Brent-WTI Spread Should Narrow Further

JULY 1, 2011   THE WALL STREET JOURNAL

By ANDREW PEAPLE

How much oil costs is key to the global economy, but which is the right price?

The discrepancy between two of the world's major benchmarks, West Texas Intermediate and Brent, has gone beyond a joke. Historically, higher quality WTI traded at a small premium to Brent, but that pattern has sharply reversed in 2011. Brent's premium to WTI widened to $20 per barrel earlier this month, and is still very high at $17.9. The spread could narrow further as market anomalies get ironed out. But confidence in WTI as a key global oil price marker is eroding.

WTI's relative weakness stems from a bottleneck at Cushing, Okla., the delivery point for WTI futures contracts. Plenty of oil is flowing in, particularly from Canada's new oil sands fields to the north. The problem is pipelines mostly aren't set up so that oil can then flow further south to the Gulf of Mexico Coast. The resulting glut is depressing WTI prices relative to Brent, which has been pushed up by losses of Libyan oil, and more recently from the North Sea and Nigeria.

Still, though the Brent premium has narrowed since the International Energy Agency decided to release oil stocks last week, the spread looks excessive. Referencing a further oil price, Louisiana Light Sweet crude, shows why. LLS and Brent are ready substitutes for each other, as both can be transported to customers by sea. But LLS's normal premium to Brent, thanks to its higher quality, has recently reversed: Brent is now around $4 more expensive, compared with an average discount to LLS this year of $2.

In turn, LLS's premium over WTI is still high, at around $14. In theory, that spread should reflect the cost of transporting Cushing's excess oil to the Gulf of Mexico, which Commerzbank estimates could be around $10 per barrel. Add the $4 discrepancy in LLS-WTI pricing to the $6 potential anomaly in LLS-Brent prices, and the Brent to WTI premium of around $18 could be more than halved.

But full elimination of the spread will require some relief for Cushing's supply-glut issues. That won't happen meaningfully until 2013, when a new oil pipeline direct from Canada to the Gulf Coast, bypassing Cushing, is expected to open. Cushing's problems mean that whatever the spread between WTI and Brent, confidence in the former as a global oil benchmark is declining. The IEA, for example, has switched to using Brent as its reference point for prices, saying Brent is more representative of market fundamentals. That should hold true until WTI's little local difficulty is resolved.

Write to Andrew Peaple at andrew.peaple@dowjones.com