Wednesday, March 20, 2013

Brent Crude and WTI - When the Same Thing Becomes Very Different

A commodity must be fungible.  The value of a bushel, barrel, or ounce of a given commodity comes not from its uniqueness, but from the fact that it is functionally identical to every other bushel, barrel, or ounce of the same commodity.  Insuring fungibility is exactly the reason commodities contracts have explicit specifications.  In addition, many different types of commodity are highly interrelated and as such, so is their price.  Consider for example the relationship between oats and corn, both used frequently as livestock feed.  If corn gets too expensive ranchers might begin feeding their livestock more oats.  As more people forgo corn in favor oats, corn prices will inevitably fall as oats' go up, which will ultimately cause more folks to switch back to the (now cheaper) corn, and the cycle repeats.  Obviously, the more related two commodities are, the more their prices are correlated.  Nowhere is this fact more salient than in the various types of crude oil globally traded.  And, unlike corn and oats, which have several non-overlapping uses, there's really only one thing to do with any type of crude: refine, then burn it.

The two major crude oil contracts traded in global markets are West Texas Intermediate, which is the American standard (what media outlets have traditionally meant when they talk about the "price of oil") and Brent Crude, which is the British standard.  The former is traded on the NYMEX, the latter the ICE, and you can read their contract specifications here and here, respectively.  Both are high-quality, refineable oils (referred to as "light, sweet crude") with the primary difference being that WTI contains less sulfur and is somewhat less dense than its British counterpart.  Now, I'm not an oil man, so someone who's worked in petroleum engineering and/or regularly wears a huge cowboy hat could do a better job explaining the specifics, but my understanding is that less sulfur and a lower density means WTI is easier to refine, making it technically the superior oil.  In theory, this should make for an obvious reltionaship between the contracts: higher quality, higher price.  Not so.

For years the prices of the two contracts reflected the quality difference, as historically American Crude Oil has traded a few dollars above the price of Brent Crude.  However, about 2008 (largely I'm sure as a result of the financial crisis) the two oils began occasionally trading places, with Brent breaking away from WTI in late 2010/early 2011 and never looking back.  Observe this chart:

There are a few key things to notice.  First, as mentioned above, observe Brent's breakaway from WTI beginning right around 2011, a pattern that seems to have more or less stabilized today, with Brent now consistently trading $10 - $20 higher than US crude.  Think about that for a minute: two products with identical uses, the only difference their respective qualities, and the inferior product is valued by the market ~15% above the superior.  That's like paying $45,000 for a Volkswagen Jetta when an A4 costs forty grand, or dropping $12 on a pound of Folgers when Shade-Grown Artisanal Hipster Roast™ only costs $9.

Brent most likely overtook WTI for three major reasons: the glut of domestic crude created as American supply has gone up from new oil discoveries; the decreased demand for oil domestically due to economic stagnation; and the ongoing, wrongheaded legal restrictions preventing the exportation of US crude.  That a literally inferior product is more expensive in open global trading is a testament to just how screwed up the US oil market has become, and further proof, as I've written before, that it's time to lift restrictions on US oil exports.

That said, the other thing to notice about the chart above is how synched up the movements of the two crudes has been over the last five years.  Even when they're at their furthest apart, a movement by one crude usually coincides with an almost identical movement by the other.  This, of course, makes sense, as these two commodities are almost the exact same thing.  In this way, any savvy oil investor should be knowledgeable about both types of crude, as the market climate may at any given moment favor one contract over the other, or in absence of a preference between the two, the other variety might be used as a powerful hedge (e.g. going long three contracts of WTI, and short one of Brent).

But in a classic case of the exception proving the rule (yes yes, I know that's not what that actually means), this lock-step relationship is by no means a permanent state of affairs.  Here's a scatter plot of WTI prices compared to Brent Crude from 2008 through 2010:


The r_squared (extent to which variability in one is explained by variability of the other) is .9918 - almost a perfect correlation.  Now, here's a scatter plot of WTI prices compared to Brent Crude from 2011 exclusively:


What the hell?  These are still the same two types of crude oil, right?  For reasons I cannot fully explain, though which I'm positive have more to do with geopolitics than actual supply and demand, the correlation between the crudes falls apart in 2011.  We're looking at an R_squared of .5253, which, obviously, is a remarkably less meaningful correlation than the 99% we observed in years prior.  That the correlation seems to evaporate when the two contracts switch places might indicate the relationship not only flipped, but moved out of synch entirely.  So let's take a look at how the two have behaved from the start of 2012 until now:


Not bad.  The R_squared is .7840, not as strong a correlation as pre-2011, but definitely moving back towards the lock-step we became used to seeing.

The takeaway point here is that highly related commodities tend to have high degrees of correlation, except when they don't.  That first tidbit (related commodities are correlated) may not seem like news, but it's a fact commodities investors all too often overlook when thinking about risk.  As mentioned above, using related (or near identical) commodities as a hedge is a great way to protect oneself in what are inherently risky markets, and taking a complimentary position in the other type of crude is a great way for oil investors to mitigate risk.  That said, the more a market is caught up in politics (and it'd be hard to find a more politically charged market than US crude) the more likely it is to be reactive to exterior, non-market forces.

Though it may not seem like it, this difference between the price drivers for the two crude contracts is actually good news for oil investors; that the prices fall in and out of correlation allows investors to trade on different types of information.  For example, an investor who's very attune to the geopolitics of oil would be well suited to make her play in the US crude market, where policy can affect the price as much or more than the underlying market factors.  Conversely, an investor who's largely ignorant of US oil policy but has a very good understanding of global oil market fundamentals might want to stick to Brent Crude (though of course being aware that major shifts in US oil policy ought to effect all oil everywhere).  Both investors then, as described above, could in theory use the other type of oil as a hedge.

Regardless, any oil investor needs be acutely aware that the powers governing oil prices can and frequently do have nothing to do with the underlying market forces, and one's strategy in these markets needs to take this information into account.

2 comments:

Eric said...

Wow, I just wrote a long comment and I think it got destroyed in the ether.

I think the differential, and decoupling, is due almost exclusively to effects of tight oil production expansion.

First, though -- refiners don't, by law, prefer "lighter and sweeter" crude. Some refiners have invested in complex processing equipment to take advantage of light-heavy differentials. Perversely, depending on the local supply-demand balance (which crudes are available to which refiners), prices for heavy, sour crudes could be bid up to parity (or theoretically above a lighter crude). It all depends on the output a refinery can expect.

Next, the decoupling in price for WTI is probably due to first and second order effects of tight oil production growth. There are transportation bottlenecks to get crude to the gulf refiners, from Cushing to Houston and even from Eagle Ford to the coast. Thus, there is a location discount applied to the crude, on top of a general "greater supply" problem. I think you're right to identify the crude export ban as also having an impact.

Lastly, refiners are considering investing in topping capacity, and producers / midstream players are considering investments in "light processing" for light oil / condensate, e.g. from Eagle Ford, so that they can export "refined products" that don't look so different than the 45'+ API crude coming out of the ground, but are legally exportable.

In the medium- to long-term, if this extra capacity comes online, and the transportation bottlenecks are solved, we may see the Brent-WTI diffs return to normal with or without a lifting of crude export ban.

Charles said...

Thanks Eric, really great comments. I'm curious to know, when you say: "we may see the Brent-WTI diffs return to normal with or without a lifting of crude export ban" what, specifically, do you mean by normal?

That is, to the historic norm, of WTI trading 5 - 15% above Brent? Or just normal in terms of the two oils' correlation being back in lock?

Many thanks.