below their high of seven months ago, but headlines still trumpet the movements of the market. Yet over the past two months, the yardstick measuring the value of crude oil has become warped.
West Texas Intermediate (WTI) crude oil traded on the New York Mercantile Exchange is the most commonly accepted benchmark for oil prices but the grade occasionally disconnects from global markets. By any reasonable measure, WTI has not been a representative crude oil for the past eight weeks in spite of Nymex officials’ denials that the market’s primary benchmark is broken.
Examples abound: two weeks ago WTI traded 15 per cent below its year-end level. Meanwhile, Opec’s price basket, far more representative of globally-traded oil, was up 8 per cent. Headlines proclaimed prices plummeting below $40 per barrel while most refiners buying physical oil saw prices rising well above $40.
Normally, WTI maintains predictable relationships with other crude streams, the most important being European-based and electronically – traded Brent. These two streams, practically equal in quality, typically trade with WTI carrying a $1.50 to $1.75 premium above Brent stemming from the realities of physical markets. As a big importer of crude, the US must pull oil from abroad, so WTI must trade at a level that would attract Brent from Europe, including transportation costs and the time value of money.
The WTI-Brent relationship changes seasonally and adjusts to local market conditions, but in a normal market WTI should sell at a premium to Brent and always at a premium to heavier, sour grades that are more difficult to refine into gasoline and diesel. Yet over recent weeks WTI has sold at a steep discount, often $10 below Brent and even below sour crudes, including the Opec basket and similar crudes from the Gulf of Mexico.
The problem resides in the physical market of the mid-continent of the US, specifically at Cushing, Oklahoma, an obscure but crucial oil gathering hub and the pricing point for financially-traded WTI on the Nymex. Often viewed as the global crude oil reference point, Cushing is really a regional, parochial crude market tenuously linked to international markets by bottlenecked pipelines from the Gulf Coast. Cushing pulls oil from the Gulf Coast, Canada or the mid-continent, but unless regional refiners process WTI, it becomes landlocked and decouples from global markets. As inventories build, WTI’s price must fall until it sells, even if that means trucking oil south.
This physical situation is not new, but the problem has worsened as Canada’s tar sands production has grown nearly 500,000 b/d since 2002 and should rise another 200,000 b/d this year, most of it headed toward mid-continent, where refining capacity has fallen by 200,000 b/d. A new pipeline will soon increase flows into the region by another 100,000 b/d. WTI will continue to disconnect from world markets until new pipeline connections create a physical escape valve for oil to flow from the mid-continent to the Gulf Coast.
Some believe the problem stems from market manipulation. In reality it’s the twin facts of higher storage capacity in the mid-continent and the bottleneck that provides a temptation for companies to trade around the storage, building it in weak markets and emptying it in strong markets. Weak markets discount spot sold oil to deferred oil, further encouraging storage and weakening WTI’s spot price; the reverse happens when spot prices are at a premium to deferred prices, depleting storage rapidly.
Although what’s happening to prices might suggest that some traders are manipulating the market, the more compelling explanation is that because a peculiar inland market sets WTI’s price, the incentive emerges to trade the WTI below its “waterborne” level in weak markets and above it in tight markets.
For WTI to regain its reputation as a valuable benchmark that minimises basis risk for hedging purposes, it must find a new pricing point (such as the Gulf Coast) or accelerate the reversal of pipeline flow to bring oil from Cushing to the Gulf Coast. The longer the problem persists, the greater the opportunity for Brent or another crude to replace WTI as the world’s surrogate of the real price of oil.
The writer is managing director and chief economist at LCM Commodities in New York
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