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Crude Benchmarks and Price Spreads: How Market Intervention Creates Disconnect Between Regional and International Crude Prices

Crude Benchmarks and Price Spreads: How Market Intervention Creates Disconnect Between Regional and International Crude Prices

Abstract: 

Speculator sentiment towards future pricing of commodities can create a wedge between regional and benchmark prices even though they are based on the same supply-demand principles. As long as financial markets continue to buoy WTI futures, these price spreads will continue to widen.


Introduction: 

There seems to be a disconnect from oil prices between the United States WTI benchmark and regional areas. Unlike most products, the WTI benchmark oil price is influenced by supply, demand and market sentiment toward oil futures contracts. These contracts are traded heavily by speculators, with future “barrels” traded in multiples of actual supply. These trades are what allow the market to determine commodity price while regional purchasers must still pay prices based on supply, demand, and composition of the physical product. This is significant because speculators do not have a physical position in the market and are outside investors trading paper commodities with no intent of purchasing physical barrels of oil. When the oil and gas market becomes volatile, financial markets may attempt to buoy benchmark prices to ensure price stability. While successful in the short term, market fundamentals of supply and demand will eventually create a disconnect between the paper commodity and the physical product. Ultimately supply and demand at the regional level through purchasers like storage companies, airlines, and refineries will be what control the true value of crude prices and bring the market back into equilibrium. Financial markets have created a disconnect in the price spreads between the NYMEX WTI futures benchmark and regional spot prices that has been growing over the last twelve months.

Recent Crude Price Swings:

A lesson in simple economics states the price of most goods is determined by the interactions of supply and demand. The same is true for commodities, such as crude oil, with a small caveat – outside speculators. At a regional level, there are much fewer speculators determining prices because regional contracts are not as heavily traded compared to an international contract like WTI. In the regional scenario, supply and demand forces set by physical purchasers drive prices while large scale international futures contracts are subject to market speculation and trading volumes. This concept is evident in the recent price crash for the May 2020 crude contract on April 20th, 2020. As demand has fallen due to the coronavirus and supply increased from the Saudi-Russia price war, oil storage has been filling up where physical crude is delivered. When the WTI front month contract was set to expire on April 21st, commodity traders that did not want to take control of physical crude needed to sell their positions. With low capacity for storage, supply and demand took over the commodity market, “leaving oil traders with no choice but to pay to unload their contracts and avoid having to take physical delivery, which would cost money since they’d need to pay the pipeline shipping costs as well as storage expenses (if they can find room)” [2]. After the contract expired and June 2020 became the new front month, the WTI price rebounded back into the mid-teens with the assumption that either storage or demand would be less of an issue in the coming month. The regional spot prices are still showing an increasing spread between what is being traded on the NYMEX and the price sellers are receiving for their physical product.

In the past year, prices for NYMEX WTI and regional blends of crude have followed the same general trend due to supply and demand principles. Over the last three months, most of the blends have started to diverge from the futures price and move closer to each other (Figure 1). California Buena Vista Hills (as well as other CA blends), which was receiving a higher price than WTI, has recently started to converge towards the benchmark price in the last three months. A major capitulation towards the WTI futures price can be seen starting in February as the regional price and WTI nearly converge mid-April. Several other regional blends also show a greater price decline than the WTI over the March to mid-April time period. Prior to April 20th, WTI futures fell $7.77 per barrel, while Colorado, Wyoming, and Oklahoma regional blends dropped $8.10, $8.57, and $9.57 per barrel, respectively. This phenomenon exists because the recent stimulus financial markets have injected in response to COVID-19, the WTI price of crude oil has been propped up to ensure price stability when true market demand would allow further correction. Unless major changes to supply or demand occur before the expiration of the current front month crude contract, regional prices will continue to diverge and traders may be forced to pay for oil take away again at the end of May.

Regional Storage: 

Figure 2: United States Total Gasoline Inventory [6]. 

Since the coronavirus pandemic began, the world has been on lockdown which has decimated petroleum demand and forced commodities into storage. These lockdowns have resulted in U.S. gasoline consumption reaching its lowest levels since the Vietnam War. Inventory (or stocks) of motor gasoline between January and April 2020 have, not surprisingly, been highest in the Gulf Coast (PADD 3), followed by the East Coast, Midwest, West Coast, and the Rocky Mountain regions. Between February 7th and March 20th, the stocks across the different regions began to decline, a typical phenomenon experienced year after year that typically lasts through November (see Figure 2). After March 20th, 2020 these inventories began to sharply rise until the week ending April 17th to levels well outside the five-year average (Figure 2). While all regions saw the same trend in gasoline inventory, each region built inventory at differing rates (Table 1).  

Figure 3: United States Total Fuel Ethanol Inventory [6]. 

Weekly U.S stocks of fuel ethanol (Figure 3) have shown the same increasing trend this year. The East Coast and Midwest regions have the highest inventory for 2020, followed by the Gulf Coast, West Coast, and Rocky Mountain regions (Table 1). Similar to gasoline, all regions show a recent rise in inventory, but at different rates between March 20 and April 10, 2020.

Figure 4:  United States Total Crude Inventory [7]. 

