Keep your eyes on the road, not on the price of oil
May 01, 2011
Oil has recaptured the attention of the popular press recently, and has done so for one important reason: the price for West Texas Intermediate (WTI)—the benchmark crude stream traded on the New York Mercantile Exchange (NYMEX)—sprinted past $100 in the first week of March and past $110 in the first week of April.
While this is an important story, an even more important story has thus far escaped the headlines. The situation described here has implications on diesel prices and the bottom lines of shippers and carriers across the U.S. Communicating this situation, however, requires a working understanding of futures markets.
The price for a futures contract represents the aggregate sentiment of the market—the point of equilibrium between all buyers and sellers of futures contracts—and as such, futures markets provide a valuable price search function. When it comes to oil futures, bullish sentiments prevail when an oil supply disruption occurs or when news portending better than expected economic performance is released.
By contrast, the bears emerge from hibernation when significant new supply is brought online, or, as is more often the case, when the economic outlook is revised down. Hence just as oil traders can push prices up, their same trading behaviors can push the price down—and there are plenty of winners and losers during both bull and bear markets.
When the majority of market participants believe that oil demand will climb faster than supply, the market goes into contango, meaning that long term futures contracts are valued more highly than near term contracts. And when in contango, the market exerts powerful pressures on the owners of physical product to stockpile. After all, why should the owner of physical product sell today a product that will be worth more tomorrow? And thus the futures market influences the physical market.
But herein lies the problem. Physical storage is limited, and as storage tanks fill up, physical products are pushed to the market. Hence any relative shortage of end use products caused by stockpiling along the supply chain will be temporary. This is why traders keep a close eye on crude oil and refined product inventories.
The tricky task is deciphering whether the change in inventories is due to buyers being unwilling or unable to purchase fuels at the prevailing price (too high) or whether sellers are unwilling to sell at that price (too low). If the high price of crude (which was set by speculators) is not supported by the fundamentals of the physical fuels markets, which is to say if fuels don’t sell at a price point that justifies the traded price, the high price for paper barrels will not be sustained.
Considering that diesel prices, at least through March, have outpaced the front month futures price for West Texas Intermediate, it appears that the futures market has not created a speculative bubble. Instead, demand for oil products has risen as the U.S. and many Eurozone economies continue along the path of recovery and emerging economies continue to grow.
The rise in demand has not been met by a sufficient increase in the supply of the right types of crude from the right places.
Saudi crude is not a perfect substitute for the 1.3 million barrels per day of Libyan crude that European refineries are configured to process. Libyan crude is both lighter and lower sulfur than Saudi crude. Because it is lighter, Libyan crude produces a higher fraction of diesel through fractional distillation.
To get an equal amount of diesel from Saudi crude requires secondary processing, which is expensive and energy intensive. Removing the sulfur from Saudi crude also requires further processing which is costly from a financial and energetic perspective. Perhaps even more importantly, the pace at which heavy sour crudes can be refined is slower than light sweet crudes.
The shuttering of exports from Libya has caused demand for other light sweet crudes like Brent Blend to increase; and, in turn, the price for Brent and other light sweet crudes has spiked.
There is a single exception to this trend: the price for West Texas Intermediate has grown at a much slower rate than other light sweet crude streams. Looking back at the year-over-year price change for the top 11 benchmark crude streams, we see that the per barrel price for WTI increased by 26 percent, while the price for every other light sweet crude stream increased by more than 40 percent.
The price for Brent Blend has increased 43 percent despite the fact that WTI is slightly lighter and sweeter. And the reason for this discrepancy is that Brent Blend is delivered to the European market and is a near substitute for the Libyan Es Sider crude stream.
The WTI price anomaly can be explained by the recent shift in the geography of oil production in North America as Canadian syncrude and shale oil from the Bakken formation in North Dakota ramp up. Both of these crude streams contribute to the bottleneck in Cushing, Okla., the delivery point for the NYMEX traded West Texas Intermediate crude stream; and this bottleneck has suppressed the WTI price for the reasons described above.
Of course, only a portion of the oil supplied to refineries across the entire U.S. is delivered through Cushing, and as a consequence, the refiner average acquisition cost (RAAC) has for the first time in the history of the Energy Information Agency’s data climbed above the WTI spot price. This means that the WTI futures and spot prices are no longer indicative of the price that refiners pay to acquire crude, and are no longer adequate for setting expectations for future fuel prices.
Just how big and out of the ordinary is the spread between the WTI and RAAC? Between January 1992 and December 2003, the average spread was just under $2.00 per barrel, meaning that refiners paid $2.00 less for a barrel of crude than the WTI spot average. Between January 2004 and June 2007, this spread had climbed as high as $8.16 per barrel, and the average spread over this period was $5.22. Between July 2008 (the height of the price spike) and December 2010, the average of the spread fell to $3.67, but volatility remained high (bouncing back and forth from $2.00 to over $4.00).
Between December 2010 and February 2011, however, the WTI-RAAC spread fell from $3.29 to negative $3.92. This downward movement is rooted in the structural change that has affected Cushing inventories and suppressed only the WTI price.
From a practical perspective, fuel consumers should not be concerned with the WTI price so much as the price that refiners pay for crude. Historically, WTI has been a good estimator of the RAAC, but this is no longer the case. There has been an absolute swing of $7.21 cents per barrel over the last few months. One way to interpret this swing is that relative to the price of WTI, the average refiner acquisition cost has increased somewhere between $4 per barrel and $8 per barrel on top of the rising price of WTI. This means that in the months heading into the summer driving season, the price for diesel and other fuels will increase far more rapidly than the WTI suggests.
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