Could Brent’s Premium Over WTI Imply a $70 above Oil prices?

``Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” Lao Tzu, Chinese Philosopher

At the start of the year despite being apprehensive over the prospective performances of global equities markets we remain buoyant on oil prices on two basic premises; one, Peak oil, where about 80% of global oil reserves are held by national oil companies, non-transparency, market distortion from government intervention and politically instability from resource rich countries has continued to placed a restrain on the supply side from adjusting to market requirements.

For instance, would you believe that despite being an oil exporting country starting May 21^st Iran will be rationing its gasoline? Yes, the country is said to hold 10% of the world’s oil reserves but subsidies have kept its supply consumption high. Reportedly high consumption levels could have been corollary to the government imposed subsidies as some have undertaken to smuggle oil and sell it at global prices beyond its borders.

When we say peak oil we mean the end of “cheap oil”. While technology has enabled access to once prohibitively costly oil patches [e.g. deep sea], national policy restrictions have been a huge barrier in expanding supply access even with such added technology at hand.

Take for instance Mexico’s once prolific Cantarell oil field, one of the largest in the world. Last year its production dropped by a significant 20% from 2 million barrels per day to 1.6 million barrels a day. Some estimates have even placed the field to produce by less than 500,000 per day or an equivalent 75% drop in 2010, according to Petroleumworld.

Yet Mexico’s national oil company Pemex suffers from foreign investment restrictions embedded in its constitution from which its two past chief executives have failed to persuade members of the Congress to have this lifted. As a result Mexico, according to Wall Street Journal, may become an oil importer within eight years!

Of course the other factor major factor is the declining US dollar.

Lately, I stumbled across a very compelling argument posed by analyst Elliott Gue of the Energy Letters where he notes of the present disconnect between the benchmark crudes of the WTI (West Texas Intermediate) and Brent Crude which could translate to a significant impact on oil prices.

Figure 3: Energy Letters: WTI-Brent spread breaks!

The WTI crude is of higher grade sweet crude and is widely used in the US and benchmarked by US refiners while the Brent Crude is of a lesser grade sweet crude than the WTI but is commonly used in Europe and in Asia and likewise benchmarked by the refiners of the respective regions.

Figure 3 shows that in the past seven years WTI maintained an average premium of $1.72 relative to the Brent. However recently, the Brent Crude turned negative by a huge amount. Such negative spread reflects of the global demand supply imbalances which could possibly induce higher crude oil prices in the coming months.

Mr. Gue says ``When Brent trades at a significant premium to WTI, US refiners start refining more WTI (and other types of crude) and less Brent. This reduces demand for Brent and pushes up demand for WTI, putting downward pressure on Brent prices relative to WTI.”

Figure 4: Stockcharts.com: US Gasoline prices reach Major Resistance Levels!

As we enter the major driving summer season in the US, a sharp drop in gasoline inventories has caused a spike in gas prices. Where the U.S. transportation sector accounts for 66% of all U.S. consumption, the recent spike in Gas prices hardly signifies a slowdown with its economy.

Figure 4 shows that in the past 3 years, each time gas prices reach the resistance levels, oil prices hit the $70 or more per bbl area, however today we see a virtual lag in the WTI prices. Technicians may see today’s actions as a sell based on previous price behavior over the past three years, but I wouldn’t bet on it.

While gasoline inventories have been dropping, crude inventories have stayed high due to low refinery utilization or bottlenecks in the supply chain as refiners reduced outputs due to maintenance related outages. However the refiners are expected to pick up the slack by completing their maintenance work soon, and should be expected to use up quickly the higher than average inventories.

On the other hand, global inventories of crude oil have dropped sharply, crude oil inventories fell to about 80.5 million barrels last February. Further, the IEA estimates that the combined supply in the US, Europe and Japan have declined at a rate of more than 1 million barrels per day during the first quarter of the year; a higher than average decline for the season.

In short, the negative spread reflects the quickening depletion of crude stocks abroad relative to the US, hence the negative spread. And this should imply for higher prices in the interim as US seasonal demand picks up and where supply imports by the US are expected to rev up in order to augment current stock levels.

Quoting Mr. Gue, ``But with US oil benchmark (WTI) prices below prevailing international benchmark (Brent) levels, US refiners are going to have trouble finding any oil to import; better oil prices are available internationally than in the US. Of course, there are certain oil supplies (such as Venezuelan heavy crude) that are relatively captive to the US market. However, with WTI prices so far under international levels, it will be tough for the US to attract additional barrels.

``It's simple economics: If the US is going to attract imports, US benchmark prices will need to rise toward international levels and WTI will have to close its discount to Brent.”

``Moreover, as US crude inventories start to draw lower and the nation begins importing again in earnest, this will represent another wall of demand for the international crude oil markets. In other words, strong US gasoline demand will eventually represent a strong draw on global crude oil supplies. Those supplies are already tight, and OPEC shows no sign of letting up on its campaign to cut output.

So fill up your gas tanks as oil prices are due back to the $70 levels and above. On the hand, you may consider oil stocks as insurance.