Figure 4 highlights how crude oil stocks have changed over the past year. Not surprisingly, according to EIA data, all regions have shown a steady increase in inventory in the past few months. In fact by April 24th, the East Coast region had used up 48% of its working storage capacity, Midwest 65%, Cushing Oklahoma 81%, Gulf Coast 60%, Rocky Mountain 61%, and the West Coast 61% (Table 1). As is evident by the above figure, total U.S stock has been increasing, driven by the COVID-19 induced drop in demand, and has also been nearing levels outside the 5-year range. Total U.S crude oil stock increased by a staggering 11% in the last month alone and 23% since March (Table 1). 

By examining crude, ethanol, and gasoline stocks in various regions throughout the United States, two themes become abundantly clear. The first is the oil and gas industry is horrifically oversupplied with downstream inventories well above their five-year averages. Secondly, each region has its own supply and demand constraints. As each region continues to become oversupplied at a different rate, prices begin to change accordingly. For example, the Rocky Mountain region has seen a crude inventory build of 23% (or 11% of its capacity) over the past four months, and as a result, prices have fallen 74% without any demand relief due to global lockdowns. The West Coast region is experiencing the same demand decline but their crude surplus has only increased by 12% (or 6% of its capacity) in the same time period causing prices to drop 65%. Clearly, each area has different supply and demand constraints unique to their situation and regional prices have responded accordingly. This can be seen as refineries are working to mitigate the increased gasoline and fuel ethanol stocks currently at or above historic levels. Shell recently reduced its processing rates due to low demand at two refineries in Louisiana and Alabama by 47% and 20%, respectively, while telling Permian operators to cut delivery volumes by 10-15% [5]. Alternatively, by examining the Cushing Oklahoma region (where WTI prices are based off), crude stock increased by a staggering 87% (38% of its capacity) over the same period but prices only fell 61%. Cushing nearly quadrupled the inventory build and their prices fell less than other regions only exacerbates the fuel supply situation. This data is a prime example highlighting the fact that the WTI benchmark is affected significantly more by some external factors or forces, propping up price more than the regional blends. 

Price Spreads: 

Theoretically, if crude oil was based solely on supply and demand principles with the same market conditions, the price spread between regional blends and WTI should remain constant.  In reality, this is not the case as different regions obviously have different supply and demand needs. Table 2 shows a twelve-month comparison of the NYMEX WTI price against the spot price for seven regional U.S. blends. The price spread between the benchmark and region price in dollars per barrel and percentage is also shown. In the last three months, recent events have caused supply and demand fundamentals to throw commodity prices into a tailspin and financial markets had to intervene in order to stabilize prices. The table shows what effect this has had on the regional blend prices since supply has not physically gone away. Prior to February, the nine-month percentage change in spread price ranged between a negative 5.9% drop and a 1.3% increase for the various areas. Average April prices (prior to the crude price collapse on April 20th) show a percentage change in regional spread price ranging from negative 35.4% to negative 9.2%.

As the regional prices adjusted to the supply-demand imbalance, the WTI price has remained propped up by monetary influence from financial markets. From the end of March and into April, crude supply and demand continued to grow out of balance. This is reflected in the spreads between regional and WTI prices. Figure 5 is another representation of the percent change in price spread by area. The figure shows all of the area blends diverging from the NYMEX WTI (at 0%) with the exception of Buena Vista Hills that is losing its positive price spread.

These movements show that true oil price is determined by whether or not a buyer exists. If refineries or storage centers cannot take the physical inventory, the market will correct at the regional level and eventually force the benchmark to adjust accordingly.

Conclusion: 

Speculator sentiment towards future pricing for commodities can create a wedge between regional and benchmark prices even though they are based on the same supply-demand principles. Price spreads will continue to widen as long as financial markets continue to buoy WTI futures. In fact, in the last twelve months, the spread between WTI futures and some regional spot prices have fallen by 35%. It does not matter how appealing the traded price is, if refineries cannot take the physical inventory, the inflated price is not representative of market demand. 

Storage inventories for gasoline and fuel ethanol reaching unprecedented levels was essentially the first canary in the coal mine showing refineries could not store or accept any more crude products. It should be no surprise that as storage for refined products builds, crude oil, the next link in the supply chain, will follow suit. This was seen when the historic negative price floor was created on April 20th. True oil price is affected by whether a buyer exists for the physical crude, and ultimately the storage and demand for the final product. This is dependent on the companies buying and selling at a regional level where the fundamentals of supply and demand remain dominant. Ultimately that is what controls the spread created from inflated prices at the commodity investment level. 


References: 

[1] https://www.cnbc.com/2018/06/18/china-tariffs-could-halt-us-crude-oil-exports-to-a-huge-growth-market.html

[2] https://www.fool.com/investing/2020/04/21/beyond-the-negative-headlines-oil-prices-arent-wha.aspx

[3] https://www.oilmonster.com/crude-oil-prices/united-states/1

[4] https://www.eia.gov/dnav/pet/pet_pri_fut_s1_d.htm

[5] https://seekingalpha.com/news/3563214-shell-shuts-cuts-rates-u-s-refineries-on-low-demand

[6] https://www.eia.gov/petroleum/weekly/gasoline.php 

[7] https://www.eia.gov/petroleum/weekly/crude.php 

[8] https://www.eia.gov/petroleum/supply/weekly/ 

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