Commodities | Aug 24 2011
– Gaddafi's fall may allow for the restoration of Libyan oil production
– Libya's future is nevertheless unclear
– There is a lot more to the Brent-WTI spread than just Libya
By Greg Peel
We recall that for most of the oil market's history the price of Brent crude has rarely been more than a dollar away from the price of West Texas Intermediate, and indeed WTI is sweeter so it has always been slightly higher, but late last week the Brent premium spread over WTI hit a new record US$26.
The spread began to blow out early in 2011, and while the move buried many an experienced speculator who thought two dollars was historically too wide let alone twenty, there are four readily identifiable reasons why the spread is justifiable. They can be summed up as (1) supply, (2) accessibility, (3) storage and (4) the Arab Spring.
Oil reserves in the North Sea have been in decline for some time now, meaning that Brent crude exhibits an underlying level of price support due to diminishing supply. Supply of West Texas crude has also seen better days (around about when James Dean was pumping the stuff), and Big Oil long ago moved its focus into the Gulf of Mexico, but we have to remember that the world's “price” for oil has always been determined by futures markets, and each futures contract has a specific delivery point.
Until this year the WTI contract was the world's oil price benchmark, and while the name “West Texas” implies a certain geography, today it simply defines oil delivered to the storage facility at Cushing, Oklahoma. Pipelines have recently be completed to Cushing from both the northern US fields and from Canada, so it matters not from whence the oil hailed, if it is at Cushing it's WTI. Brent is also a blend of around five different North Sea oils, but either way the Brent price refers to oil delivered to the storage facility at Sullom Voe on Shetland Island in Scotland.
Somehow Shetland seems to have a more remote feel to it than Oklahoma, but in fact the opposite is true. Sullom Voe features a port for ocean going carriers and Cushing is landlocked with no pipelines to connect it to the coast. It's never been a problem in the past, because the US does not export WTI. Indeed, Cushing's central location makes it ideal as a distribution point for continental America. Brent, on the other hand, is exported all around Europe and beyond.
So on point (1), Brent crude is in diminishing supply while the supply of WTI is presently abundant. That alone should suggest a premium except that the obvious response would be for the world to buy cheaper WTI instead of more expensive Brent. That leads us to point (2) – it can't, which further presses the premium.
The biggest influence on the price spread is nevertheless point (3) – storage. There remains plenty of storage capacity at Sullom Voe but at Cushing excess storage is now very limited. What does remain is very expensive on a demand-supply basis. Therefore if you buy a WTI futures contract for delivery and have to pay a lot more for storage, you won't be prepared to pay as much for the actual oil. Hence a large part of the Brent-WTI premium is reflective of the difference in storage cost.
Note that prior to 2011 all the world's different oils would trade in a tight price range. The case is still the same today except for one oil – WTI. Brent is not more expensive than other oils, WTI is cheaper than all other oils.
Only then do we move on to point (4) – the Arab Spring. Revolutions have been rolling through North Africa and into the Middle East all year, but it was only when significant oil-producer Libya joined the throng that global oil supply was materially disrupted. Europe is usually Libya's biggest customer by virtue of proximity, and previous colonial ruler Italy its biggest customer in Europe. When Libyan oil was cut off, Brent had to fill the gap. The demand on Brent was further pressured by ongoing unrest in Nigeria, which is actually Africa's biggest oil producer and producer of the lightest, sweetest global crude available in any size.
So all of the above has conspired to send the Brent-WTI spread into the heavens in 2011. However, before the opening bell in US markets on Monday, news had come through that Tripoli had been overrun by the rebels and the Gaddifi regime appeared about to fall. Oil traders geared up for a big drop in the Brent price on the assumption Libyan supply would soon be restored, and spread traders salivated in expectation the Brent-WTI spread would be crunched.
They would have been rather disappointed when by the close of trade Brent fell only US26c. Never mind – spreads work in two directions – so the punters bought up WTI instead by US$2, knocking a bit under 10% off the gap. The question is, nevertheless, as to whether there is sufficient justification for either the Brent price falling or the spread closing.
Assuming Gaddafi falls, it shouldn't take too long to get production up and running again in Libya, JP Morgan suggests. The situation will have to be sufficiently safe, because it is foreign oil companies who run production and not any national industry, and foreign companies will not risk sending in previously evacuated staff too soon. The bulk of Libya's oil facilities are well away from Tripoli thus providing greater comfort.
The speed of restart will nevertheless depend on just what state the oil facilities are in. They haven't been bombed, because both the government and the rebels would be lost without Libyan oil, but they may well have been looted for equipment and base metals which are very valuable these days. If things aren't too bad, JPM suspects production could resume in earnest by end-2011.
There is, however, another problem. When the allies took Iraq they installed a military government to keep control as they began to restore oil production. When the Egyptian dictatorship fell, the military was on the side of the rebels and quickly restored order. But in Libya the military represents Gaddafi's regime, and with no military all that is left is a rag-tag bunch of amateurs from disparate tribes to keep the peace. Those tribes will likely now vow for supremacy. Hence Gaddafi may fall, but the new Libya may not be a place foreign oil companies would want to risk immediately.
Even if immediate peace is achieved, there is no guarantee a smooth transition will be made towards a new government, and any government could range from secular democratic to hard line Sharia. The point is the restoration of at least some Libyan oil production might be able to be achieved by year-end, but Libya's tiring facilities and untapped reserves require serious ongoing foreign capital injection if the country's oil supply is going to continue to make a mark on global supply.
On that basis, JP Morgan is not necessarily confident of a swift pullback in the price of Brent crude, despite the analysts already assuming lower global oil demand ahead due to the global economic slowdown. They have set a target of US$100-120/bbl in 2012 which is US$9 lower than their previous forecast but right where we are now.
As for the WTI spread, all of points (1), (2) and (3) will remain in place irrespective of what happens in Libya. And remember that Louisiana Light from the Gulf trades in a tight spread with Brent not WTI, as does Malaysian Tapis, and most everything else.
The American consumer is seeing no benefit from the relatively low WTI price anyway despite what one might assume. The only winners are the US mid-west refiners who can buy WTI crude at WTI prices and refine it into petrol for sale at the pump for Brent-equivalent prices.
There are plans afoot to build a pipeline from Cushing to the Gulf coast to relieve the storage issue at Cushing and restore the balance in world (or at least US) oil prices. A cynic might suggest they might have thought of building a pipeline out at the time they were building a pipeline in. The problem is, of course, such construction would take years and require significant capital that the US government is in no position to help with.
So the world will remain under the influence of declining North Sea oil supply at the same time emerging economy demand for crude is accelerating into the future. It is already expected, barring any sudden major oil find (and there haven't been any of those for many a moon), that OPEC's control over oil pricing must become even more significant. On that point, the following graph is interesting:
Provided by the blog Crude Oil Peak, this graph uses information gathered by the International Energy Agency (IEA), the US Energy Information Administration (EIA) and the International Monetary Fund (IMF) to chart the gap between crude oil reserves in Iran and expected demand emanating from a growing Iranian economy. Iran supposedly boasts the world's second greatest reserves of oil after Saudi Arabia (the reserves of which have always been in question), but as this graph suggests the outlook is for falling supply meeting growing domestic demand, thus rapidly reducing potential export supply.
Time to switch to gas?
Technical limitations
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