Why the premium for Brent oil won't last

West Texas Intermediate (WTI) is the primary benchmark for crude oil prices in the US. Historically, WTI has been $1-$3/barrel more expensive than Brent crude, which is the benchmark for most of the global oil trade. But high oil prices led to a dramatic reversal of the historical trends over the past two years.
 
Increasing US oil production, combined with falling US demand, resulted in a major bottleneck in the nation's most important oil hub in Cushing, Okla. Oil production across regions of the middle of the US flowed into Cushing at a faster pace than it flowed out, and the result was a mini-glut of oil centered on Cushing. 

Because of insufficient pipeline capacity to get mid-continent oil to the Gulf Coast where it could benefit from global markets, the price of WTI became depressed relative to Brent. Brent suddenly began to trade at a premium to WTI, and in 2011 this differential increased to above $25 per barrel. 

The substantial increase in the Brent-WTI differential created profitable opportunities for certain refiners. While some refineries on the East Coast were closing due to lack of profitability, other refiners could access the disadvantaged mid-continent crude and sell the finished products to coastal markets at prices that were more reflective of Brent crude. As WTI prices softened in 2012, refiners like Valero (NYSE: VLO) and Tesoro Corp. (NYSE: TSO) saw their share prices increase by 62 percent and 89 percent respectively. Western Refining (NYSE: WNR), possibly the company best positioned to benefit from the Brent-WTI differential, saw its share price more than double in 2012.

Yet the high Brent-WTI differential will not last, and this will create opportunities – and some threats – for investors. The differential will return to historical norms; only the timing is uncertain. (Commodity traders could effectively take advantage of a return to historical norms by implementing various spread strategies). 

The differential should begin to subside this year because there are a number of projects in the pipeline that will relieve the bottleneck in Cushing. Last year Seaway Crude Pipeline Company – a 50/50 joint venture between Enterprise and Enbridge – reversed the flow direction of the Seaway Pipeline. This allowed the transport of 150,000 barrels per day {b.p.d.) of crude oil from Cushing to Gulf Coast refineries near Houston. This month the capacity of the Seaway pipeline will be increased by 250,000 b.p.d. 

Later this year the southern leg of Keystone – which President Obama endorsed from the campaign trail in 2012 and which should not be confused with the proposed Keystone XL – should come onstream. This Keystone-Cushing extension will have the initial capacity to transport 700,000 b.p.d. of oil from Cushing to Gulf Coast refineries. These three projects have a total capacity of 1.1 million b.p.d., which amounts to most of the increase in US oil production capacity over the past three years.

The most obvious beneficiaries of these pipeline expansions are the pipeline companies themselves and crude oil producers with the newfound ability to get their crude to the global market. The potential losers in this scenario are the refineries that currently benefit from the Brent-WTI differential, and railway companies that have benefited from moving crude oil out of areas like North Dakota's Bakken Formation. Last year the Energy Information Administration (EIA) reported that year over year deliveries of petroleum by rail had increased by 38 percent. The largest mover of that crude oil was BNSF. Canadian Pacific Railway (NYSE:CP) also transports Bakken crude and benefits from the current system, and Phillips 66 just announced a five-year agreement to deliver crude oil from the Bakken to a New Jersey refinery by rail. 

The railways and refineries will not suffer immediately from the pipeline expansions. But the 1.1 million b.p.d. increase of crude oil transport by pipeline from Cushing – and the inevitable narrowing of the Brent-WTI differential – will cut into their profits unless oil production capacity catches back up. Thus, it would be prudent to keep close tabs on companies in these categories – especially as the Keystone-Cushing extension approaches completion.

– This article is a modified version of a story in Energy Trends Insider, a free subscriber-only newsletter that identifies and analyzes financial trends in the energy sector. It's published by Consumer Energy Report.