Crude switch triggers US oil recovery

It was one of the wildest rides in commodity markets.

After years of trading within a few dollars of one another, the world’s two most important oil contracts parted company this year. The “spread” between the two rapidly became one of the most popular trades for hedge funds, who made and lost millions as a barrel of North Sea Brent crude rose to as much as $28 a barrel more than the price of West Texas Intermediate, its US counterpart.

Click to enlarge

Those days may just have come to an end. The spread, or difference between the two contracts, collapsed to just $7.88 on Thursday, a move of more than $10 in little over a week, as the price of WTI shot up to as much as $103 a barrel before falling back to $99.

The drop has implications beyond the trading books of risk-hungry hedge fund managers. The divergence between WTI and Brent has hurt investors such as pension funds who traditionally invest in WTI, as well as companies from airlines to refiners who used the contract to hedge.

Behind the dramatic move in the spread was a decision by Enbridge, the pipeline’s new owner, and joint venture partner Enterprise to reverse a pipeline between the US Midwest and the Gulf Coast. The pipeline switch, which the companies plan to execute by the second quarter of next year, should help drain the excess of crude oil inventories in and around Cushing in Oklahoma, the delivery point of the WTI contract. Traders want to move oil from Cushing to the Gulf Coast, where prices are much higher. The surplus stocks were the root cause of the divergence.

Traders and analysts reacted by scrambling to revise their predictions about oil prices. Morgan Stanley, which had earlier this year called for the Brent/WTI spread to hit $50, said it was now expecting the spread to remain in the $5-$15 range. JPMorgan raised its forecast for average WTI prices next year by $12.50 to $110.

Nonetheless, analysts are not expecting Brent and WTI to trade at parity any time soon. A surge in production from shale oil formations such as Bakken in North Dakota as well as from Canada’s tar sands means that, even after the reversal of the Seaway pipeline, there will still be a surplus of oil in the US midwest.

However, the reversal is not the only development to help reconnect WTI with global oil markets.

Shipments of oil out of the US midwest by railway have been rising rapidly, with the Bakken Oil Express terminal moving its first crude last week. The number of railcars transporting oil in the US was up 19.4 per cent in October from a year earlier, according to the Department of Energy.

That could be crucial to maintaining a hefty differential between WTI and Brent. The cost of moving oil by rail, estimated at roughly $5-$10 a barrel, is significantly higher than by pipeline.

CME celebrates

Among the parties with the most at stake in the planned reversal of the Seaway pipeline is CME Group, owner of Nymex, the energy exchange.

WTI is CME’s flagship energy futures contract, but its status as a global benchmark has been thrown into doubt this year as it lagged behind other crude streams. The Dow Jones-UBS commodity index is cutting exposure to WTI as it adds Brent to its basket for the first time.

WTI remains the deepest crude futures market, but Brent has been gaining ground. Volume in Brent futures topped WTI in a third of trading sessions since September and open interest is approaching 1m contracts. CME did not conceal its pleasure at the Seaway announcement on Wednesday: “We believe this new project will enhance the significance of our Nymex Light Sweet Crude Oil (WTI) benchmark.”

“We anticipate that rail capacity will still be required to move crude oil to the US Gulf Coast from midwest through next year as the Seaway will not be able to absorb all of the volumes we had anticipated would be needed to be moved by barge and rail,” says David Greely of Goldman Sachs.

Nonetheless, some believe that so-called “Cushing syndrome” may not be a thing of the past. “We would warn against getting too carried away here,” says Amrita Sen, oil analyst at Barclays Capital.

The Seaway pipeline could start moving 150,000 barrels per day to the coast by the second quarter, increasing to 400,000 b/d by 2013, according to its owners.

But several other projects are in doubt. TransCanada’s Keystone XL project remains in regulatory limbo after environmental protests led the US government to delay a decision on its approval, though the company said on Wednesday it was hopeful of building the section of the pipeline from Cushing to the coast. Enterprise said late on Wednesday that the Wrangler project, that would have carried 800,000 b/d from Cushing to Port Arthur in Texas, will now be subsumed into the Seaway reversal.

“Behind all this euphoria, a lot of key pipelines have actually been cancelled,” Ms Sen notes.

In addition, the narrowing of the Brent/WTI spread could actually cause inventories in Cushing to build up more sharply.

When WTI was trading at a steep discount, producers and traders did their utmost to avoid delivery of oil into Cushing, a trend that has led stocks at the hub to fall by nearly a quarter, or 10m barrels, since April.

Now the spread has narrowed, deliveries may rise, pushing down Front-month futures and so leading to more volatility for pension fund investors.

“Producers could begin to send their oil back to Cushing rather than seek to bypass it on the railroad,” says Francisco Flores-Macias, analyst at LCM Commodities, an energy brokerage.

One thing is certain: its wildest days may be behind it, but the Brent/WTI spread will capture the interest of oil traders for some time yet.

Additional reporting by Gregory Meyer in New York