The Commodity Investor: Brent & WTI, Tale Of Two Oils & Two Prices

October 24, 2011

Understanding why the price spread is occurring between the two benchmarks is important if you want to trade in crude oil or invest in oil companies.

 

The price differential between Brent and West Texas Intermediate (WTI) crude oil has been high throughout this year, trending in the $20-$25 range. Brent crude is currently trading at $110/bbl while its West Texas Intermediate counterpart is trading at a $23 discount: $87/bbl.

This is a historical anomaly since Brent and WTI have traditionally traded in a tight range with each other (within a $2 range prior to 2011). But why is the spread suddenly so large? Why is WTI trading at a discount and what can we expect going forward? Before I answer these questions, there are key factors we need to understand.

Oil Benchmarks

First, why do we have WTI and Brent benchmarks in the first place? The WTI and Brent benchmarks are just that — crude oil benchmarks that traders use to determine transactional settlement prices. Crude oil production is global in nature and crude types are extremely varied. Since the product range is so large, benchmarks are used to give a reference point that can be globally quoted and traded.

There are over 160 different types of crude produced in the world. Each type of crude is priced differently based on its quality, which is determined by several factors, the most important of which are American Petroleum Institute (API) gravity and sulfur content.

Sulfur content determines whether a crude is sweet or sour. A crude type with low sulfur content — less than 0.5 percent — is considered “sweet” and is highly desirable. Sweet crude is easier to refine into gasoline and other products.

API gravity measures whether a crude oil is heavy or light: Crude oil with an API above 10 is light because it’ll float on water; a crude oil with an API below 10 is heavy and will sink.

Both WTI and Brent are considered light, sweet crudes because they both have sulfur content of less than 0.5 percent and an API level above 10. Even though these two types of crude are used as global benchmarks, it’s important to point out that the system is imperfect (and to some extent flawed) because these two benchmarks cover only light, sweet crudes traded in Europe and America.

For example, Brent and WTI don’t reflect heavy, sour crudes that are more common in the marketplace, such as Venezuela produces. These two benchmarks only offer a glimpse into the global crude-oil picture. In essence we have two regional benchmarks masquerading as global benchmarks, and that’s one of the reasons for the large spread.

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