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 an energy staple for most of the inhabitants of planet earth. Besides being one of the most actively traded commodities, the price of crude oil is extremely sensitive to geopolitical and weather events.
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—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 5% sulfur.
Brent's sulfur content is 0.37%, making it one of the lowest sulfur-containing oils in the world. WTI has a lower sulfur percentage, .24%, and is considered "sweeter".
Benchmarks and Trading Markets
WTI is the benchmark crude for North America. WTI is a better grade of crude oil for the production of gasoline while Brent oil favors the production of diesel fuels.
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.
Crude Oil Costs
Crude oil costs approximately $3 to $4 per barrel to ship from Europe to the United States on supertankers. There are differences in the costs of storing crude oil in European and North American trading hubs. In a normal market, the price difference between Brent and WTI hovers around a $2.50 to $4.00 premium for WTI vs. Brent.
This difference is due to the lower sulfur content of WTI. However, there are times when this differential favors a premium for Brent. These circumstances often occur for geopolitical reasons.
Quality and Location Affect Pricing
Not only do 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. Each of the spreads between Brent and WTI is a perfect example of how quality and location spreads affect the structure and pricing of crude oil around the globe.
World Events Can Affect Crude Oil Prices
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.
Political events are not the only influence on crude oil prices. Weather 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.
Price Fluctuations Based on Foreign Events
There can be seismic shifts in world events that affect pricing changes. A premium drop for Brent occurred in 2015, 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.
Understanding Influences Is Crucial for Investors
Investor anticipation of prices, supply or demand, and their sentiments are some of the key components to understanding the fundamentals of the world crude oil market. Crude oil is a commodity market, volatile and highly influenced by consumer and investor sentiments. As such, it pays to monitor global events and sentiment closely when investing in crude oil.