Analysts question WTI/Brent spread

WTI this week touched the psychologically significant $70 a barrel mark for the first time since August 2006, before dropping to around the $69/bbl level.

Yet it continues to trade below Brent. In June 28 trading, ICE July Brent closed at $70.52/bbl while Nymex WTI settled at $69.57.

“There is in our view now absolutely no reason at all for WTI to be trading so far below Brent, indeed it is becoming something of an absurdity,” says Barclays Capital in a research note, referring to the fact that crude inventories at Cushing are now lower than they were this time last year, falling for a fifth straight week by a sizeable 1.4 mb down to 24.1 mb.

This year has seen WTI trade below Brent since March due to a number of factors, most notably a series of unplanned refinery outages causing a glut of supply at Cushing in Oklahoma, the main delivery point for US crude.

Lehman Brothers recently hiked their price forecast for Brent oil after the contract sustained levels above $70 for two weeks in June, pushing average quarterly prices to $69 - $4 above Lehman’s original forecast. “How much crude oil – as opposed to petroleum product – prices could increase in 2H07 and 2008 depends on the status of global refining,” noted Lehman’s Edward Morse, chief energy economist.

At one stage in May, the expiring June Brent contract moved to a $7.34 per barrel premium over WTI. The dislocation renewed debate over the suitability of WTI as a benchmark, such was the fragility of having the Cushing pipeline as a pricing point given the effect of unplanned refinery outages creating a glut of oil.

The dislocation between WTI and Brent was not helped by the effect of institutional investors rolling out of the front month and into the subsequent one, exacerbating the curve’s contago and making it more attractive to buy oil on spot and then keep oil in storage, referred to as “cash and carry arbitrage.”

Yet these economics appear to be changing. Spreads no longer show the dislocation that has characterized the WTI market in recent months, as the so-called “floating storage” is now being sent to refineries on the US Gulf or Caribbean. Last week crude oil imports into the US Gulf ran at 7.148 mb/day, the highest ever single week’s import level. Gasoline demand is driving this, with the Energy Information Administration (EIA) reporting a fall of 0.7million barrels for gasoline stocks and of 2.3 million barrels for distillate stocks, going against market expectations of increases for both.

With US oil stocks falling for five consecutive weeks, some are now claiming that the continued disparity between Brent and WTI is due to a mis-pricing, such are the reductions in Cushing’s inventory. Such sentiment may quash recent calls for Brent to supersede WTI as the benchmark oil contract.

“Brent has its defects,” note Kevin Norrish and Paul Horsnell of Barclays Capital. “Being a market for cargoes rather than pipeline crude is an advantage in terms of the logistics of arbitrage, but it also means that there is a mismatch between the ideal underlying contract volume in the futures market and the far larger cargo size. The recent rush to condemn WTI and canonize Brent is a bit over the top, seeing how clunky physical Brent price mechanisms are.”