What Does the Record-High Spread Between WTI and Brent Mean for Oil Investors?

by: Kenneth D. Worth

The spread between West Texas Intermediate crude oil for delivery at Cushing, Oklahoma and comparable oil for delivery almost anywhere else in the world has surged to record levels. The discount of WTI to Brent hit a previously unfathomable $18.50 a barrel as Brent crude traded at $103.93 per barrel, up $2.29, while NYMEX WTI traded at $85.43, up only $1.11 a barrel. (WTI has historically sold at a dollar or two premium to Brent, which is a slightly heavier and more sour blend.) Clearly there is a supply/demand imbalance at Cushing, Oklahoma not replicated elsewhere in the world, and specifically not replicated anywhere you can just put oil in a tanker and send it to China.

Primary media outlets continue to refer to the "price of oil" as that deliverable at Cushing, Oklahoma and trading on the NYMEX. This convention is distorting our view of how high oil prices really are right now ($85 vs. $104). This in turn affects our judgment of the impact oil prices could be having on the nascent recovery of the US economy. At $104 a barrel, we are not very far from levels that could seriously constrain economic growth and would very likely send the economy back into recession.

Meanwhile, Brent crude (i.e. the real "price of oil") hit $104 a barrel. It looks to move much higher. OPEC either cannot increase production (due to Peak Oil) or, as they claim, they are simply choosing to leave the barrels in the ground for future generations. It is reassuring to imagine that someone is in control of this energy mess, so we let OPEC continue to play the part.

China needs an additional million barrels of oil per day this year to continue to grow its economy. With trillions of dollars in foreign exchange reserves, China tends to get what it wants. The nation is now the world's second largest economy and the planet's largest energy consumer. It has mountains of cash from booming exports and will outbid the rest of the world for the oil it needs to continue its rapid growth.

It would thus be quite reasonable to conclude that oil prices could hit $140 a barrel this year. That would only be an additional increase of 35%. Oil prices that high would almost certainly send the US economy back into recession. Year over year increases in the price of oil greater than 80% have consistently resulted in recessions. Consider the following cases in point: 1973-75, 1980-82, 1990-91, 2000-01, 2008-09. All were preceded by significant oil shocks.

Investing wisely requires accurate information. The media outlets are doing investors a disservice by continuing to quote a price that is a "benchmark" only as a result of its central location in an era in which Texas oilfields fueled the epicenter of global manufacturing in the American Midwest. Those days are gone.

The recommendation would be to stay long the exploration and production stocks (NYSEARCA:XOP), as well as oil service stocks (NYSEARCA:OIH), stay long Brent crude (NYSEARCA:BNO) and wholesale gasoline (NYSEARCA:UGA). Continue to avoid Cushing crude (NYSEARCA:USO) and (NYSEARCA:OIL).

If and when we get to $140 a barrel on Brent, buying put options on the Nasdaq 100 (QQQQ) wouldn't be a bad idea. One idea would be to start buying QQQQ puts when and if Brent crude reaches $120.

Jan 12 $55 puts on QQQQ are currently trading around three bucks. That is not a lot to pay for downside insurance in a market that is looking more and more "frothy" by the day. We could very well have an additional 10% to the upside in this market. Should oil hit $140, however, the sell-off in equities will indeed be something to watch, and those three dollar puts should perform very nicely.

Disclosure: I am long XOP, BNO, UGA.