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Transforming Character of Crude Oil Markets

November 30th, 2012

OMAHA (Capstone Energy Services) – 2012 may be the first year that the number of contracts traded for Brent crude oil futures may exceed that of West Texas Intermediate (WTI). For years the NYMEX WTI contract has been the benchmark futures contracts for world oil markets, but that role is now changing as the Brent futures contract increases in importance. Underlying this transformation is the ongoing inventory surplus in Cushing, Oklahoma, where the NYMEX WTI contract is physically settled each month, and the increasing independence that the U.S. is creating through rapidly increasing domestic crude oil production.

Brent crude oil futures prices have experienced the full effect of supply disruption risk due to instability in the Middle East. Brent prices rose 34% in the last two years while WTI rose only 9%. The price differential between the two futures contracts is now at nearly $23 per barrel – $110 per barrel for Brent and $87 per barrel for WTI. This differential may narrow in 2013 as delivery capacity from Cushing to the Gulf Coast increases. Nevertheless, abundant supplies of domestic crude oil will likely continue to sustain a price differential between WTI and Brent crude in the future. In addition, as the volume of U.S. crude oil production increases, export restrictions by the U.S. government, enacted in 1975, could further isolate WTI from international markets. As U.S. dependence on international crude supplies declines, the price effect of geopolitical risk will be increasingly apparent in the size of WTI/Brent price differential as well as in the actual price.

The growing importance of Brent crude has prompted both S&P and Dow Jones to modify the weighting in their respective commodity indices, increasing Brent Crude and decreasing WTI. Nevertheless, WTI still remains critically important for gauging the fundamentals of the crude oil markets in North America while Brent is becoming the accepted benchmark for international crude markets. While both will continue to be volatile and respond to both domestic and international economic and geopolitical risks, WTI will have upside protection so long as North American domestic production capability continues to increase.

An important aspect of North American production capability will be infrastructure, including pipelines to move crude oil from production areas to refineries, and expanding and upgrading refinery capabilities. These projects face continued opposition from various political and environmental groups. In addition, the new production capability is from shale formations utilizing horizontal drilling and hydraulic fracturing (“fracking”) which are highly controversial. Numerous state and federal investigations and regulatory proceedings are underway, the outcome of which is far from certain. As a result, the transformation of North American crude oil markets and the vision of independence continue to be an uncertain work in progress.

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By Ed Freeman

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