The One Number That Shows Oil Prices Are About to Jump

As the market price for crude oil again flirts with $50 a barrel in New York and $53 in London, there's a much more important oil price bellwether that's being ignored.

It's crucial to predicting where oil prices are headed.

Whenever this number is high, oil prices tend to surge.

And it's not been this high in two years...

Why Brent Trades Higher Than WTI

I'm talking about the spread between WTI and Brent, which is once again expanding.

WTI is West Texas Intermediate, the benchmark crude rate for futures contracts in New York.

Brent is the crude rate set daily in London. Both are denominated in dollars, the currency for the vast majority of international oil trades.

Brent is often used as a gauge of international oil prices, while WTI is used to measure U.S. prices.

But both benchmarks consist of better quality oil than well over 70% of the crude traded globally on any given day. That means most consignments are priced at discount to one or the other of the bellwether rates.

WTI is slightly sweeter (i.e., has a lower sulfur content) than Brent. That should make it slightly more valuable.

Yet, except for a few trading days since mid-August 2010 (most during the lowest ebb in the oil pricing collapse), that has not been the case.

The price of Brent has consistently been higher than that for WTI. The reasons are twofold.

First, Brent is used more frequently for oil trades worldwide than WTI. This has an impact on something called the crude "strip," a snapshot of multi-month forward pricing.

The strip will tell you at any time during the trading day what the average price is for multiple months.

The strip consistently favors Brent over WTI as the barometer for trade. A new benchmark - the Argus Sour Crude Rate - has been introduced that more accurately reflects the quality of the international oil being traded.

Even the Saudis are now using it. But Brent remains the more widely used yardstick.

Now some of this follows from the central location of London in worldwide energy pricing and project finance.

Despite Its Higher Quality, U.S. Oil Trades at a Discount

The decision by the UK to leave the EU (Brexit) may begin eroding that preferential position, given that much of it flows from London being a ready conduit for transactions with the continent and beyond.

Yet for now, Brent remains preferred.

Second, U.S. prices have been influenced by two primary domestic American market considerations, each restraining prices.

Initially (roughly from the third quarter of 2010 through late 2015), pipeline bottlenecks had put a lid on significant pricing increases. A glut of oil in storage resulted.

This was particularly noticeable at Cushing, Okla.

This is the location of the largest crude oil pipeline confluence in the United States and the place where the daily WTI price is set. Subsequent opening of pipelines (both direct and operating in reverse mode) has improved the flow from Cushing south to the petrochemical complexes on the Gulf Coast.

In addition, there's the rise in overall U.S. production, primarily as a result of growing unconventional (shale and tight) oil extraction. Once again, the concern has been an oil surplus, providing another dampening on local prices.

Much of the angst expressed over excess U.S. production has been overdone for reasons I have often discussed in Oil & Energy Investor. The goal is obviously a balance between supply and demand, a condition that will result in a more accurate price.

Here's What the Oil Balance Is Really About

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However, that balance is often misunderstood. If we were operating on a time-sensitive balance - one in which the level of supply would just meet demand - oil prices would be well above $100 a barrel.

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"Just in time" management doesn't work well when it comes to raw materials.

Remember, futures contracts are set by the pricing perceptions of traders. This is done incrementally. In a restrained pricing environment, traders will peg their prices to the expected cost of the next available barrel.

However, under conditions of uncertainty, traders will peg to the anticipated cost of the most expensive or least expensive next available barrel. Any appreciable rise or contraction in expected cost will be reflected (sometimes overly magnified) in futures contracts.

Now, the balance the market needs is not one where the oil demand and oil supply are equivalent within a 30-day period. Rather, it's one where the distinction between the two is stable.

Excess supply is not automatically a negative factor. It allows for a buffer - should the unexpected happen, supply will not be interrupted.

There is now little doubt that this balance is approaching.

Both the International Energy Agency (IEA) and the OPEC oil cartel have acknowledged this. The best indication is to review the trend line for the pricing floor since May, once again a matter addressed here previously.

Oil price levels are set by forces operating internationally, influenced by factors arising in Asia (the primary driver), not North America or Western Europe.

This "Spread" Is at Record Highs - Which Means Oil Is About to Go Up

Which brings us back to the WTI-Brent spread.

Brent is more sensitive to global supply and demand balance flows. It picks up the signals faster than WTI, owing to its more frequent usage in trades worldwide and its greater vulnerability to geopolitical events.

Those events can also pressure WTI. But there the effect is translated into what it means for U.S. exports.

For years, American market conditions would impact on the international setting of oil prices only to the extent that imports into the United States would rise or fall.

But in late 2015, Congress finally ended the over four-decade ban on exporting American crude, and there are currently over 1.1 million barrels leaving the United States daily.

Yet available additional export volume capacity is limited medium term.

As a result, further declines in Venezuelan production, or Libya, or Nigeria, or the next hot-button disagreement in the Persian Gulf, will not result in rising U.S. exports.

So events like that are felt in Brent first, not in WTI.

That's why, for the first time in two years, the spread of Brent price to WTI as a percentage of WTI (the more accurate way to measure the spread) has exceeded 8% for four consecutive daily trading sessions.

The last time this happened, it came at the end of a significant trend in which the spread expanded to a double-digit percentage difference, with early September 2015 comprising the end of the cycle.

Two periods of major pricing advances occurred during that trend.

Admittedly, these pricing spikes emerged from low price bases. But by the time we reached the end of the cycle, prices were about the same as they are today.

All of this seems to indicate that the rise in the spread, occurring early in a new process, may well be a harbinger of a higher overall pricing dynamic moving forward.

P.S. Should Venezuela really collapse - as looks increasingly likely - some 1.5 million barrels of oil per day could be taken off the market. Much of this lost supply could be made up for by Saudi Arabia, but it would cut the "spare capacity" that OPEC saves for emergencies down to record lows.

In the past, that's driven oil prices upwards very fast. Combine this with the record-high WTI-Brent spread, and oil could rise even faster. My premium Energy Inner Circle Members just received a special report on the best way to play this. To see how you can join and get it today, click here.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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