The Convergence And Decline Of Brent And WTI Oil Futures

by: Robert Loftus

At the time of this article the spread between Brent and WTI oil futures contracts had narrowed to less than $6 per barrel. In this article I will be expanding upon points made in a previous article, and describing why Brent and WTI oil futures should continue to converge, and then begin on a steady downward trajectory going into the fall of 2013. Oil and gasoline consumption in the U.S. has been falling for several years (see chart below). When the Brent/WTI price-spread was at its peak, oil refiners were able to maintain their profitability -in spite of declining U.S. consumption- by exporting finished gasoline from the U.S. to foreign markets. As the Brent/WTI spread narrows, the price advantage that promotes those exports is diminished. With exports diminishing, U.S. oil companies will have to become more aggressive at capturing the market for U.S. consumers, or risk falling short of the sales volume needed to satisfy their investors. The critical factor in narrowing the Brent/WTI spread is the provision of crude oil to refineries in PADD District 1, which covers a geographic area including many large East Coast cities. As oil companies improve their logistical capabilities to deal with the problem of getting North American crude to PADD District 1 refineries, a natural market mechanism develops, which is capable of creating long-term downward pressure on oil and gasoline prices.

Total oil consumption in the U.S. has been declining steadily for the last several years.

That decline is the result of several factors, and is likely to accelerate due to recent changes in the North American marketplace. Many American consumers are now retiring late 90s and early 20-oughts era SUVs from America's roadways, and those SUVs are being replaced with smaller and more fuel efficient vehicles. New vehicle sales figures indicate that the top-selling passenger vehicles in 2013 are all small and mid-sized sedans, which are capable of better than 30 miles per gallon on the highway. The presence of Ford and Chevy pickup trucks at the top of the sales lists does not mean that sales of these vehicles are surging, as sales of those two particular model lines have topped U.S. light-vehicle sales charts for many years. The U.S. military has historically been the largest consumer of kerosene type jet fuel in the American market, but has now embarked on a bio-fuels project that is projected to eventually reduce demand for petroleum-based jet fuels by 700,000 gallons per year. Honeywell is also engaging in efforts to promote this fuel to commercial clients. Railroads have historically been massive consumers of diesel fuel in the U.S. and now the BNSF railway has announced plans to begin testing Liquefied Natural Gas in some of its rail engines. None of these developments will - individually - have a massive, or instant impact on oil demand, but in combination they have the potential to contribute to the ongoing reduction in petroleum demand, and to thereby moderate prices for both crude oil, and finished petroleum products.

U.S. exports of finished gasoline have spiked in recent years, as U.S. refiners have sought to maintain their profitability in spite of a declining U.S. market.

These exports are the reason that gas prices have remained relatively "sticky" in recent years, in spite of increasing US crude oil production, and are the reason that the Brent futures price has been the primary determinant of gasoline prices in the U.S., and not the WTI price. As the spread between WTI and Brent prices grew, it became very profitable to export finished gasoline to foreign markets. The drop in gasoline exports seen at the far right in the chart above corresponds to the recent narrowing of the WTI/Brent price spread.

Source: EIA Short Term Energy Outlook, June 11 2013.

Narrowing of the Brent/WTI spread means that the input cost advantage for U.S. refiners that are intent on exporting finished gasoline to foreign markets is diminished. As mentioned above, there has been an observable decline in finished gasoline exports (scroll all the way to the bottom of the page for 2013 figures) as the Brent/WTI spread has narrowed in recent months. It appears that U.S. oil producers and refiners have responded to this condition by aggressively expanding rail shipping of petroleum products. The AAR Weekly Rail Report issued on 6/20/13 indicates a 35.6% YOY increase in rail shipments of Petroleum and Petroleum Products.

The importance of PADD District 1 is rooted in two factors: the District area includes many large East Coast cities, which are massive population centers, and refineries in PADD District 1 are typically configured to operate using the kind of light-sweet crude, which has traditionally come from the North Sea or countries like Saudi Arabia, but which is now being pumped from Williston Basin wells in North Dakota and Eastern Montana. As shipments of Williston Basin crude to PADD District 1 refineries increases, the demand for Light Sweet crude imports decreases, which creates downward pressure on Brent contract prices. As the Brent futures price comes closer to the WTI price, the price advantage associated with exporting finished gasoline and diesel fuel from Gulf Coast refineries to foreign markets is diminished. As the price advantage of exporting finished petroleum products is diminished, oil producers and refiners are forced to become more aggressive about capturing U.S. market share, so as to maintain the sales volume needed to satisfy shareholders. As U.S. oil producers and refiners become more aggressive about capturing U.S. market share, they create downward pressure on demand for Brent oil imports, and we have a competitive feedback loop, which should create long-term downward pressure on oil and gasoline futures contracts. Finally, increased Williston Basin production also creates a buffer against any international disputes, which may cause a spike in Brent contract prices.

Multiple market factors point to a convergence of the Brent/WTI price spread. Petroleum demand in the U.S. has been declining for several years, and strong new car sales along with new technologies in air travel and railroads suggest a steady and continuous decline in demand. Narrowing of the Brent/WTI price spread will decrease export opportunities for Gulf Coast refiners, and increase the impetus for U.S. oil producers and refiners to maximize their U.S. market share so as to maintain the sales volume needed to satisfy their investors. A critical factor in the process of capturing U.S. market share will be the ability of U.S. oil producers to get Williston Basin light-sweet crude to refiners in PADD District 1. As Williston Basin deliveries increase, demand for Brent supplies will decrease, which should create additional downward pressure on Brent contract prices. A combination of market factors appear to be leading to the creation of a competitive feedback loop, which should result in first a convergence, and then a steady decline in Brent and WTI futures contracts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.