Saturday, July 18, 2015

The Benchmarks

When one pictures an oil well or an oil rig, images of fountains of black liquid in the desert raining upon crowds of rig workers, and just like that, the business suits overseeing them suck up every ounce to exchange barrels of the stuff for stacks of cash. For some, it may be the teeter-totter motions of a pumpjack rocking beside the highway. Despite the fantasy, crude oil as a basic commodity is obviously more complicated than that, but the common psychological predispositions towards oil and its extraction often creates an ignorance to the kinds of oil, how it is extracted, and where it comes from. Even some traders in the industry take for granted the knowledge of being able to distinguish between the West Texas Intermediate Crude Oil benchmark and the Brent Crude Oil benchmark in their investment decisions. So it might seem basic, but it's a necessary education into which I choose to delve.

Crude oil, petroleum is a fossil fuel found below the upper crust of the earth. Therefore, it demands the drilling of wells and the laying of pipes in order for extracting to be plentiful and in the end profitable. Everyone knows these because they see the state of Texas populated by countless pumps accessing reserves of the black liquid underground. Various exploration techniques are used to first discover the pools of the underground liquid to ensure the efficient placement of a rig or well. As a result, the United States has discovered a vast oil supply in the state of Texas called the Permian Basin. Along with these reserves, discoveries of oil in North Dakota, Alaska, and Canada help to make up the first benchmark to discuss, the West Texas Intermediate (WTI) benchmark. This ticker for crude oil includes barrels of oil that are supplied through Cushing, Oklahoma which has become the informal oil headquarters of the United States. Pipelines from Canada and other northern oilfields transport crude to Cushing and finally throughout the states to be consumed, stored, and delivered after being traded on the commodities market. The New York Mercantile Exchange negotiates contracts for a fixed number of barrels to be delivered by a specific month in a specific year. The prices of these futures contracts fluctuate under normal market conditions and respond to supply and demand forces that come from rig counts, storage capacity, and overall production reported by Cushing, Oklahoma.

In the same way, the Brent international benchmark responds to global changes in the oil supply that may or may not include U.S. supply. Brent crude oil is traded on the Intercontinental Exchange of Futures in Europe representing petroleum that comes from Asia, South America, Europe, Africa, and the Middle East. Due to what it the areas it encompasses, Brent contracts account for around two-thirds of the oil futures contracts in the world. Its scope makes it more powerful than WTI in deciding global oil prices. The oil that flows through this giant market primarily comes from oilfields in the North Sea, namely, the Brent, Forties, Oseberg, and Ekofisk rigs. At the same time, extractions from Russia, the Middle East, Central Asia, and South America price their oil with the Brent international benchmark. International supply and demand, military conflicts, and global economic performance are among the things that create fluctuations in the price of Brent crude oil.

So they come from different places, what makes the difference? Shouldn't they still cost the same?

Not exactly. Like the many products on a grocery store shelf, variances in quality and well location cause differences in prices. Crude oil has two basic qualities that change how expensive it is to refine. Sulfur content in extracted petroleum changes how much time and money are needed to get the final product to market. Brent crude, for example, has a low sulfur content making it good for refining into diesel fuel and gasoline. The "sweetness" (low sulfur content) enables refineries to spend less on the processing of this kind of oil. Extractions from North America traded based on the WTI benchmark have lower sulfur content than Brent making the higher quality crude cheaper to refine. Another factor that plays into refining expenses is the density of the oil being extracted. Using water as a basis, oil producers assess the quality of the oil on its ability to float in water. Again, WTI and Brent both prove to have a low density with a slight advantage going to WTI. As a result, both crude oil types are known as being "sweet" and "light" with respect to their indicated sulfur content and density. One might wonder where all the low-quality product has gone as it isn't represented by a major benchmark. Low-quality oil most likely lost its profitability in competition with the "light, sweet" WTI and Brent. Even then, most oils of a different quality assimilated into pricing with the international benchmark except for a basket of oil from the Middle East that maintains a separate benchmark for contracts between them and Asian countries. The contracts that trade on an exchange in the Persian Gulf represent a mix of "heavy, sour" oil from Dubai, Oman, and Abu Dhabi. This oil has survived in the market because of its extremely low extraction price. Countries like Saudi Arabia, Kuwait, Iraq, Iran, and other Middle Eastern exporters have sealed cheap extraction costs for the countless wells in their deserts and rigs in the Gulf. On top of that, shorter delivery routes to Asian markets significantly reduce transportation costs that Brent and WTI producers must sustain. That brings up a key difference between the U.S. crude benchmark and the international crude benchmark, land-locked versus sea-based pumping. Crude locked underground in deep cauldrons prove to be more expensive to transport and store as seen in the reserves found in Canada, Texas, and the Dakotas. Pipelines are the easiest way to move crude around on land but with the necessity of capital for construction and maintenance. The controversy surrounding the Keystone Pipeline serves as a primary example of the unwieldy nature of pipeline projects The only other way is through delivery on trucks which has high fuel and time costs. The only other manner of transportation on land is trucks which accumulated high fuel and time costs. Brent oil contracts receive most of its product from water-based rigs in the North Sea. On these rigs, transportation costs are cheaper as large tankers and barges prove to be a more efficient way of storing and moving oil.

