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Goldman Presents Three Scenarios For Where The WTI-Brent Spread Is Headed (And Why The Firm Has Been Wrong So Far)

Tyler Durden's picture





 

Back in January, when collapsing the Brent-WTI trade was all the rage after the spread had hit all time wides, we cited a JPM report which contrary to Goldman (which 6 months ago had seen WTI higher than Brent) warned that the spread was likely to persist and even widen, and for once, agreed with Jamie Dimon's firm, cautioning: "those who believe that a compression trade between the spot curves is a slam dunk: be very careful." Sure enough, some decided to be brave and sell Brent while buying WTI. Considering today the spread just hit a new all time record of over $23, those brave souls have now been wiped out. Yet that does not explain why the spread continues to diverge, and has recently taken a sharp $7 jump in just the past few days. Below we present David Greely's latest thoughts on what the reason for this unprecedented divergence is, on why he has been dead wrong, and why he believes, eventually, he may be proven right, even as Goldman's prop desk has almost certainly milked this move for its entire duration.

From Goldman:

After trading in a range between -$10/bbl and -$15/bbl for the past 3 months, the WTI-Brent spread collapsed at the beginning of June, to a record low close of -$21.80/bbl on Monday (see Exhibit 1). The recent collapse of the WTI-Brent spread raises something of a  puzzle in that the usual suspects, the logistical issues surrounding the WTI delivery point in Cushing, Oklahoma, are not to blame.

It is true that the logistical issues surrounding Cushing are responsible to a large extent for the wide discount of WTI to Brent this year. In particular, the WTI-Brent spread set its prior record low in February of this year when the opening of the Keystone pipeline into Cushing and a string of unplanned refinery outages in the US midcontinent led to the dislocation of the US midcontinent crude oil market from the rest of the word crude oil market. Further, the logistical issues surrounding Cushing also seem to bear responsibility for the WTI-Brent spread remaining wider than we anticipated from March through May. However, the recent June decline of $7.77/bbl in the WTI-Brent spread has been primarily driven by the weakening of the US Gulf Coast light-sweet crude oil prices relative to Brent crude oil prices, not a Cushing bottleneck.

More specifically, we can break the WTI-Brent spread into two legs: the WTI-LLS spread and the LLS-Brent spread. The first represents the light-sweet crude oil price differential between the US midcontinent and the US Gulf Coast markets. The second represents the light-sweet crude oil price differential between the US Gulf Coast and Northwest Europe. Typically, we would expect a Cushing bottleneck to widen the WTI-LLS price spread. This is what happened earlier this year in February. However, the WTI-LLS spread has traded in a range between -$12/bbl and -$18/bbl since March, and has not experienced a sharp decline recently (see Exhibit 2).

On the other hand, the LLS-Brent price spread has collapsed recently, with LLS declining to a $5.45/bbl discount to Brent (see Exhibit 3). Because both LLS and Brent can be moved by tanker, the LLS-Brent spread reflects shipping costs. Consequently, the recent decline in the LLS-Brent spread suggests that the arb between the US Gulf Coast and Europe has flipped, and the oil market is now directing light-sweet crude oil away from the US Gulf Coast and toward Europe.

More details on why the recent collapse in the spread can not be blamed on Cushing this time:

While crude oil inventories at Cushing remain high, supporting the wide WTI-LLS spread, they have been drawing fairly consistently since peaking in early April at 41.9 mmb. In the past two weeks, they have drawn by 1.2 mmb, falling back below the 40 mmb mark for the first time since February (see Exhibit 4). Further, storage capacity at Cushing continues to grow. The US Department of Energy recently reported that shell crude oil storage capacity in Cushing reached 57.9 mmb by the end of March, with working storage capacity of 48.0 mmb. This implies that Cushing inventories have room to build 9.1 mmb, or that Cushing inventories are currently occupying 81 percent of working storage capacity (see Exhibit 5). Consequently, while inventories at the WTI delivery point remain high, storage capacity is
by no means full.

Reflecting the spare storage capacity available in Cushing, near-dated WTI timespreads have strengthened considerably since their collapse in February, when a string of refinery outages in the US midcontinent in the wake of severe winter storms undercut demand for crude oil in the region (see Exhibit 6). Further, WTI and LLS prices remain highly correlated. This suggests that the while WTI is trading at a steep discount to LLS, the US midcontinent crude oil market has not dislocated from the US Gulf Coast oil market like it did in February. Instead, the two markets remain integrated (see Exhibit 7).

