London, 16 June 2011

The near-record premium for a barrel of Brent oil compared to West Texas Intermediate (WTI) cannot be explained away by problems at the Cushing hub, according to Julian Jessop Chief International Economist with Capital Economics. Brent has risen further than other benchmarks too, including the similar Light Louisiana Sweet, as well as those of lower quality overseas. Capital Economics suspect that the price of Brent has also been boosted more than others by speculative demand.

Oil prices have, of course, surged across the board this year, largely due to the unrest in the Middle East. But what needs to be explained is why Brent has risen so much further than the traditional US benchmark, WTI. The price spread peaked earlier this week at nearly $23 per barrel (pb), and still stands at around $20pb. The underperformance of WTI can partly be attributed to refining and capacity problems at the storage and pricing facility for WTI, located at Cushing in Oklahoma. These have led to a build up in stocks which has depressed prices. What’s more, the delivery point at Cushing is landlocked, which makes it harder to shift these stocks around the world to take advantage of price differences elsewhere.

"This cannot be the whole story," says Jessop. "The logistical problems at Cushing are not entirely new, but WTI has generally traded at a small premium to Brent. WTI is of higher quality, being lighter and slightly sweeter, which makes it easier and cheaper to turn into gasoline or diesel. The last time that Brent traded significantly above WTI was in May 2007 following a major refinery shutdown at Cushing. The spread then peaked at around $8pb, well below current levels.

"The price of Brent has also risen much more this year than that of most other benchmarks. For example, the spread between Brent and Dubai crude has widened by around $10pb. This partly reflects the fact that Brent is lighter than Dubai crude and indeed lighter than much of the oil produced by Saudi Arabia (which has a higher sulphur content too). Brent is therefore a more natural substitute than these Gulf crudes for the relatively light oil previously supplied by Libya. There have also been disruptions in the supply of light crude from Nigeria, and production shutdowns affecting the supply of Brent itself.

"Consistent with the importance of the type of oil, the price of Brent had (until very recently) continued to move closely in line with another US crude, Light Louisiana Sweet, which is of similar quality and, unlike WTI, easily shippable elsewhere by sea. However, a small but unusual gap opened up last week in favour of Brent here too. (See Charts 1 and 2.) It cannot be a coincidence that the bulk of the surge in the Brent – Louisiana spread has taken place since OPEC surprised many by failing to raise output quotas on 8th June. We suspect that this surge reflected a jump in speculative demand, which will have benefited Brent disproportionately as it is now the main benchmark for oil prices in financial markets.

"The current (roughly) $20pb spread between Brent and WTI can therefore be broken down as follows: $10 for the logistical problems at Cushing, an additional $5 for Brent’s greater attractiveness compared to other non-US crudes as a substitute for Libyan oil, and a further $5 due to a spike in speculative demand following disappointment at OPEC’s failure to boost quotas. However, all of these elements should diminish over time, starting with the latter as Saudi Arabia raises output regardless. Middle East tensions will also fade (eventually) and there are plans in place to ease the supply constraints at Cushing."

Overall, Capital Economics expect the Brent-WTI spread to be back below $10pb by the end of the year.

Ends --

Julian Jessopis Chief International Economist (+44 (0) 20 7808 4996) with Capital Economics

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