There is a major change in the American Oil market that will effect the price of WTI to Brent Sea Oil. This will directly effect the companies that drill and extract oil from the ground and the refineries that sell the final petroleum products on the market. There will be some able to adapt and others that will struggle. I define the winners and losers by how it affects the companies' income (top line) and their profits (bottom line). By this we can see how and why it will affect us as investors.
The spread between West Texas Intermediate (WTI) and Brent crude represents the difference between two crude benchmarks, with WTI more representing the price U.S. oil producers receive and Brent more representing the prices received internationally. The two crude oils are of similar quality and theoretically should price very closely to each other. However, the prices had differed greatly between the two crudes because a recent surge in production in the United States has caused a buildup of crude oil inventories at Cushing, Oklahoma, where WTI is priced. This created a supply and demand imbalance at the hub, causing WTI to trade lower than Brent. Before this increase in U.S. oil production, the two crudes had historically traded in line with each other.
The spread between WTI and Brent crudes closed at $7.51 per barrel on February 21, which compared to the previous week's spread of $8.81 per barrel. This was the first time WTI-Brent spread traded below $8.00 per barrel since last October. Last week, WTI prices rose by $1.90 per barrel, while Brent traded up by $0.77 per barrel. Consequently, the WTI-Brent spread traded narrower on the week.
The U.S. Energy Information Association in its latest "Short Term Energy Outlook" dated February 11, 2014, report noted that it expects the spread between WTI and Brent to average $11 per barrel over 2014, slightly higher than current levels. The forecast takes into account increasing uncertainty for existing refinery infrastructure to process an increase in light sweet crude production in North America, pushing WTI prices down relative to Brent. The EIA stated that its forecast reflects;
"the economics of transporting and processing the growing production of light sweet crude oil in U.S. and Canadian refineries."
WTI had traded as low as $23 per barrel under Brent in February of 2013. Over the course of the 2013, the spread narrowed due to several factors. Firstly, increased midstream infrastructure came online, facilitating the movement of crude from inland to refiners on the coast. One notable example is the expansion of the Seaway Pipeline in January 2013, which allows more crude to flow from the Oklahoma crude hub at Cushing to the Gulf Coast, where a great amount of refining capacity sits. Plus, later in 2013, Sunoco's Permian Express Pipeline and the reversal of Magellan Midstream Partners' Longhorn Pipeline are allowing more crude from the Permian Basin in West Texas to flow directly to the Gulf Coast. Increased pipeline capacity and crude transportation by rail have allowed inland domestic crude to more efficiently travel to refiners on the East and West coasts, which has also reduced less purchasing of Brent-like imports due to lower prices of WTI.
Fracking and horizontal drilling techniques increased production capabilities, particularly from the Bakken in North Dakota and the Permian Basin in West Texas. Accompanying the crude production growth were increasing stocks of crude inventories-particularly at Cushing, the major crude hub in Oklahoma. During Q4 2013, Cushing inventories rose for seven weeks straight after several months of declines. This was a signal that inland crude production flowing into Cushing may have started to overtake the existing takeaway capacity, which would have depressed WTI crude oil prices compared to Brent prices even more. During this period, the spread gradually widened to levels as wide as ~$19 per barrel in late November before closing 2013 at ~$12 per barrel. The recent narrowing was partially driven by the news of the imminent opening of the southern portion of TransCanada's (NYSE:TRP) Keystone XL pipeline and stabilizing tensions in the Middle East.
1. When WTI trades below Brent, this results in companies extracting oil will receive a lower prices compared to their international counterparts, as WTI is the U.S. benchmark and Brent is the international benchmark. For companies extracting oil, they enjoy higher prices per barrel that drives more money to the top line, and most of their expenses are set, so they profit by higher prices. There is a number based on all of their expenses a company has that represents their break even (B/E) point. A price below that and the company will lose money regardless of how much they can take out of the ground.
2. Companies that transport the oil from wells to refineries get paid regardless the price, as they get paid shipping per barrel from point A to B. A good company that runs an efficient operation will profit with any price range.
3. The refinery also is affected by the price, because they pay market price to buy the crude and sell refined products against the market price. The refinery always like to buy-low and sell-high, and with a larger price spread between WTI and Brent crude prices, it is easier for refineries receiving WTI to create a more profitable business model. Refineries that only accept WTI or Brent are locked into the price structure the market drives, but some that have the ability to accept both, due to the availability of transportation means and have an additional opportunity to use the best priced crude oil available. As noted above the southern portion of TransCanada's Keystone XL pipeline is a game changer for the oil refineries in the south. With the U.S. oil production glut that filled the storage facilities, now they can market it for a better price and over time, level out and reduce the spread.
As an investor, when I evaluate oil companies that extract oil effectively and efficiently, I want to ensure they have a long term marketing plan that adapts to the effect on changes in the market. Oil companies in Texas, Louisiana, Oklahoma and New Mexico will see the oil get to market much easier with more pipelines opening. These companies could see an increase in price, more comparable to Brent. Companies in the Bakken Region are improving, but have a less mature distribution system and infrastructure established to move product.
If I am comparing refineries, once again effective and efficiency go a long way, but the other factor I must consider is if the refinery can purchase crude oil at a WTI moving closer to Brent (smaller spread) and market the refined products at the profitable prices. My goal is the company turns a respectable profit that improves the top line income and enhances their profits to investors in the form of dividends or stock price appreciation.
Companies that we believe will be successful in 2014 by returning a favorable dividend and or stock price appreciation include:
Smaller companies, MLPs and Trusts
- Chesapeake Energy (NYSE:CHK)
- Chesapeake Granite Wash Trust (NYSE:CHKR)
- CVR Refining (NYSE:CVRR)
- Kinder Morgan Energy Partners, LP (NYSE:KMP)
- Northern Tier Energy LP (NYSE:NTI)
This is not an all-encompassing list, just a group we are confident about their metrics.