Understanding the Crude Oil Market
Pricing Differentials Between Brent Crude and WTI
Marc Rich, one of the most influential and controversial commodity traders that ever lived, once referred to oil as the blood that flows through the veins of the world. Crude oil is a fundamental source of energy for the world’s economy. Besides being one of the most actively traded commodities, the price of crude oil is extremely sensitive to geopolitical and weather events.
In fact, the world crude oil market is all about investor anticipation of supply and demand, and oil prices are very volatile and highly influenced by consumer and investor sentiment. As such, global events like the mounting threat of the new coronavirus can send shockwaves throughout the market.
The International Energy Agency predicted in its April 2020 report that global oil demand would drop to levels last seen in 1995, all because of the COVID-19 pandemic. Over 100 countries have reported laboratory-confirmed cases of COVID-19, according to the World Health Organization, and the uncertainty about how far the virus may spread has rocked the financial markets and caused ripple effects throughout the economy.
The Two Most Popular Grades of Crude Oil
When it comes to physical oil, there are different grades. The most popular traded grades are Brent North Sea Crude (commonly known as Brent crude) and West Texas Intermediate (commonly known as WTI). Brent refers to oil that is produced in the Brent oil fields and other sites in the North Sea.
Brent crude's price is the benchmark for African, European, and Middle Eastern crude oil. The pricing mechanism for Brent dictates the value of roughly two-thirds of the world's crude oil production.
Oil contains sulfur, and the percentage of sulfur in crude oil dictates the amount of processing needed to refine the oil into energy products. "Sweet crude" is a term that refers to crude oil that has less than 1% sulfur.
The sulfur content of both Brent and WTI is well under 1%, making them both “sweet.” They are also less dense (“lighter”) than many of the crude oils extracted elsewhere. Both of these characteristics make them easier to refine and more attractive to petroleum product producers.
Benchmarks and Trading Markets
WTI is the benchmark crude for North America.
The NYMEX (New York Mercantile Exchange) division of the CME (Chicago Mercantile Exchange) lists futures contracts of WTI crude oil. Delivery for WTI crude futures occurs in Cushing, Oklahoma.
Brent crude oil futures trade on the Intercontinental Exchange (ICE). Since Brent crude is traded internationally, the delivery locations will vary by country.
Since both types of oil are used as benchmarks, different countries will use them in different manners. Asian countries tend to use a mixture of Brent and WTI benchmark prices to value their crude oil.
Factors That Affect Benchmark Pricing
Brent and WTI crude have different properties, which result in a price differential called a quality spread. They are also located in different parts of the world (Brent in Europe and WTI in North America). This is referred to as a location spread.
The nominal price of crude oil is just one factor involved in understanding the crude oil market.
According to CME Group, which runs the NYMEX commodities market, the WTI/Brent Spread is influenced by four key factors:
- U.S. crude oil production levels
- Crude oil supply and demand balance in the U.S.
- North Sea crude oil operations
- Geopolitical issues in the international crude oil market
How World Events Can Affect Crude Oil Prices
Political shifts, weather events, and global health crises have been some of the biggest shock factors in the oil market.
Because of the coronavirus outbreak, the International Energy Agency (IEA) cut its forecast for global oil demand in March 2020, predicting the first year-over-year decline in demand since 2009. The IEA stated in its April 2020 report that demand will probably still be down by December 2020.
To understand how world events can cause the spread between Brent and WTI to move dramatically for long periods, look back a few years. At the start of 2011, the Brent-WTI spread was close to flat.
The spread widened during 2011 with Brent trading at a premium compared to WTI. Around the time that the Arab Spring (an uprising across much of the Arabic region) began in Egypt in February of 2011, the spread widened.
Fears concerning the closure of the Suez Canal and a lack of available supply caused Brent crude oil to become more expensive than WTI. As tensions eased over the canal's operation, the spread reduced.
Then, in late 2011, the Iranian government threatened to close the Straits of Hormuz, through which approximately 20% of the world's oil flows each day. Once again, the spread widened, as Brent soared to $25 premium per barrel higher than WTI.
In 2015, a premium drop for Brent occurred for two reasons. First, an agreement with Iran was struck allowing the country to export more oil, which should have increased the amount of Iranian crude flowing into the market on a daily basis. Since Brent is the pricing benchmark for Iranian crude, this depressed the price of Brent at the time.
Second, U.S. rig counts dropped at about the same time. And, with expanding support for exporting U.S. crude abroad, that meant less drilling in the future and less U.S. production on a daily basis.
Therefore, Brent prices moved lower by virtue of hints of more Iranian crude and WTI strengthened because of less U.S. production and increasing exports. It is important to notice that anticipation of an influx of oil into the market was enough to cause price fluctuations.
Weather, too, can have drastic effects on prices. The U.S. Energy Information Administration attributed hurricanes in 2005 to sharp rises in oil prices, as refineries and production shut down for the duration of the weather events.
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