Crude Oil Supply Battles keeping WTI and Brent Apart

Daily Analysis - 20/12/2017

Price Premium for Brent Crude above WTI at $7 per barrel


Divergence of the prices between the American supplied crude, called West Texas Intermediate (WTI) and the crude commonly referred to as Brent, which is a blend of different crude oils from the North Sea between Britain and Norway, is now about $7 per barrel. We are going to try to understand why this is so and, as is our usual intent, to figure out how to make money from this reality.

Why is there a difference in price at all? Isn’t all crude oil a commodity?

Yes, crude oil is a commodity and therefore, by definition, substitutable between sources. However, unlike other commodities like the metals or the agriculturals, all crude oils are not created equal. Indeed neither are agricultural crops. Corn or sugar have specific grades with specific standards by which other grades are measured and therefore sell at premiums to or discounts from. Those standards are called benchmarks. WTI and Brent are benchmark products. However unlike corn or sugar whose variability’s are generally minor, crude oil varies greatly. The most important variables are weight, called specific gravity, which means how dense the stuff is, and “sweetness”, which refers to the sulfur content. Both of these variables directly affect the costs at which refineries can process the crude into refined products. Therefore practically all outputs sell at discounts or premiums relative to the benchmarks. This is the reason that Brent is blended together from the outputs form the over forty fields in the North Sea. More on this blending feature below.


Supply and demand are crucial in the crude oil market

While we all understand that supply effects demand which in turn effects supply etc., the supply and demand functions for crude have particular characteristics we need to be aware of because there is a great deal of profit to be obtained from these understandings and potential losses resulting from ignorance of them. First is that demand is pretty steady for crude oil. It doesn’t vary much from year to year. It grows at a steady pace, a few percentage points a year, based almost entirely on macro-economic growth in trading zones. Thus, when there is macroeconomic recession, (shrinkage or less growth) demand for fuels shrinks accordingly. Therefore the major element in the pricing of crude is supply. So much so that the most widely watched and traded events on the weekly economic calendar is the Crude Oil Inventory Report. It shows the difference in the amounts of crude stored in the US from week to week. And it is a classic example of the supply of a good directly effecting its price. If more of the stuff is available than was expected to be, price almost always falls and vice versa. That is why it is so widely watched and traded as an event: The movement in the price is highly predictable as the result is published. Have a look for yourself and see that when the result diverges from the expectation the price will move accordingly. Every Wednesday, 15:30 GMT. (See the chart showing the changes week to week)


Competition between the producers is great and has enormous impact on supply

Oil producers are divided into two groups; those who are members of the international oil cartel, called The Organization of Petroleum Exporting Countries (OPEC) and their non-member supporters, and the rest of the world, comprised largely of the North American producers. The rivalry between these two groups is intense. This is principally so because the cartel members are much more dependent on the commodity than are the non-cartel members. For non-cartel producers, their output is part of the long supply chain of economic activity in their economies of which they play their part. For the cartel members, crude is almost always their only, or certainly their principal economic output. Therefore it is in the cartel members’ interest to keep prices high, while the non-cartel members have a more cooperative, integrative role in their economies. Too, the cartel was established because of and functions in the context of economic abuse by the western consumer nations. Politics plays more of a role in the supply of oil than any other commodity.


US Dollar price effects crude prices

As with all capital assets, they are priced relative to other assets. In the case of crude the other side of the equation is the US dollar which is how all oil is priced and paid for. Therefore, we must be aware of whether the value of the US Dollar is rising or falling when speaking of oil. In other words, when the US Dollar strengthens the price of oil usually falls and vice versa. The difference between USDEUR and USD JPY (Japan is a major oil importer) impacts the price of oil as well since these economic zones consume crude in huge quantities.


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