- The Brent-WTI spread has blown out to over US$17
- The gap reflects lack of storage at Cushing
- The global oil price is US$117/bbl not US$100/bbl

By Greg Peel

As explained back in February in an FNArena feature story (Death In West Texas), this year has seen a rapid extension of the usually tight premium between the world's benchmark West Texas Intermediate crude futures price and Europe's major benchmark Brent crude futures price.

Just to recap, while oil is the largest cross-border traded commodity in the world, the "price" of oil is set in futures markets in which producers and suppliers hedge their exposures and speculators provide abundant liquidity. Trading paper is a lot easier than moving supertankers of crude around the globe, and only a tiny percentage of expired futures contracts actually result in delivery. Over 95% are closed out for cash.

Oil is produced all over the world and while gold, for example, is generic, oils vary at each location in their density and sulphur content providing variations of light and heavy, sweet and sour. This means individual oil prices trade at varying discounts/premiums to each other. Given a level of substitutability, those price gaps have, in the past, remained fairly tight.

West Texas crude has long been the world's oil price benchmark for no other reason than one of history. The US became the world's first major oil producer, and Oklahoma is the industry's historical centre. US oil production has long since moved focus to the Gulf of Mexico but the biggest storage facility for US crude remains at land-locked Cushing, Oklahoma, in the US mid-west, to which West Texas oil futures obligations must be delivered.

The futures price of any consumable commodity reflects not only a balance of demand and supply, but also the cost of storing that commodity (storage charge and carry cost). If storage becomes expensive, which will occur when the supply of available storage is tight, then the value of the oil at that expensive storage facility must compensate for the additional cost. At the end of the day, oils remain substitutable once they have left storage (net of relevant transport costs) so the price of oil futures contracts which require delivery to that point of storage must fall. The price of Brent crude, which is deliverable to a facility in Scotland on the North Sea, has not blown out over WTI in 2011 because more people now prefer Brent. It is simply that the value of WTI in storage has fallen below that of Brent to reflect the greater storage cost.

Which is why oil analysts, economists, producers and consumers have switched to Brent as the benchmark ? as the "price of oil" in their calculations in 2011 ? and are now ignoring WTI. There remain those who won't let go of WTI as the "price of oil" mostly because of patriotism or ignorance. Ironically, the price of Gulf of Mexico crudes such as Louisiana Light have tracked closely with Brent thus also leaving WTI behind. Indeed, just about every oil produced on the planet is remaining in lockstep with Brent, net of quality discounts/premiums, leaving WTI to be very much a loner.

This is important for oil producers and consumers across the globe, because it is the higher price they must assume, not the WTI price. In Australia for example, we have always benchmarked off the Malaysian Tapis price delivered to Singapore, but Tapis supply is waning and more and more Brent is arriving at the Singapore refineries to substitute, despite the distance it must travel. So the price Australia is now paying at the pump is being benchmarked off Brent while on the flipside, oil producers such as Woodside ((WPL)) are assuming the Brent benchmark in their earnings guidance.

The market understands that the "price of oil" at present represents a premium for lost production from the major oil producing nation of Libya. Libya is normally a significant oil supplier to Europe so while production is lost there, North Sea oil must fill the gap and hence there is individual upward pressure on the price of Brent.

It is an easy mistake to think the whole problem could just be solved if everyone bought more WTI instead, particularly if it is in a "glut". But Cushing is right smack in the middle of the US, far from any port. And the oil from that storage centre has typically serviced extensive US domestic demand. It's never been considered an "export oil" and indeed there are no pipelines to feed it to the Gulf ports.

The US is a net oil importer, not an exporter. Its greatest source of imports is Canadian crude which enters the US via a pipeline. That pipeline leaves Hardity, Alberta, before reaching storage tanks at Pakota, Illinois, and then moving on to the tanks at Cushing, Oklahoma ? the end of the line. Storage at Cushing began to run out when the pipeline was completed and today Cushing holds a record 40m barrels.

To reflect this import flow, and the subsequent rise in storage cost at Cushing, the WTI price has been falling in relation to the Brent price all year. It has appeared as if the Brent price has been rising over WTI but this is a misconception. The price of all oil has been rising on emerging market demand and MENA disruption, along with a little help from a weak US dollar.

While we have since had a big plunge in the oil price(s) when the speculative bubble burst last month, at the same time the Canadian pipeline sprang a leak. Under leaky conditions, the Brent-WTI spread held steady at around US$15/bbl. But it was announced last night that not only had the leak finally been repaired, Canada intended to increase the flow down the pipe to catch up with lost June deliveries.

In other words, storage at Cushing is going to become even more expensive.

And last night the US Energy Information Agency increased its global oil demand forecast by 300,000 barrels per day to 1.7m barrels per day. The US dollar was also weaker, so Brent crude responded to the news by rising US$2.30 to US$116.78/bbl. Normally WTI would have had the same response to maintain the running price gap, but this time it didn't given the pipeline news. West Texas added only US8c last night to US$99.09/bbl. The Brent-WTI spread is now a whopping US$17.69.

Already the price disparity prevailing over 2011 has encouraged Cushing oil to be transported to the Gulf refineries by rail and barge, but this is still a slow process. So now the plan is to build another pipeline ? this one from Cushing to Houston. The problem is, it will take possibly two years to build.

In the meantime, readers are reminded to ignore the price of West Texas crude even if media outlets continue to use it as the global "price of oil". The price to worry about is now, firmly, that of Brent crude, and all other world oils are closely tied.

Oil is not US$100/bbl, it is US$117/bbl.