US and global oil prices are diverging again. Here's what that means.

A domestic oil glut helped bring US crude prices inline with the global benchmark. But in the last month or so, the spread between the two has widened again.

After a brief period earlier this year in which the spread between WTI and Brent had vanished, the difference between the two oil benchmark prices has widened once again.

For several years, WTI traded at a discount to Brent – sometimes by $5 to $10 per barrel – owing to the rapid increase in oil production from the United States where the WTI marker is based. With drillers unable to export their crude, higher supplies tended to somewhat saturate refiners’ ability to process crude. Moreover, the inability for pipeline builders to keep up with the pace of drilling also led to local supply gluts.

After the oil bust that began last year, the markets have been closely watching drilling activity in U.S. shale. Rig counts have dropped precipitously, tens of billions of dollars have been slashed from corporate spending budgets, and even some small oil players have missed debt payments. (Related: Misleading IEA Statement Sends Oil Prices Crashing)

That had oil markets betting that the U.S. would see a relatively swift drop in production, which would push up WTI. As a result, by January 2015, the spread between the two benchmarks narrowed.

Since then, the two have diverged once again, opening up a $10 per barrel difference. There are several reasons for this.

The first is geopolitical. Since January, it has become increasingly clear that Libya is tearing at its seams, with much of its oil production getting knocked offline once again. Libya saw its oil output drop to less than 200,000 barrels per day in February, down from around 1 million barrels per day last October. While this may not have been enough to significantly move the needle, the loss of Libya’s production to global supply is not trivial. This has provided some lift to Brent prices. (Related: The Real Problem Behind Low Oil Prices)

More importantly, however, is the lag between the drop in rig counts in the U.S. and actual levels of production. Rigs have fallen by almost 50 percent since October 2014, but total U.S. oil production has yet to see any declines. This is weighing on WTI.

 

Moreover, due to the contango seen in the oil markets – a phenomenon in which delivery for oil now is much cheaper than delivery in the future – has pushed many producers to put oil in storage for sale at a later date. But months of diverting oil into storage without any let up in production levels has raised concerns that storage is starting to fill up. Storage levels at the key oil hub of Cushing, Oklahoma have doubled in the last three months. Across the country, oil storage has reachedabout 60 percent of capacity on average, according to the EIA. As a result,investors are betting that prices are about to dive once again. (Related: Middle East Oil Addiction Could Spell Disaster)

And they are. WTI hit a fresh low for 2015 on March 16, dropping below $44 per barrel. The IEA released an updated forecast on March 13 in which it said that U.S. oil production “continues to defy expectations.” The agency revised upwards its projection for U.S. oil output this year by 300,000 barrels per day.

There are reasons to doubt that storage capacity will run out, including short-term seasonal refinery outages and rising demand. But for now, the WTI/Brent spread does not appear to be going away.

Interestingly, the price disparity is changing oil trade patterns. As the Wall Street Journal reported, Asian buyers are shifting their purchases away from the relatively more expensive Middle Eastern crude in favor of oil from the Americas, which is priced based on a link to WTI. Mexico sold crude to South Korea for the first time in over 20 years as a result of favorable pricing in the western hemisphere. This trend will likely continue as long as the spread endures.

The only way the spread between the two benchmarks shrinks again is if oil production in the U.S. actually begins to fall. The industry, perhaps desperate to keep pumping in order to keep cash flow going during the period of down prices (which, ironically, prolongs the bust), has shown a determination to keep going. However, now that prices are dipping once again, higher cost producers will almost certainly be forced out of the market in the coming weeks and months. Once that happens, and U.S. oil production starts to turn downwards, WTI will begin to rise, and the WTI/Brent spread may once again narrow.

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Source: http://oilprice.com/Energy/Oil-Prices/The-Reemergence-Of-The-WTIBrent-Spread.html