- Two benchmarks for crude oil
- A location, quality, and political risk spread
- Brent-WTI going into the December OPEC meeting
The price of nearby NYMEX WTI crude oil moved higher and lower in choppy trading last week. The active month January NYMEX crude oil futures market began to rise from a low at $50.69 per barrel on October 3 and reached a high at $58.74 on November 22. The price of fell to a low at $54.85 on November 20 and then recovered to settle last Friday at $57.77. January Brent crude oil futures on the Intercontinental Exchange settled at a$63.39 per barrel on November 22.
The price of crude oil fell as optimism over a “phase one” trade agreement between the US and China declined as both sides in the trade war appeared to be stalling. It recovered over prospects for an extension to the current OPEC production quotas. Crude oil is the energy commodity that powers the world. The United States Oil Fund (UCO) is the ETF that reflects the price action in WTI futures, while the United States Brent Oil Fund (BNO) moves higher and lower with the price of Brent futures on ICE.
Two benchmarks for crude oil
Crude oil producers around the world extract different grades of petroleum from the crust of the earth. The output is classified based on physical characteristics and chemical composition using terms such as “sweet” or “sour,” “light,” or “heavy.” Sweet crudes have lower sulfur content than sour crudes. Light crude oil is preferable for refining into gasoline, while heavier crudes are more appropriate for processing into distillates fuels. Heavier crude oil has higher specific gravity than light crude oil.
The two world crude oil benchmarks are West Texas Intermediate and Brent North Sea crude oil. The WTI oil trades on the NYMEX futures exchange and is a lighter and sweeter crude oil compared to the Brent benchmark that trades on the Intercontinental Exchange. The many other grades of the energy commodity trade at premiums or discounts to the WTI and Brent benchmark prices.
Approximately two-thirds of the world’s crude oil output use Brent as a pricing mechanism. Brent is the benchmark for the crude oil that comes from the Middle East that is home to over 50% of the global reserves.
A location, quality, and political risk spread
The spread between the prices of Brent and WTI crude oil is a location and quality spread. WTI crude oil reflects the grade that comes from the crust of the earth in North America. Meanwhile, the spread transcends just the sulfur levels and specific gravity of the petroleum. The Middle East is the most turbulent political region in the world, and it employs the Brent benchmark for pricing. Therefore, the Brent-WTI spread is also a price differential that reflects the political risk of supplies from the Middle East.
(Source: CQG)
The long-term chart of the price of WTI minus the price of Brent crude oil highlights that the Brent premium reached a high at $27.64 per barrel in 2011. During that time, the Arab Spring was sweeping through the Middle East, causing significant political change. The period was a time when supply concerns peaked.
(Source: CQG)
The weekly chart illustrates that the Brent premium has traded between $3.48 and $11.59 per barrel so far in 2019. The mid-September, it spiked from $5.37 to $7.41 per barrel following the drone attack on Saudi production, which temporarily impacted around 6% of the world’s supplies.
Aside from a location and quality spread, the Brent-WTI differential also serves as a barometer of political risk in the Middle East. At the same time, the increase in US output, which recently reached a new high at 12.8 million barrels per day, has caused the Brent crude oil to trade at a premium to WTI. The US is now the world’s leading producer of petroleum with daily output levels above both Saudi Arabia and Russia.
Brent-WTI going into the December OPEC meeting
The oil ministers of OPEC will meet on December 5 and 6 to decide on production policy for the first six months of 2020. Volatility in the oil futures arena tends to increase going into the biannual meeting. All signs are that the cartel will extend the current 1.2 million barrel per day production cut into 2020. The price of nearby Brent futures has been trading around the bottom end of OPEC’s desired $60 to $70 per barrel range.
Last Friday, the Brent premium over WTI was at the $5.64 per barrel level. Typically, the Brent premium expands as the price of crude oil moves higher and lower when it declines.
Since OPEC members use the Brent benchmark as the primary pricing mechanism, the policy decision in early December will likely cause an increase in price variance in the Brent-WTI spread. The Brent-WTI spread can provide clues when it comes to the path of least resistance for oil prices. Make sure to include the spread in your calculus when it comes to analyzing the price path of the energy commodity.
The United States Oil Fund LP (USO) was trading at $12.04 per share on Monday morning, down $0.07 (-0.58%). Year-to-date, USO has gained 0.25%, versus a 17.73% rise in the benchmark S&P 500 index during the same period.
USO currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 109 ETFs in the Commodity ETFs category.
About the Author: Andrew Hecht
Andrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.