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In a Volatile Oil Market, Much of the Action Is Between Benchmarks

Growing U.S. shale production is depressing the U.S. crude benchmark, WTI, relative to the global Brent standard and shifting the flow around the world.

As energy investors bet on the direction of crude oil prices following the recent plunge of more than 50 percent, the question of which benchmark to use is more relevant than ever.

The difference between the price of Brent, the global oil benchmark, and West Texas Intermediate, the leading U.S. crude, has fluctuated dramatically in recent months, altering the flow of oil around the world. WTI was trading at $53.11 a barrel on April 14, more than $5 cheaper than Brent, at $58.46. That discount was up from zero in January but down from a recent peak of more than $12 in late February.

Notwithstanding the volatility, the discount on WTI has widened recently relative to the historical pattern because of the boom in U.S. shale oil production, which has overwhelmed local storage capacity and outpaced the building of new pipelines. U.S. crude oil inventories are at their highest level for this time of year in at least 80 years, the U.S. Energy Information Administration, a government agency, said on April 8. The WTI discount has also been driven by the country’s four-decades-old ban on crude exports, analysts and investors say. The spread is likely to narrow next year as U.S. drilling activity slows in response to weaker prices, according to analysts and EIA projections.

The benchmark dynamic has more than a passing interest for commodities investors. “The Brent-WTI spread for a long time was risk-on, risk-off,” says Phil Flynn, an oil markets analyst at the Price Futures Group in Chicago. “When it seemed there was risk in the Middle East, people would buy Brent crude and sell WTI. When there was concern of disruption overseas, the hedge would be to be long Brent versus WTI because the U.S. has plenty of oil on the glide.” The prospect of a sustained discount on WTI “could really rewrite where the spread is going to go in the long term,” Flynn adds. “A lot of investors have been playing this spread as a hedge against oil but also against their entire portfolio.”

The big differential between the benchmarks is also driving significant changes in global oil trade. Most notably, Latin American countries like Mexico, which links its oil price to WTI, have taken advantage of the price gap to bolster their crude exports to Asia this year.

“Traditionally, Asian markets prefer Middle Eastern crude because it’s cheaper for them to bring it in because it’s closer,” says Mara Roberts, a New York–based oil and gas analyst at BMI Research, a unit of Fitch Group. “The WTI benchmark was at enough of a discount for Chinese refineries to want to bring in Latin American crudes.”

According to the EIA, Mexico’s state-run oil company, Petróleos Mexicanos, or Pemex, cut its official crude price for Asian buyers to $7.85 below that for Dubai/Oman crude, a Middle East benchmark that closely mirrors Brent, in February, and to $7.05 below in March. The agency described those price cuts as “two of the largest discounts since at least 1995.” South Korea’s GS Caltex Corp., a major oil refiner, bought 1 million barrels of crude oil from Pemex for March delivery, its first purchase of Mexican crude in more than two decades, the EIA said. Pemex is also due to ship 5 million barrels of oil to South Korea through April, it added.

Latin American crude exports to Asia rose to 1.55 million barrels a day on average last year and to 1.97 million bpd on average so far this year, compared with 1.22 million bpd in 2013, according to shipping-data provider ClipperData. Mexico has not only gained a new client in South Korea but has also intensified its oil trade with India, exporting an average of 128,000 bpd to the South Asian country so far this year, up from 75,000 bpd in 2013 and 2014, the firm says.

Colombia has also bolstered its exports to Asia while reducing shipments to the U.S. In 2013 Colombia exported 115,000 bpd of oil to Asia and 298,000 bpd to the U.S. Last year it exported 224,000 bpd to Asia and 223,000 bpd to the U.S., ClipperData says.

“The fact that you have a lot of domestic production in the U.S. pushes out imports. So those imports have to go somewhere,” said Abudi Zein, ClipperData’s chief operating officer.

The U.S.’s oil imports accounted for 27 percent of the country’s consumed oil in 2014, according to the EIA, the lowest share since the mid-1980s.

Asian demand for Latin American crude may wane, however, if the WTI discount narrows. The EIA projects that WTI will average $7 less than Brent this year and $5 less in 2016 as a drop in U.S. oil-drilling activity curbs production. The oil rig count in the U.S. fell to 760 in the week to April 10, the lowest level since December 2010, according to oil services firm Baker Hughes.

Some investors say the WTI discount to Brent would disappear if the U.S. cancels its ban on exports, a policy adopted in the 1970s after an embargo by Middle East countries created fuel shortages in the U.S. Eliminating the ban would allow U.S. producers to sell their oil abroad at higher prices.

“The spread is completely artificial,” says William O’Grady, chief market strategist at St. Louis–based Confluence Investment Management. “If U.S. crude could be exported, that spread would narrow rapidly, probably mostly from Brent falling rather than WTI going up. What’s the likelihood that the rules will be changed? Not very high.” O’Grady adds that any proposed change would face vehement opposition from U.S. refiners, which have profited by refining cheaper domestic oil and then selling refined products at prices tied to Brent prices on the world market.

WTI has traditionally tracked closely with Brent but began trading at significant discounts at times since 2011 as U.S. production increased and pipeline constraints limited the ability to ship the crude to refineries from Cushing, Oklahoma, the country’s storage hub.

Although Brent remains the leading global benchmark, some experts are questioning its future relevance. Brent takes its name from the North Sea’s Brent field. It is used to price two thirds of the world’s internationally traded crude oil supplies. But the field has been severely depleted, and in February Royal Dutch Shell said it would decommission the Brent field over the next decade.

Platts, a unit of McGraw Hill Financial that focuses on commodity price-reporting and calculates the Brent price, said in February that it plans big changes in the benchmark within five years to incorporate crudes from possibly as far away as Africa and Russia.

“I don’t see the Brent benchmark going away,” says O’Grady. “It won’t be Brent anymore, but it’ll be Brent-like crudes from a lot of parts of the world that will be delivered in lieu of Brent.”

Price Futures Group’s Flynn says WTI will also face major changes. The crude comes mainly from conventional wells in Texas’s Permian Basin, but the big output growth today is coming from advanced technologies like hydraulic fracturing in other parts of the country, which produce an ultralight crude known as condensate. “Let’s face it, a lot of the Brent crude isn’t just North Sea; it’s African crude as well,” he says. “And WTI is getting flushed in with condensate, so both of those targets are going to be changing.”

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