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.

 

The Brent-WTI Spread

WTI is a crude oil specific to the Midwest region of the U.S. Its large discount to Brent can be attributed to several different factors indigenous to the North American market.

Specifically, the amount of crude oil going to refineries in the Midwest is increasing because of increased supply from Canadian oil sands and from North Dakota’s Bakken Shale. This glut of crude into the Midwest region pushes prices of WTI at the Cushing, Okla., delivery point lower.

In contrast, Brent is reflective of crude produced in the North Sea region. Brent is more indicative of the Eurasian supply/demand balance and many analysts argue that Brent is a more global benchmark and reacts more to global events.

For example, the political transition in the Middle East has taken several large producers off-line. Specifically, Libyan and Syrian crude oil has been unavailable or greatly reduced for several months. Libyan production dropped by 1 mmbbls/day since the revolution, and because Libya is a major exporter to Europe, this supply shock pushed Brent prices higher.

Bottom line: WTI is a regional benchmark reflective of supply/demand issues in the American Midwest, while Brent is a European benchmark reflective of specific European issues (with slightly higher exposure to regions such as Africa and the Mideast).

While WTI and Brent are still widely used to set global oil prices, this may no longer be the case in a few years. Already we’re seeing major producers shifting away from the two benchmarks. Brazil’s Petrobras (NYSE: PBR) has recently switched its benchmark pricing from WTI to Brent; and Saudi Arabia, Iraq and Kuwait all shifted their benchmark pricing for U.S. exports from WTI to the Argus Sour Crude Index.

These two benchmarks will increasingly become irrelevant as markets seek one global benchmark. The widening Brent-WTI spread is accelerating this trend. However, since we are several years away from that, you can still profitably trade the WTI and Brent spreads.

Trading The Spread

One way to continue playing this ongoing price differential is to go long companies that have a large exposure to Brent while avoiding WTI-based companies. One of the companies that gives you Brent exposure is Anadarko Petroleum (NYSE: APC), which is one of the largest independent oil & gas exploration and production companies. Anadarko has a large footprint in Africa, giving it coveted exposure to Brent crude. Specifically, it has more than 2 billion barrels of reserves in Algeria and has production of more than 100,000 barrels/day in Ghana.

I also recommend Apache Corp. (NYSE: APA) for its diverse footprint. Not only is it active in markets such as Argentina and Australia, but it also has a large exposure to Egypt. Apache also recently bought hydrocarbon assets from BP (NYSE: BP) in Egypt’s Western Desert, increasing its exposure in an important market. In addition, it has more than 60,000 barrels of oil production in the North Sea, giving you direct exposure to Brent crude.



Disclosure: Amine Bouchentouf does not own any of the stocks mentioned or have a position in crude oil.

 

Amine Bouchentouf is a partner at Parador Capital LLC, an institutional advisory firm focused on commodities and emerging markets. He is the author of the best-selling “Commodities For Dummies,” published by Wiley. Amine is also the founder of Commodities Investors LLC, an advisory firm dedicated to providing insightful information on all things commodities. He can be reached at [email protected].

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