Consequently, neither the behavior of prices or fundamentals point to the logistical issues surrounding the WTI delivery point in Cushing, Oklahoma as the main driver of the recent June collapse in WTI-Brent spreads. Rather, the evidence suggests that the recent collapse in the WTI-Brent spread has been driven primarily by the flipping of the light-sweet crude oil arb between the US Gulf Coast and Europe, which is now directing flows away from the US Gulf Coast and toward Europe and Asia.

Unlike last time around, Greely, who still is confident that the spread will eventually have to close, is far less confident (to be expected after loosing clients their capital on any 50% leveraged position).

At this point it remains far from clear if the recent flipping of the transatlantic light sweet crude oil arb is sustainable. We believe that it is most likely that it is not sustainable for more than a few months, and we continue to expect the WTI-Brent spread to narrow. However, we continue to refrain from making a trading recommendation on the WTI-Brent spread as we believe that the risk associated with the fundamental uncertainty is too high. In order to highlight these risks, we can envision several scenarios that may play out, some of which would suggest the spread remains wide, others that it collapses quickly. In each scenario, we find that the size of the LLS-Brent spread should be limited by tanker rates which have been running between $3-$4/bbl on the Northern Europe-US Gulf Coast route, which with the LLS-Brent spread now at -$5.45/bbl suggests that downside risk in the LLSBrent spread is limited from current levels, and that the arb has likely overshot recently. However, while we expect the WTI-LLS spread to narrow as Cushing continues to draw, we continue to believe that WTI and the US midcontinent oil market will remain prone to dislocations, which will continue to pose downside risks to WTI-Brent spreads until the logistical issues at Cushing are resolved.

So instead of piling insult on insolvency, Greely this time provides readers a sampling menu of three scenarios as to what may happen to the spread.

Scenario 1: Recent supply disruptions in the light sweet crude oil market are driving the flipping of the arb, arb likely to revert back in coming months

In our mainline scenario, we believe that the flipping of the transatlantic light-sweet crude oil arb is likely a short-term response to the supply disruptions that continue to plague the light sweet crude oil market. Of course, the largest supply disruption has been the loss of  Libyan production, which removed over 1.5 million b/d of light sweet crude oil production from the market. More recently, however, other supply disruptions have occurred, including:

  • Nexen brought forward planned maintenance on its Buzzard field in the North Sea to June and July from September. The field produced 80 thousand b/d in May, and it is not expected to return to full production until the end of July.
  • Royal Dutch Shell’s Nigerian unit declared force majeure on planned loadings of 200-250 thousand b/d of Bonny Light crude oil in June and July. According to a company spokesperson, the pipeline was repaired and production restarted on June 12.

Consequently, it is likely the case that the flipping of the transatlantic light sweet crude oil arb is being driven by a near-term shortage of light sweet crude oil due to the recent and ongoing supply disruptions. As these supplies reenter the market, we could then expect to see the arb revert to its former direction, with LLS rising back above Brent.

Such a reversal could be accelerated by a resumption of Libyan crude oil production, or more likely in the near term, by increases in Saudi production. Reports have stated that Saudi will increase its crude oil production to 10 millon b/d in July. To the extent that the new Saudi super-light blend can offset the shortfall in light sweet crude oil, this increased supply could allow the LLS-Brent spread to revert to more normal levels.

Scenario 2: The process of resource reallocation has accelerated, and will sustain the flipping of the arb as oil is redirected to the emerging markets

The downside risk to the spreads scenario is that the flipping of the arb is sustained over a longer-term period as the market’s means of redirecting oil on a structural basis to meet the growing demand of the emerging market countries. We have long argued that in response to tightening supply constraints, oil prices are rising in order to bid oil away from developed market consumers in order to supply the growth in emerging market demand. We have called this process “resource realignment.” It could be the case that the flipping of the transatlantic light sweet crude oil arb is another step in that process.

As we have been observing for some time now, the drawdown on the overhang of US petroleum inventories built up during the economic recession has been driven not by renewed strength in US oil demand, but by a reduction in net US oil imports. Up until now, this has been largely a feature of the US petroleum product markets, where lower imports and higher exports to South America and Europe, have driven the draw on US petroleum product inventories. Meanwhile, US crude oil inventories remain high, even along the US Gulf Coast (see Exhibit 10), supported by low US refinery runs. Consequently, it could be that the oil market is now directing light-sweet crudes away from the US Gulf Coast as an extension of the rebalancing process that has been under way since the beginning of the US recovery.

