Given the importance these benchmarks have in pricing crude worldwide, it is useful to review what they are before talking about their widening spreads.
Brent and WTI (West Texas Intermediate) are the two principal crude oil price benchmarks of global trade. Brent is set in London, WTI on the NYMEX in New York.
As I have observed in Money Morning on a number of occasions, neither benchmark actually reflects the quality of the oil traded worldwide.
On average, 85% of the oil in the international market on any given day is more sour (having a higher sulfur content) than either of these benchmarks. That means the actual trades are done at a discount to the price of one or the other of these standards.
Both are denominated in dollars, the currency in which virtually all oil consignments internationally are priced. That certainly is one primary reason for their continued use.
In addition, the daily liquidity of futures contracts traded in the world's two largest investment locations is yet a reason for their use.
Finally, with more than 200 benchmark rates for crude existing throughout the world, most having insufficient volume to constitute a basis for oil prices, there needs to be yardsticks to determine pricing differentials and swaps.
Those common yardsticks should be the most liquid and highest volume trading contracts available.
Brent and WTI fit the bill in all of these aspects, despite the fact they don't reflect the lower quality of most oil traded.
Oil Prices: Global Markets Favor Brent CrudeStill, the most interesting development since mid-August 2010 has been the following: despite representing lower quality oil, Brent has been trading at a premium to WTI.
Of the two, Brent has more sulfur content. That should result in a lower price rather than higher comparative price.
Actual trading conditions prompt a spread in favor of Brent for several reasons.
First, Brent is used as the basis for more actual daily trades worldwide than WTI is. Brent is the preferred standard for determining discounted prices in many global markets where even lower quality volume is offered.
Second, Brent represents a crude standard that does not have significant supply glut concerns. WTI, on the other hand, may be traded in New York, but the daily spot price is set at Cushing, Okla.
Cushing is the main pipeline hub in the United States, but the city has experienced a surplus backlog for some time. New pipeline projects and the construction of additional storage capacity are addressing this problem.
But until the network to move oil from Cushing improves, the glut will continue to suppress WTI pricing
The price difference or spread between Brent and WTI is an indicator of overall global oil market conditions. It widened lately, closing last week at the highest difference since mid-October of last year.
The nominal difference in price (the one determined by simply subtracting the WTI rate from Brent) was $23.32 a barrel. The better way to express the spread, and my preferred approach, is to treat that difference as a percentage of WTI.
By using this figure, we can obtain a thumbnail indicator of the real effect the spread has on prices in the U.S.
Yesterday, that spread rate hit 27.1%.
Refineries Are Set to AdvanceThe consequences have two results that energy investors need to consider.
The first is the obvious one. Given its more dominant use as a global benchmark, a higher Brent price translates into higher import pricing in the American market.
The advent of increasing U.S. domestic unconventional production (shale and tight oil) is resulting in less dependence on imports. Five years ago, the U.S. imported nearly two-thirds of its daily oil consumption. By the end of 2012, that figure may fall to less than 50%.
This is a remarkable transformation.
In a similar development, U.S. production will register this year at a daily level higher than at any point in more than a decade. This has led to much discussion about self-sufficiency being a realistic future goal.
And it is possible.
A few decades down the road, if current projections of unconventional reserves are accurate, the U.S. will need to import only about 30% of daily requirements. Virtually all of that would be provided by the huge Canadian oil sands deposits.
But for the next 20 years or so, those higher Brent oil prices will affect U.S. prices, even if we rely on fewer imports. Even after that, given the global nature of oil pricing, the spread will affect the American market.
The second major result of the Brent premium to WTI is less apparent.
Still, it has a bigger impact on U.S. energy investment prospects. When the spread increases, so do margins (and thereby profitability) at American-based refineries.
A spike in the spread often leads to a decline in refinery share prices at the outset, but quickly prompts a recovery and improvement thereafter. This is because the single biggest cost component in refining remains crude oil.
Still, if a refinery can balance consignment sourcing and stockpiles supply in advance of the spike, a later increase in Brent over WTI allows an improved margin. This is why increasing inventory figures in weekly EIA reports need to be read with care. They may have less to say about retail demand levels and more to say about the massaging of refinery margins.
One conclusion, however, is beyond dispute.
The rise in the spread between Brent and WTI provides an element investors need to watch.
But it is also an indicator of where to profit when investing.
Related Articles and Links:
The Challenge in the Persian Gulf with Iran Looms Large
Ignore the Doom-and-Gloom Crowd When They Talk About $40 Oil
You Can Drill All You Want, Oil Prices Are Still Headed Higher
This Key Energy Metric Could Make You A Lot of Money