Decoupling trans-Atlantic crude oil markets

(From Steve Maloney at Towers Perrin, steve.maloney@towersperrin.com)

The continued decline of the USD has been an important factor in the equity price rally that began in March. We've seen the effects of USD weakness in other commodities, notably gold and crude oil. Storage is the new international bank with excess oil supply serving as a currency hedge. Clearly, this is no way to run a reserve currency but can be a great opportunity for companies positioned to play it.

The Obama Administration is clearly deploying a weak dollar policy in an attempt to restart the US industrial economy. Deficit spending and low interest rates come at a price. The Fiscal 2009 Federal deficit is at least $1.4 billion and next year looks even worse. According to Bloomberg, the dollar lost over 10% of its value on a trade-weighted basis the past six months, the biggest drop since 1991. Worse, the dollar represents less than 40% of new reserves, down from the 63% 10-year average.

With dollars practically free, the flood of USD dollars is fueling talk about restructuring the world's reserve currencies. Long before the 2010 resets and IMF policy changes, markets are already responding by breakouts in crude oil and gold prices.

Crude oil price dynamics can create interesting inter-market effects as well which reinforce the breakout dynamics.

In the US, one of the more important price benchmarks is West Texas Intermediate (WTI). The WTI market comprises pipeline flows gathered in Midland which may be directed to the US Gulf Coast or to the storage facilities in the vicinity of Cushing, Oklahoma. Flow through Cushing continues up towards refineries and other processing facilities in the Chicago area. In 1983, NYMEX created the WTI contract with delivery in Cushing based, in part, on ready access to US refineries then concentrated in the US Gulf Coast. WTI is considered "sweet" in that it has less than 1% sulfur making the grade ideal as refinery feed for the higher resulting yields. With refineries driving US industrial production in the Midwest and the Gulf Coast, WTI prices were excellent marks for the physical product. As formulas-based trading emerged in 1986, financial markets synchronized with NYMEX and later the commodity markets of ICE and Dubai.

Similarly, Brent crude oil is located on the other side of the Atlantic Basin. Like WTI, Brent is a commingled crude with low sulfur content and ideal as refinery feed used for motor fuel and industrial products. Brent was originally drawn from both the Brent and Ninian systems in the North Sea. As the original Brent field declined, Platts introduced a new price benchmark in 2002 combining Brent with production from the Forties and Oseberg. Ekofisk was added to the mix in 2007. So, when we talk about Brent today, we're really talking about North Sea oil from several sources.

Since both WTI and Brent are sweet crude, one would expect the price spreads across the Atlantic Basin would reflect market coupling, modulated by the cost of freight. Consequently, we would expect WTI to price at a premium to Brent. This premium can erode or go negative due to pipeline interruptions, supply chain constraints, and US refinery outages. Such outages occur during the hurricane season impacting the US Gulf Coast in late-summer and early fall which present spikes when refineries or production is halted.

However, those traditional market dynamics have changed, partly due to shifts in the US physical market, amplified by the decline in US industrial production, and amplified by the collapse of the dollar.

The US physical market changed as a result of interconnection with Canadian products increasing the supply to Cushing. This supply enhancement was driven by the strong US economy of several years ago. As this supply grew ahead of the declining US economy, prices sifted to contango. This shift has been amplified by growing storage capacity in the Cushing vicinity. With storage costing some $1.25-$1.75 per barrel-month, the convenience yield was running in the range of ~50% annualized return for much of the past year.

The Brent market has seen similar dynamics, though without the pipeline and hurricane effects. Like WTI, the price curves are in contango which provides incentives for storing crude ahead of demand. While Cushing saw tank farms expand, Platts reported charters by BP and Shell of very large crude carriers starting a year ago mooring off the UK coast.

As crude prices fell, we also saw spikes in the WTI-Brent spread volatilities. These spikes can be explained, in part, by the disproportionate storage additions at Cushing compared to storage available for Brent. However, the final complication has been the decline in the USD, and falling refinery utilizations (and margins) reflecting the overall collapse of the US industrial economy. For example, US industrial utilizations remain stuck below 70%, compared to the long-term average of 80%. By comparison, lows in previous US recessions were in the range of 75%. These lows are even more pronounced in the Midwest where a substantial portion of Cushing flows were directed. US industrial demand has retreated to levels seen around 2002 or so. Today, Cushing inventories have ranged well above 30 million barrels, compared to inventories in the 2004-2005 period of 15 million to 20 million barrels.

By comparison, European industrial utilization declines lagged US declines. The lagging differential injected volatility and anomalous behavior in the spreads.

Looking ahead, the continued weakness of the USD combined with differences in supply chain dynamics between the US and Europe may create arbitrage opportunities in the WTI-Brent spreads that were heretofore episodic. Unless new dynamics emerge, the increased volatility combined with this weakness can continue to drive crude oil into storage ahead of production needs. As long as the industrial economy and the USD remains weak, storage will serve as an attractive currency hedge. But, with increased demand, there may not be as much letup in price pressures.

In my next blog, I'll talk about the effects of recent developments on traditional spreads between natural gas and crude oil markets.

Stephen Maloney
Managing Consultant, Risk and Financial Services
Towers Perrin
steve.maloney@towersperrin.com