The historic disconnect between West Texas Intermediate, the global oil benchmark traded at the Chicago Mercantile Exchange (CME), and Brent crude oil, the relative “upstart” traded at the Intercontinental Exchange (ICE), is more, I think, than a temporary realignment.
I think it marks a sea change in the benchmark pricing of global oil, most certainly to the benefit of the European Brent grade but not entirely so. It is becoming clear that no one benchmark, whether U.S. or foreign, is any longer capable of describing what’s happening in oil. And that is a big deal for the future of oil pricing and the future of your energy portfolio.
Oil is unique, unlike any other commodity because there are literally hundreds of grades of the black gold. No one is exactly the same as the other; they can vary in many ways, but most significantly in their sulfur content.
Sweet grades, like WTI and Brent, have less sulfur and are easier to refine and therefore generally more expensive and in demand. Sour grades, like Mars, Omani and Dubai crudes are more plentiful and generally the supply benchmarks in Asia.
Financially speaking, however, the huge growth of financial oil left the many separate physical grades of oil behind decades ago. For ease, liquidity and access, all of “oil” has been financially accessed using the futures-based global benchmark of WTI, which I traded for almost 10 years on the New York Mercantile Exchange, now owned by the CME, with Brent crude, first traded at the IPE and now owned by the ICE lagging far behind.
Indeed, real physical oil began to be priced in the many unique markets using the WTI benchmark, with some producers and end-users sometimes opting to offset any differential risk with other outside ‘basis” hedges.
The important takeaway is that the prices of physical oil actually paid on the cash markets was overwhelmingly controlled by the prices created at the futures market nexus — contracts between real world users and producers refer to WTI (as do the Europeans to Brent using the Brent Weighted Average formula (BWAVE)).
OK, it’s a complicated market, I admit. But for the last month and a half, fundamental supply bulges at the WTI delivery point in Cushing, combined with financial rebalancing of indexes away from WTI and into Brent, have been two of the most important reasons why WTI crude has ridiculously lagged not just Brent crude, but virtually every grade of crude oil traded on futures and cash markets both here in the U.S. and abroad.
The WTI/Brent spread has grown to an over $17 dollar discount, where historically WTI has often traded over Brent crude.
There are a lot of big problems with a benchmark that no longer correctly follows what is really happening in the rest of the global oil market.
One thing that surely happens is that users of the benchmark begin to lose confidence in the ability of the financial instruments to satisfy their hedging (and speculative) needs.
We have already seen motion of the biggest energy hedge funds towards the ICE benchmark, while Aramco, the Saudi oil company, has begun to rely upon the Argus Sour Crude Index (ASCI) to help price exports since the first of the year.
But perhaps the most important outcome is that producers and end users that have been using WTI to value real, physical oil no longer pay or receive a representative price for other grades, particularly if they have refrained from using the OTC markets to offset their basis risks.
For large-scale producers like Saudi Arabia, it will most certainly accelerate their move to the ASCI price benchmark they already initiated and which I’ve studied extensively in the past.
For other end users, particularly the independent refiners, it’s been a real, if temporary boon: input costs for crude based on WTI has sharply lagged the market prices they can receive for finished products like gasoline and heating oil.
Those refining margins have absolutely exploded and so have their stocks: Valero(VLO) is up more than 47% in the last three months alone, and Tesoro(TSO) is up a stunning 62% in the same time.
Even if the fundamental and financial disconnects clear at Cushing and WTI again resumes a better tracking of global oil again, I would expect that this “shock” to the system will never allow WTI the status of lone benchmark for oil that it has enjoyed for the past 30 years.
When we talk about “oil,” whether we refer to a price running across the top of the CNBC screen or in articles or videos, we can no longer merely refer to WTI and be correct. We are moving into a new age of oil, where only a basket price, including Brent and I expect Mars, Dubai and Omani sour crudes, will be used to correctly represent the “price of oil.”
This is a massive change and one we need to be aware of to correctly value the underlying energy stocks that rely upon these prices.