Further the impact on the LLS-Brent spread of this process of resource realignment could be augmented by the growth in US lower-48 crude oil and condensate production. With the US lower-48 becoming one of the leading growth regions for Non-OPEC supply, we may be beginning to see a trend of light-sweet crudes and condensates making their way past and around the Cushing bottlenecks to the rest of the United States. With crude oil production from the Bakken shale expected to grow by 180 thousand b/d this year and the Eagle Ford increasing production by 75 thousand b/d over the past 12 months, the United States will likely require less light-sweet crudes from the seaborne markets, allowing these crudes to flow to the rest of the world (see Exhibit 11).

Under this scenario, the reversal of the transatlantic light sweet crude oil arb would be sustainable. It would also suggest that the tightening that we expect in the oil market in 2H2011, which we expect to push the oil market to critically tight levels in 2012, has likely accelerated significantly. This would suggest this scenario presents upside risk to our Brent crude oil forecast.

And last, Scenario 3: Brent prices have risen too quickly, with a market correction to be driven by increased crude oil flows to Europe.

In the upside risk to spreads scenario, it could be the case that Brent have risen too quickly in the anticipation that the prior scenario is unfolding. That is, the market is pricing as if the tightening has accelerated, even if it hasn’t. Under this scenario, we would expect a market correction in the near term as the flipping of the transatlantic light sweet crude oil arb would motivate participants in the physical market to redirect crude oil flows to Europe, forcing Brent prices back in line with fundamentals. The ability to sell Brent forward to lock in the profit on shipping an LLS cargo would suggest that the correction could begin even before the physical volumes would arrive in Europe. While there are no clear signs this is the case, Brent prices have risen faster than we have anticipated based on our fundamental outlook and have been quite strong in the face of disappointing economic data. This scenario would, of course, present downside risk to current Brent crude oil prices.

All that said, Goldman would still like clients to sell the spread.. to its prop, pardon, flow traders.

Under any of these scenarios, however, we believe that the downside risk to spreads from current levels is limited.

The LLS-Brent spread closed Monday at -$5.45/bbl. Tanker rates between Northern Europe and the US Gulf Coast have ranged between $3.50-$4.00/bbl in recent months according to Drewry. This suggests that the current spread would cover the cost of pulling oil from the US Gulf Coast to Europe, and is more than large enough to pull West African cargoes to Northern Europe and away from the US Gulf Coast. This suggests in turn that the declines in the LLS-Brent price spread will likely be limited from here, and that the arb may have overshot recently.

This implies that any further deterioration in the WTI-Brent spread would need to be driven by Cushing-related issues, which would weaken the WTI-LLS spread. However, should the WTI-LLS spread hold in its recent range of -$14/bbl to -$18/bbl, the WTI-Brent spread would likely not fall significantly below -$22/bbl. As we expect that the inventories in Cushing will continue to draw and the WTI-LLS spread will compress in the coming months, we continue to expect WTI-Brent spreads to strengthen substantially from current levels.

Bottom line: at this point, courtesy of bizarro centrally-planned markets, expect the spread to do the opposite of the logical, and of what Goldman "expects" it to do.

 


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Tue, 06/14/2011 - 10:12 | Link to Comment mickeyman
mickeyman's picture

Isn't this like when Goldman experts forecast oil would run to $200/bbl back in 2008, and they got their clients in long oil near the peak, then made a nice profit taking the other side of the trade.

Do you listen to your broker?

Tue, 06/14/2011 - 10:33 | Link to Comment malikai
malikai's picture

I listen to my broker. Then I wait a bit and go and do the opposite. Works pretty well.

Tue, 06/14/2011 - 13:16 | Link to Comment mickeyman
mickeyman's picture

Ha!

A friend of mine had a broker he used to call "The Great White Shark". His advice was perfect, provided you did the opposite of what he suggested.

Wed, 06/15/2011 - 06:07 | Link to Comment malikai
malikai's picture

I have two equities accounts, one of them is really small, basically my sucker account. I use that to trade broker's reccomendations with. It loses money constantly and I'm always having to put cash in it. Its with a TBTF and this is the broker I listen to. I trade small lots of their reccomendations so as to keep the information flowing and have a "I'm the sucker" relationship with.

