The followers of the crude oil markets, as well as other interested parties, have been aware of the unusual spread between WTI and Brent, which this week exceeded $24 as the WTI price continued to be beaten down because of overall weakness in the US economy.
(Click charts to enlarge)
This condition is especially beneficial for the Oil Refiners in the middle of the country, who have enjoyed unprecedented refining margins, and many of which have remained profitable despite weak demand for the products. In fact, readers of my previous article on this topic may have felt that the WTI/Brent spread was a compelling reason not to take my sound advice and exit this group at the time, all the more reason to do a little more work to understand why this condition is not going to be around much longer.
1. The "Glut" of WTI is Disappearing
One of the original drivers of the spread was a perceived excess of supply of WTI, which started in mid-2009 when the refining industry in the middle of the country as well as around the lakes slowed down because of recession conditions.
The WTI Cushing inventory went to over 40 million barrels earlier this year, but since May has been steadily declining, and within a few weeks will reach levels not seen since in 2009, when the inventory exceeded 30 million barrels for the first time.
2. The "Shortage" of Brent is turning around
On the other side of the equation, the perceived shortage of Brent in Europe, partly aggravated by the Libyan revolution, which took 1.5 million barrels per day of light crude out of the supply chain, has driven the price of Brent up.
In the past few weeks, however, inventories of Brent have increased, and with additional worry about the European debt crisis slowing down the economy, the inventory has an opportunity to reach the five-year levels within a couple of months.
3. The Current Spread is Unsupportable by the Fundamentals
Oil and finished products are fungible, and the price differential in the $20's per barrel is an opportunity to ship crude oil or products into that region from elsewhere.
Since this condition has developed, exports of finished products out of North America have reached unprecedented levels:
Fundamentally, the price differential between WTI and Brent should not exceed the shipping cost of a barrel of oil between Cushing and London, plus some risk premium.
I have a calculation on the shipping cost of crude oil via rail between Tulsa and New Orleans in my Instablog. Currently the VLCC day rate has plunged to such low levels that BW Maritime is actually refusing shipments:
All of this points to the fact that the spread of 24 per barrel is greatly higher than it ought to be based on shipping factors, and someone sufficiently determined should be able to profit from trans-shipment at least temporarily.
4. The IEA and the EIA are willing to intervene
Engineering Professor and Secretary of Energy Dr. Stephen Chu surely realizes that at least 20 cents per gallon on the US pump price for Unleaded in much of the US can be attributed to this situation. As a result, a release of 60 million barrels from both the US and International Strategic Petroleum Reserves was done in July, despite the market being well supplied in most of the world, with the potential for this crude oil to make it into the inventory in Europe. No less of an authority than Goldman Sacs can see the ramifications of this.
The first 2.5 million barrels of this oil was drawn this week, Both the IEA and EIA have announced the possibility of additional releases if the price of Brent gets too high, and if the strategy works as intended, the prices of Brent and WTI will return to something approaching their historical balance.
5. The Experts think the game is up
Holly/Frontier CEO Mike Jennings and Uri Yemin, CEO of Delek Holdings, as have other analysts, have been recently quoted as saying that the WTI/Brent spread is vulnerable.
What to Do
1. Short the Spread
It takes some nerve to go long on WTI at the same time the market is so weak, but shorting Brent and going long WTI is a strategy that might prove to be successful in a 90-day time frame. One of the drawbacks on this is that Brent is not in contango, but WTI still is, so the farther out your trade is, the less profitable because of the time effect.
2. Sell the Refiners
If you haven't already, it might finally be time to lighten up on this group. Particularly vulnerable are companies that benefited unusually from the WTI/Brent situation in the first place, such as Western Refining (NYSE:WNR), and high-cost producers, such as Valero (NYSE:VLO). The HFC CEO still believes that Holly/Frontier will still be profitable even with a lower spread. The two new spinoff companies, Marathon Petroleum (NYSE:MPC) and the Conoco Philips Spinoff which has yet to be made will be in uncharted waters with a rapidly changing refinery margin situation. MPC has recovered a bit from the recent correction, the details are still forthcoming on the COP spinoff.
3. Get Conservative
If you think that we are in a double dip, we have substantial evidence that an investment in XOM will give you some portfolio stability in bad times, per my recent article on this topic.
As we are so fond of saying, the world is full of chaos, and there are no guarantees on anything, but those that count on a continuation of the unusually large and vulnerable WTI/Brent spread may be putting themselves at additional risk.
Disclosure: I am long CLMT.