The Hindu Business Line : The dynamics of crude oil

In recent times, WTI has been trading at a heavy discount to Brent, which is seen as a broken benchmark. For India, this means a spurt in the oil import bill and inflationary tendencies.

As India marches forward, it is inevitable that the country's energy consumption will also increase. The total oil bill constitutes almost 40 per cent of the total imports. India primarily imports crude oil of the Oman-Dubai sour grade and the Brent sweet in the ratio of 58:42.

Prices in the oil market have been concentrated around three main regional crude oil benchmarks, or `marker' crudes: West Texas Intermediate (WTI) from the US, Brent Blend from the UK North Sea and Dubai, or Fateh, from the UAE.

Crude oil is graded on the basis of its specific gravity (API) and the sulphur level. Higher API gravity degree oil values have a greater commercial value. The lower the level of sulphur, the sweeter and the more preferred the oil.

West Texas Intermediate (WTI) is the underlying commodity of the NYMEX oil futures contracts. It is of very high quality with an API gravity of 39.6 degrees (a `light' crude oil), and containing only about 0.24 per cent of sulphur (a `sweet' crude oil). It is ideal for refining products such as low-sulphur petrol and low-sulphur diesel.

Brent is a benchmark for oil from Europe, Africa and West Asia and is traded on the ICE exchange (London). Its API gravity is 38.3 degrees (a `light' crude, but not as `light' as WTI), while it contains about 0.37 per cent of sulphur (a `sweet' crude, but again less `sweet' than WTI). Brent blend is ideal for making gasoline and middle distillates.

As a result of the gravity and sulphur differences, WTI is preferred by refiners and is processed into high-value products such as petrol, diesel, heating oil, and jet fuel. It typically trades at a $1-2/barrel premium to Brent. However, in recent times, it has been seen that WTI trades at a heavy discount (as high as $7 per barrel) to Brent. Logically, WTI is a higher grade crude and should trade at a higher price. So, what is the reason for this divergence from the norm?

WTI and Brent

One reason is that the North Sea fields from where Brent is sourced are fast depleting. Brent prices were pushed up in March by a port strike at the Fos-Lavera oil terminal near Marseille (France). During the 18-day long strike, almost 60 vessels, including 39 oil and six gas tankers, were stranded outside Europe's second-largest import hub.

The Marseille port is the world's third largest oil hub with 64.2 million tonnes moving through it annually. It was feared that the strike could lead to the shutdown of nearly half of France's refineries. This could have slashed 7 per cent of European refinery capacity or 1.10 million barrels per day. As refined oil is turned into petrol and then sent by tanker to the US, the strike was affecting not only the Europeans but also the Americans, just ahead of the peak summer demand season.

No sooner had the strike in Europe settled than concerns arose in the US. Cushing, Oklahoma, is the most significant crude oil trading hub in North America. The US Energy Department reported that oil stockpiles in Cushing were nearly at their full storage. Aided by refinery shutdowns due to fire and maintenance, inventories rose 3.8 per cent to 28 million barrels for the week ended April 13, 2007 — the highest since April 2004 when the Department began reporting on supplies there.

Nigerian and Iranian oil grades are also priced according to a Brent-based formula. As the political situation gets tense, Brent shows a bigger increase in prices.

The broken benchmark

The pricing difference may decline as refiners finish maintenance and maximise gasoline output in time for the summer driving season. WTI prices could rise by the third quarter on increased refinery consumption and availability of additional storage.

Of greater concern is the International Energy Agency's statement that the recent discount on WTI to other globally traded types of oil raises hedging risks and could change WTI's status as one of the two main world benchmarks. It has diverged so drastically from other grade prices that some market participants are calling it a `broken benchmark'.

This could have a huge impact on oil pricing. Traded crude oil is usually based on a formula approach where a marker crude is used as the base and a quality as well as a demand/supply differential (premium/discount) is added, depending on the crude oil being purchased.

Thus, in times of tight supply, this premium usually rises and over time gradually drags up the marker crude price, whilst in times of surplus supply, a reduced premium or even a discount will drag down the marker crude price. Currently, Brent is estimated to be used as a basis for about 60 per cent of the oil market. If the price difference does not roll back soon, European crude and product imports into the US will be pinched.

Given Brent's historical discount, US' imports of the sea-borne crude tied to Brent prices would be expensive and may not be available economically. From the Indian perspective, Brent prices determine about 42 per cent of the oil import bill. A higher Brent would mean higher prices to pay.

Energy is essential for the growth of the economy. Rising prices could lead to inflationary tendencies and in the longer run, we would have to be satisfied with a lower economic growth rate.

Sourced from www.QuantumAmc.com

Please send suggestions and queries to younginvestor@thehindu.co.in, or The Research Bureau, The Hindu Business Line, 859-860, Anna Salai, Chennai-600002.

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