My other account is the inverse of the first account. It's with a small po-dunk broker who is equally trying to sell me bullshit, but I don't trade their reccomendations at all. With that account I do the inverse trades as with my TBTF account. So far this year, returns are ~+50% on my real account and ~-15% on the TBTF account. I write off the 15% loss as payment for all the good info those chumps give me. With this system, I am actually upset when the TBTF throw me a bone every once in a while and give me a good hint.

What else can you do in this circus other than put on the clown suit and play the organ?

Tue, 06/14/2011 - 10:19 | Link to Comment lizzy36
lizzy36's picture

Amusing that x-goldman trader, now head of JPM's oil trading desk was responsible for $38M in Q1.

J.P. Morgan's oil desk has been an important factor in the success of the bank's commodities business. The desk is run by Jeffrey Frase—a former Goldman Sachs trader for 17 years who jumped to Lehman Brothers Inc. in 2007, the year before it failed—to run its oil desk.

Lehman went under in September 2008, and Mr. Frase joined J.P. Morgan in October 2008. He is known in the oil-trading community as a "sustainable earner," said one person familiar with J.P. Morgan's commodities group.

A J.P. Morgan spokeswoman said Mr. Frase declined to comment.

Some notable trades that worked well for Mr. Frase's group in the first quarter included one on the widening spread between Brent and Nymex crude oil—the two benchmark prices—which helped return about $38 million in the first quarter. J.P. Morgan also made money on fuel oil and Asian oil markets, according to people familiar with the matter.

Tue, 06/14/2011 - 10:27 | Link to Comment malikai
malikai's picture

A very interesting read indeed. I like how they give you three different scenarios to bait with. Those guys are kinda smartly.

Tue, 06/14/2011 - 10:31 | Link to Comment SheepDog-One
SheepDog-One's picture

WTI to Brent spread $20, and WTI is only thousands of barrels per day. I dont see any correlation at all its nonsense.

Tue, 06/14/2011 - 11:43 | Link to Comment CrashisOptimistic
CrashisOptimistic's picture

It is largely nonsense.  Oil analysts exist to generate more money under management.  Not to make trading profits. 

But a pseudo-sophisticated analysis that is carefully structured to avoid any suggestion of something that would cause clients, or more specifically, potential clients to keep their money in savings accounts has value  to the firm as a money attractant and so analyst salaries are paid.

Brent is higher than WTI because it is more valuable.  It is more valuable because 9.1% unemployment in the US has reduced demand for WTI.

There are, at present, rail cars that are being leased and filled with Cushing oil and sent to the Gulf Coast refineries.  The cost of shipping is $6.  When they arrive at the refinery, the price quoted by the entrepreneuer to that refinery is Brent minus $1.

The Cushing theory was meaningful at the beginning of all this.  No longer.

Tue, 06/14/2011 - 10:37 | Link to Comment Iconoclast
Iconoclast's picture

fwiw I suspect OIL will hit 200 a barrel inside two years irrespective of the state of the global economy once the truth about oil reserves can no longer be surpressed...China recently and quietly surpassed the USA as the biggest energy consumer and they haven't even revved up their engine yet.. 

Tue, 06/14/2011 - 10:41 | Link to Comment Cassandra Syndrome
Cassandra Syndrome's picture

Maybe its because Brent is backed up by more physical quantities than WTI, too many paper & electronic trades with WTI artificially increasing notional quantity and reducing the price?

Tue, 06/14/2011 - 10:44 | Link to Comment Flakmeister
Flakmeister's picture

Reposted from an earlier thread:

Learnt something recently that helps explain the WTI Brent spread...

The definition of WTI is based on API specific gravity and Sulfur content. I presume that people understand what "condensate" and "wet gas" are. Condensate production is rising as it is a by product of the shale NG plays (in fact the production of the shale NG is focused on those areas that are wet). Now, the pipeline guys are blending Alberta Tar sand syn-crude with light sweet condensate to satisfy the WTI requirements. The catch is that this blend is a poor substitute for real WTI (from the Permian Basin). When you analyze the refining yields, the blended stuff comes up short....

Call it the hedonistic adjustment to the quality of crude oil....almost forgot, there was a time (quite recent) when pipelines would never blend products of different quality...

Tue, 06/14/2011 - 10:57 | Link to Comment r101958
r101958's picture

Good points Flak. One must also ask.........why are they blending product if there is plenty of regular light sweet getting produced?

Tue, 06/14/2011 - 11:00 | Link to Comment Flakmeister
Flakmeister's picture

I don't follow... the real question is what fraction of the flow into Cushing is real light sweet? As I pointed out earlier, I would be mighty pissed if I was a producer of real light sweet and captive to a Cushing delivery...

