Oil Price Differentials leading to shift in Market?

There has been growing consensus in the marketplace that the international benchmark for crude oil has shifted to Brent Crude. West Texas Intermediate (WTI) is virtually unavailable outside the USA, whilst the North Sea’s Brent Crude is traded more widely internationally. In 2013, the outlook for crude oil looks relatively stable, yet there is potential for greater regionalisation of world crude oil prices due to wider spreads between the different oil prices.

Currently WTI crude oil is trading at around US$91 per barrel and Brent crude oil at US$110 per barrel. This represents a spread of around $19 between the two crudes in a market where the prices of different streams of crude oil, as a truly global market with low shipping costs, usually move together due to the arbitrage opportunities. The spread has also widened noticeably from January 2013 when it was around $10. It is my contention that new demand and supply dynamics is transforming the global crude oil market into a regionally sensitive one. Enhanced oil recovery technologies have increased the number of potentially recoverable reserves, particularly in shale formations, tar sands, subsalt reservoirs, and deepwater wells. This increase in potentially recoverable oil reserves has enabled consumers to source crude oil locally, the consequence of which is the beginning of a decoupling of the global oil market. This is most evident in the USA and Canada where shale plays and tar sands have enabled local sourcing of oil to the extent that the current infrastructure is unable to accommodate the oversupply (Cushing, Oklahama is experiencing an ongoing glut due to inadequate pipeline infrastructure).

Even in the Middle-East and Asia, the same trend is observable. Dubai-Oman crude oil is trading at US$105 per barrel, resulting in a $5 spread relative to Brent. The spread has widened substantially from around $3 in January. This reflects doubts over OPEC’s spare capacity as a cushion for any potential shocks to world oil supply and security concerns over Iran and Syria. Furthermore, increased preference that investors are showing for Brent futures rather than other crude futures contracts is affecting the pricing of underlying crudes.

Therefore, my estimate for crude oil prices for 2013 is that Brent trades at around an average of $115 per barrel, WTI at an average of $90, and Dubai-Oman at an average of $108. Price differentials are likely to widen as a result of increasingly local sourcing of oil by consumers. With wide stockpiling of spare capacity, there is also less need to draw on supplies from other areas of the world. Global spare capacity is around 2 million barrels per day and projected to increase to 3.5 million barrels per day by July 2013, roughly 3.5% of oil demand and well above the danger zone of 1% that would induce a price spike. However, although unlikely, a supply shock could lead to price differentials closing among the various streams of crude oil. Global demand growth for crude oil is also modest whilst supply is growing modestly, which should also help moderate oil prices.

It should be said that price differentials will only last as long as the spread does not get too big that arbitrage opportunities become too lucrative to refuse for IOCs. There is potential for US refiners - Marathon Petroleum Corp, HollyFrontier Corp and Tesoro Corp – to take advantage of the price differential between WTI and Brent Crude. These companies can provide excellent arbitrage exposure for investors interested in the current oil market.