Now that the benchmarks have been expounded upon, a useful piece of data for analysis is the Brent-WTI spread.

From Market Realist

Price data from before 2010 is a lot different than what is shown. In fact before 2009, the spread had rarely deviated from $1.00 give or take a few cents. This could be because of the use of the spot price in the earlier years of the oil industry where purchases would be made at extraction costs listed at the spot. Nevertheless, the global oil supply and demand seemed very stable in before 2009 with prices acquiescing to the massaging hands of OPEC which used speculation on various military crises along with production quotas to keep crude prices high. But supply is changing, The spread above shows a significant decrease in the price of WTI oil in early 2011. Investors and economists attribute this to a supply glut in Cushing that causes backups in the pipelines that delivered oil sold on the New York Mercantile Exchange. Where did the glut come from in a time of some economists and environmentalists warning of reserves beginning a descent from "peak oil?" Fracking! The new extraction method of fracking opened up the possibility of tapping reserves that couldn't have been tapped before. Permian Basin production saw an increase to almost 1.5 million barrels a day from new fracking opportunities while the North Sea saw mediocre results 1. Production from the UK, Norway, and other countries vested in the North Sea saw slight decreases to 1.4 million barrels a day 2. Therefore, the spread is seen as a reaction of supply forces that correct the market trading price. So as WTI sees lower prices, the oil companies pumping through Cushing see lower profit margins. At the same time, fracking companies have higher costs for discovery and method of extraction than typical North Sea and Middle Eastern rigs and wells forcing a struggle for profitability. In order to soften the pressure from the glut, the spread has been fought by President Obama allowing the foreign export of WTI oil in an attempt to seek more demand for an oversupply. The chart shows the price reactions of this event in late 2013 and early 2014. Unfortunately, this wasn't enough. The international supply was flooded with new oil and stockpiles skyrocketed sending both benchmarks to new lows. OPEC, now losing a lot of its market share to new the new American fracking industry, maintained production in order to try and weed out companies looking to take more bites into their market share. So is the twilight prices are stuck in now. A valley that has multiple forces pushing up and down with continued lengths of volatility.

How can the distinction between WTI and Brent help in trading?

1. WTI can be used as an indicator of U.S. demand.
Most gasoline and fuel bought and sold in the United States comes from WTI contracts in Cushing. Thus, an increase in domestic demand can help push prices in a certain direction. For example, if stock markets show positive gains with an increase in jobs and productivity, expect to see WTI price increase due to demand strengthening.

2. WTI and Brent benchmarks represent different input costs for different companies.
Because of the locational differences between the two types of crude oil, an investor can gauge how much oil costs for a company that he is evaluating. Importing oil that is bought far from a company's main source of business increases transportation costs so look to identify input costs based on proximity.

3. Differences in benchmark prices can filter out exchange rate effects.
As national economies have to deal with oil price fluctuations, so to must they cope with the effects of flexible exchange rates. Brent and WTI are both traded in USD so a nation's currency's performance can reduce or improve their ability to import/export crude oil in the international market. This will become especially relevant as more WTI oil is traded out into other markets. Recently, a stronger dollar has hurt the purchasing power of other currencies forcing prices down on a decrease in global demand. 

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