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Trader's Corner

This week’s Trader’s Corner looks at the spread between West Texas Intermediate (WTI) and Brent crude.

This week, we want to look at the reduction in the spread between WTI crude and Brent crude. As you know, WTI has lost its status as the world’s benchmark crude. Brent now holds that position.

At one time, the U.S. easily used all of the oil it could produce and a lot more. Refiners in the Midwest could easily consume all of the oil produced in that region and imported from Canada.

The ability of Midwest refineries to do this was critical for WTI to be the world benchmark. The reason is that WTI futures contracts are settled at Cushing, Okla. So crude inventory at Cushing is critical for the price of WTI.

Cushing is problematic because it is a landlocked location dependent on Midwest refineries to keep inventory under control. That had not been a problem during the era of low U.S. and Canadian crude production. In fact, there were crude lines running from the U.S. Gulf Coast so imported crude could augment available local supply.

Since the U.S. was easily the dominant consumer of crude, the world essential was priced in a way that would allow various crudes around the world the ability to move into the U.S. market. So WTI was the standard, and everyone generally priced off of it.

But two important things began to happen. One was that emerging economies, such as China and India, began to consume a lot of oil. Suddenly the U.S. was not the only place for producer nations to go with their crude. For example, China imported less than 4 million barrels per day (bpd) of crude in 2008, but is around 5.42 million bpd now. Expectations are its import demand will surpass 10 million bpd by the end of this decade. This has put a lot of upward price pressure on crude as WTI had to price higher to pull the needed barrels to the U.S.

Second, increases in Canadian and U.S. crude production suddenly overwhelmed the ability of U.S. Midwest refiners to take all of the local supply. That caused the landlocked nature of Cushing to become a real problem. With no ability to manage excess production, Cushing was soon overwhelmed, which drove the price lower. Below are charts of just the changes in U.S. production, followed by Cushing inventory. Click to enlarge.

It didn’t take long for the world to understand that WTI no longer was reflecting the realities of the global crude supply and demand picture. Not surprising, Brent, a grade that is largely based on North Sea production (though declining and rote with production and labor issues), was adopted as a benchmark crude. Below is a chart showing the price relationship between Brent and WTI. Click to enlarge.

As the chart shows, WTI used to price higher than Brent, but that changed when a major pipeline connected Canadian crude to Cushing. WTI was soon trading around $28 per barrel less than Brent.

It was this sharp fall in WTI crude that suddenly had U.S. products such as propane able to move easily into export markets it once would have little chance, or even need, to compete. Then came the shale gas production, which added tremendous amounts of new propane supply. This overwhelmed propane demand, causing propane to price at incredibly low relative values to WTI crude, in the 25 to 30 percent range.

But notice that the spread between WTI and Brent has been closing recently. For one of the key reasons, go back to the Cushing crude inventory chart and notice that Cushing inventory has started coming down this year.

It has been a fairly slow but steady trend down as more Midwest producers use railcars to bypass Cushing, going directly to higher-valued Gulf Coast markets. And, of course, the 400,000-bpd Seaway pipeline opening really made the difference. That line that used to take products from the Gulf Coast to Cushing was reversed.

In the last few weeks, inventory has gone up again, but we believe that is because of the shutting of the 90,000-bpd Exxon Mobil Pegasus crude line that carried product from Illinois to Texas. The line was shut following a spill in Arkansas a couple of weeks ago.

When that line is returned to service (no timeline announced), we suspect the slow downtrend could resume. But as the production chart shows, more options will have to be used to keep inventory under control, so more lines are proposed to do just that. The increases in North American crude production are expected to continue.

So what does all of this have to do with propane? We all know that the industry has responded to all of the new propane production by building export facilities and by petrochemicals expanding facilities to use more of the cheap available domestic supply. That is causing the surplus inventory on propane to come down.

The result is upward pressure on propane prices. But, as the industry takes care of surplus crude in Cushing with new lines and transport options, the value of WTI crude should also increase against the global market. That fact will begin to change the economics of where U.S. propane is competitive against other global exports.

So while there is no doubt U.S. propane is going to price higher because of the new options to export it, the world market is going to start pushing back at some point. The ability for the global market to push back will be significantly aided by the further closing of the Brent/WTI crude price spread.

It is important that when we are making decisions about supply that we do not focus on just one side of the equation – new export capacity, for example. It is literally a global market with numerous factors combining to determine the final outcome. One of those factors will be how WTI prices against the global crude market as infrastructure is put in place to debottleneck Midwest crude supplies.

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Crude fell sharply as traders worried about demand destruction, with signs the global economy is getting weaker.

Propane was lower, but held up well against the sharp fall in crude. The reduction of propane inventory surpluses remains a support for prices.

We begin this week neutral in our outlook. Though lower last week, propane showed enough resistance to the fall in crude to prevent us from feeling bearish. On the other hand, we don’t feel confident just yet in the current crude rebound.

Monday: Propane fell as crude had another dramatic sell-off, equal to the 2.8 percent pullback on Friday. Reports of slower growth for the Chinese economy kept the downward pressure on crude.

Tuesday: Crude rallied late to post a 1-cent gain, but propane extended its losses into a second day. Brent crude fell to less than $100 for the first time since last July.

Wednesday: The U.S. Energy Information Administration report was supportive of propane, with a draw during a week that normally has a build. Crude got support from a draw on inventory, but it wasn’t enough to change the downward momentum. A decrease in global economic growth projections by the International Monetary Fund caused more bearishness in commodities markets.

Thursday: Propane and crude both rebounded, cutting into some of the losses for the week. Comments by the Organization of Petroleum Exporting Countries that it might call an emergency meeting to discuss production provided some support for crude, but mostly it was opportunity buying after big losses on previous days.

Friday: It was a weak day for propane as prices fell, even though crude posted a small gain. It was not a strong up day for crude, but it did manage to take out a technical resistance point.

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Cost Management Solutions LLC (CMS) is a firm dedicated to the analysis of the energy markets for the propane marketplace. Since we are not a supplier of propane, you can be assured our focus is to provide an unbiased analysis.

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