Tue, 06/14/2011 - 11:23 | Link to Comment r101958
r101958's picture

put another way....they most likely started blending last year in August when the difference between Brent and WTI really began. So, why did they start blending? That question, most likely, will never be answered with any clarity. Maybe price supression and/or inability to produce the real thing? One may also ask 'why was the legal amount of ethanol added to fuel raised from 10% to 15%'? Perhaps because it reduces oil used for gas by 400k brl/day. It also allows masking of the price of gas by hiding some of those costs in gov't ethanol subsidies (and ethanol ends up being at least as expensive as fuel created with oil--but with part of the price hidden).

Tue, 06/14/2011 - 11:22 | Link to Comment malikai
malikai's picture

I'd just put the ethanol subsidy simply on the power of the agri lobby in DC. As we all know it only costs a few million to buy off enough senators to get a bill like that through. And of course it doesn't hurt that ethanol is viewed as being "green".. LOL

As for the mixing of condensate to satisfy the API gravity in syncrude; it sounds plausible. But syncrude is more expensive to produce than most light sweets, so I don't get the point of flooding the market with more expensive oil and depressing the prices.. I just can't connect that.

Keystone XL went online early this year, sending loads of syncrude to cushing, just about the same time the February jump in the spread kicked off.

I'd venture to say that all of this is a simple set of fundamentals being used and abused by the Goldmans and JPMs in order to liberate a few traders of their money. I'm sure their prop desks are getting some good numbers out of this game.

Tue, 06/14/2011 - 12:00 | Link to Comment Flakmeister
Flakmeister's picture

My old link giving all the crude prices doesn't work anymore....so I can't find the spread. My understanding is the blending is being done with condensate. IIRC, the syncrude is API 32, a 20% or so cut with condensate gives you a blend that satisfies WTI.... Typically condensate was used as feedstock for plastics and production is up because of the "wet gas" plays...

Hard to draw conclusions given the dearth of good data....

Tue, 06/14/2011 - 12:20 | Link to Comment malikai
malikai's picture

I wonder what they do with the sulphor. I understand syncrude is a bit sour as well. That's got to add to the cost.

As far as the BRN/WTI spread goes. Looks like eyes are on the spread now and it's beginning its retreat from a peak ratio of 1.222.

Tue, 06/14/2011 - 12:13 | Link to Comment CrashisOptimistic
CrashisOptimistic's picture

Ethanol does not have the same BTUs of energy content that crude does.  Keep increasing its proportion and we will soon see mileage on cars fall, and get noticed.

Tue, 06/14/2011 - 11:52 | Link to Comment CrashisOptimistic
CrashisOptimistic's picture

Clarifying what Flak said above, a lot of "oil production" being ballyhooed as a by product of shale gas drilling is not oil.  It is wet gas or condensate.

This stuff does not contain 5.8 million BTUs per barrel.  You can't get the same number of gallons of gasoline from a barrel of it as you can from a barrel of oil.

Barrels of "oil" from these sources are being quoted as additive to barrels of actual crude and they are not.

It's all bogus.  You have to understand the industry.  Drillers and explorers depend on investment money.  They persuade investors to give them that money to drill via the use of hype.  Reports of declining oil production are not supportive of that hype and so enormous efforts are made to manufacture oil production numbers.

We're about to see it from KSA's Vanadium laced Manifa oil field.  It is heavy sour with a lot of vanadium in it (which corrodes the tanks and pipes of a refinery).  It is so bad that KSA is building their own refineries for that oil and will sell the output, funding the cost of corrosion of tanks and pipes themselves.

This is not the world where a drill could go down a thousand feet in Ghawar and produce a 30 year gusher.  It's just not, and it never will be again.

Tue, 06/14/2011 - 10:52 | Link to Comment r101958
r101958's picture

Brent is the 'real' oil price. WTI is next to meaningless in the world oil picture. Watch RBOB gas as it trends with Brent prices. That will tell the story. Seems to me that WTI is, more than anything else, serving a political purpose; to make it appear, to the 'unedgumicated', as if oil prices are really still below $100.

Tue, 06/14/2011 - 11:20 | Link to Comment King Dong
King Dong's picture

+1

Tue, 06/14/2011 - 11:57 | Link to Comment richard in norway
richard in norway's picture

which is why it mirrors the stock market so well

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