Is It Time To Collapse The WTI-Crude Spread?

Recently there has been much speculation about the nature of the notable divergence between WTI and Brent. Explanations range from the now traditional Cushing syndrome, to Hess attempting to corner the BFOE, to correlation desks blowing up, to the ludicrous, which includes HFT (as much as it is trendy to blame parasitic HFT for everything, is not responsible for correlation trades, especially not in markets that do not have endogenous liquidity at least 1,000 times above that needed for HFT to actually add value). Probably the best explanation to date comes from JPM's Lawrence Eagles who in a just released note asks "Is Brent-WTI wide enough." His lede: "Brent and WTI have been trading increasingly as entirely separate commodities in recent weeks, driven by decidedly different fundamentals. Yet this is an  important spread, which tells us a lot about regional Midwest and international crude economics and will, over time, drive investment that will ‘normalize’ price discrepancies." In other words, it is not the spread's wideness that is the outlier: it is the fact that it was overlapping for so long that is peculiar. In time, Eagles claims, speculation may drive the spread so wide that the economic incentive to close the gaping infrastructure holes will be large enough and the discounting of this act will bring the spreads back to parity. In the meantime, the spread will likely persist. Not only that, but he also believes that the 2012 calendar dated differential, currently trading at a far more reasonable $2.50, will likely also diverge, as two years is insufficient time for the required changes to transpire. Furthermore, the last straw that convinces us that it is likely early to bet on a convergence, is Goldman's just released commodities report which has a WTI target $2 above Brent. By now everyone should know what they say about trading Goldman recommendations...

The complete explanation from JPM:

Brent and WTI have been trading increasingly as entirely separate commodities in recent weeks, driven by decidedly different fundamentals. Yet this is an important spread, which tells us a lot about regional Midwest and international crude economics and will, over time, drive investment that will ‘normalize’ price discrepancies.

We continue to see Brent tightness as reflecting both the ongoing decline in North Sea crude supplies, along with increased pull of Middle Eastern, Russian and West African crudes by Asia. Concern that Brent has become overextended have been underscored by the wide differentials of Dated to Urals. Urals and Brent refining margins confirm this trend, but in relation to comparative crudes, Bonny Light and LLS the ‘overvaluation’ is less apparent. This signals to us that it is Urals that is cheap, rather than Brent that is overvalued—a factor we relate to the Belarus oil pricing dispute. If correct, this pricing gap should narrow in the coming weeks, amid signals the dispute has been resolved.

Unsurprisingly the main issue for the wide Brent –WTI spread seems to lie not with Brent but rather with WTI.

An examination of the monthly flows is revealing. Domestic crude flows into and out of the Midwest have collapsed in recent months, as rising production within the region and continued inflows from Canada squeeze out supplies from the Gulf Coast. Equally significantly, the wide price spread between WTI and Brent has led to a sharp increase in flows out Padd 2 to the Gulf. As we have said before, ‘price will always find a way’.

Latest available data indicate that net flows between Padd III and Padd II dipped below 800 kbd for the first time since 1986 (which is as far back as available data goes). Furthermore, data for imports from Canada into Padd II also indicate a decline in late 2010, but we see this as a dual function of increasing Bakken production, alongside pipeline  restrictions.

Pricing differentials clearly economically price-out shipments of oil from the Gulf Coast to Cushing, Oklahoma. However while spot prices are clearly indicating a lack of ullage, or demand for incremental shipments, the solution to the problem revolves around reconfiguring pipeline flows to rebalance the system. Therefore we have to take not only average spot prices into account, but forward prices too.

With the Calendar 2012 Dated Brent-WTI differential at less than $2.5/bbl, it seems the market is already discounting a resolution to the issue by 2012. Relief will come when the TransCanada Keystone project is completed to Nederland, Texas, but this is some way off and will still result in WTI pricing below historical levels as Cushing changes from being a premium inland market, to a transit point for Canadian and locally produced grades as they head towards higher value markets.

But over time it is likely that further outlets will be needed. The market spreads do not currently appear to provide the financial incentive to undertake the contractually tortuous process of reversing pipelines or building more, which means that either incentives need to increase, or the process has to be driven by under-utilization. Most likely a combination of both.

The net result is that prompt WTI spreads have to remain wide for some time to come, and ‘supercontangos’ will remain a recurring feature on the landscape. Longer-term incentives however suggest that the Brent-WTI spread in 2012 needs to widen.

And there you have it: nothing more than a question of medium-term supply/demand imbalance, and one likely without an immediate catalyst that will bring the spreads to parity. Then again, the cliffhanger is, of course, that this is a JP Morgan report... about commodities. And there is hardly a firm that has perfected the art of manipulation in that particular space better than JPM: not even Goldman. Which is why at the end of the day we wouldn't be surprised if it were to come out that it was not Hess but rather the House of Dimon that was currently cornering the Brent market. Unfortunately, for the time being no incremental information is available. Suffice to say: those who believe that a compression trade between the spot curves is a slam dunk: be very careful.

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