By Julian Murdoch
Brent crude, you may remember, is drilled from the North Sea oil fields and serves as the benchmark for European crude oil, while WTI (aka West Texas Intermediate crude) serves as the benchmark for U.S. oil.
WTI is a sweeter, lighter crude, and all things being equal, gasoline refiners prefer to work with WTI over Brent. Thus, in a vacuum, WTI should trade at a premium to Brent. But we don't live in a world of blind equality.
Looking back over the past five years (except for 2008, that is), WTI tended to obey common wisdom and run at a premium to Brent by roughly $2. But in 2008, the latter half of 2009 and now over the past few months, the two switched, with Brent trading at a premium—sometimes a substantial one—to WTI:
On Monday, that premium was $8.74—the largest spread seen over the past five years. So what gives?
Brent Trading Games, WTI Surpluses
Oil expert Chris Cook, former compliance director for the International Petroleum Exchange, points out that futures aren't what set the price of Brent crude. Physical cargoes coming out of the North Sea do.
"That amount coming out of the North Sea is gradually declining," he told Hard Assets Investor in a phone interview Monday. "It's been in secular decline for some time."
According to the Energy Information Administration, production in the North Sea in 2006 was 4.343 million barrels per day, but by the end of 2010, it had dropped 23 percent to just 3.348 million bpd. What's more, the EIA predicts this trend will continue to the tune of 185,000 barrels per day in 2011 and 156,000 bpd in 2012 (EIA's recent Short-Term Energy Outlook - Jan 2011).
New exploration licenses continue to be issued for the North Sea, and new discoveries continue to be made, but overall, says Cook, nothing can come close to slowing—never mind stopping—the production decline.
It hasn't helped that existing rigs in the area have had a few mishaps. Statoil briefly closed two of its fields in the North Sea earlier this month after a gas leak was discovered. (Combined, the two fields—Snorre and Vigdis—produce around 157,000 bpd.) Then just last week, Royal Dutch Shell closed four interconnected rigs in the original Brent field, when large hunks began falling off one. That took about 20,000 bpd off line, and the complex will stay closed for several weeks to come.
"The fewer and fewer cargos there are knocking about," says Cook, "the easier it is for people to actually influence [the price]. That is exactly what is going on—trading games. Hetco, the trading arm of Hess Co. in the U.S., has bought up roughly a third of this month's cargo and some of the next."
These "trading games among consenting adults," as Cook terms them, have gone on for years. But as Brent became a more widely adopted global benchmark in the 1990s, these trading plays began to affect the volatility of the global price of crude—and the Brent-WTI spread.
"I think we're seeing some games which have temporarily pumped up the arbitrage between the two contracts," he says. "Brent is financially pumped up, whereas WTI is more rooted in the underlying market because it is deliverable."
Physical delivery of WTI crude, which occurs in Cushing, Okla., has a real effect on crude prices due to the storage/delivery bottleneck that sometimes accumulates there. That means short-term inventory surpluses and deficits can have a significant impact on prices.
"Inventories in the U.S. have been coming down in the last few months, but there is still a healthy amount of oil in storage in the U.S., which tends to push the market more into contango,," says John Hyland, portfolio manager and chief investment officer of United States Commodity Funds LLC.
Indeed, according to the EIA's weekly petroleum inventory reports, inventories are still well above five-year averages, although they are lower today than in previous months.
So with tight supply and trading games pushing Brent prices up, and oil surpluses keeping WTI prices low, it only makes sense that the Brent-WTI spread should be as high as it is today.
But will the trend continue? No way to tell for sure. No matter—U.S. ETF investors can easily invest in either side of the spread.
Investing In The Brent-WTI Spread
The two funds are similar in that they both own a single, front-month contract and roll it two weeks prior to expiration. The only difference is USO owns WTI, while BNO owns Brent.
Although there's no guarantee that Brent will continue to outperform WTI, the future curves imply that maybe, it just might:
On the left, we've plotted the futures curve for both oil contracts over the next year. On the right, we show the historical cost of rolling that front-month contract over the last year.
Immediately obvious is that WTI is in fairly strong contango through the next year—a function of the aforementioned ample inventories. Brent's curve, on the other hand, remains comparatively flat, although technically in contango. If these conditions persist, then BNO will likely continue to outperform USO simply because of the roll cost—although all it takes is a drop in U.S. inventories to quickly flatten the WTI futures curve and change the picture completely.
So what's an investor to do?
One option would be to buy one and sell the other, depending on which way you think the spread is going to go, and take advantage of the arbitrage between the underlying crudes. With Brent at such a tremendous premium, it's a tempting play, although a flattening of the WTI curve could work against you.
Another option is to pick the crude that aligns with your investment strategy, whether it's something U.S.-centric or a more global approach. Hyland sees real opportunities in the latter.
"If you're bullish on oil because you're bullish on India and China, you're already halfway there to being non-U.S. centric. You've already concluded that the price of oil is no longer solely dictated by how many people are going to drive to Disneyland this summer," he says. "So take the next logical step and think about what kind of oil exposure you want to buy."
In the end, when it comes to crude, it pays to remember that more options exist than just plain old WTI.
Disclosure: No positions