Monday, October 24, 2011

The oil price. Libya and the WTI-Brent spread.

By Kathleen Brooks, Research Director UK EMEA,

Change has been in the air in Libya since August, when Qaddafi was ousted from power, however now that Qaddafi is dead the pace of change could accelerate very quickly.

What does this mean for the markets?

Geo-political tensions and revolutions are always difficult to price into the market especially when they take place in a major oil producer nation. However the Libya conflict is considered one of the strongest forces keeping upward pressure on Brent crude oil, which has stayed close to $100 per barrel during the recent market turmoil and threat of a global recession. It is also one of the reasons why Brent crude (considered European oil) has maintained a large premium to its US counterpart WTI in recent months.

Libya is important to the oil market, especially in Europe. It has the largest reserves in Africa and the ninth largest in the world with more than 40 billion barrels. Before the revolution Libya produced around 1.6 million barrels per day, and the bulk of this was exported to Europe. During the past 6 months of conflict production has been suspended or sharply reduced, which has kept upward pressure on the Brent price.

Going forward there are a couple of situations that could arise:

1, Oil production resumes, Brent crude comes under pressure reducing the Brent-WTI spread. We think this may happen in the long-term but we are reluctant to conclude that just because Qaddafi is dead the price of Brent will moderate. We think this for a couple of reasons: firstly, we don't know the extent of the damage to production facilities caused by the civil unrest. Secondly, just because Qaddafi may be dead does not mean that the fighting will end. We need to know who will take over power and until a stable government is created it is unlikely production will be reinstated to its previous capacity.

2, Events in the Middle East have a negligible impact on the price of Brent and the Brent-WTI spread. We think this is more likely, at least in the near-term. The wide Brent-WTI spread was also caused by excess supply at Cushing ? a major hub for US oil, so factors outside the US may keep upward pressure on Brent. Signs are emerging that Brent crude may be taking over the mantle of the global oil benchmark, which previously rested with WTI. Interestingly, even as supplies were drawn down at Cushing during the summer months, the spread between Brent and WTI did not start to narrow.

Supply is also an issue in Europe. Low stock levels combined with interruption to supply from the Middle East means that stocks of oil in Europe are low and they will take some time to build up, which should limit downward pressure on Brent prices.

Forward curves suggest the spread may narrow in 2012

This is an impossible question to answer with any degree of accuracy. But traditionally WTI has traded at a premium to Brent because it is higher quality, so on a historical basis then the spread should narrow. Added to this, the forward curves for Brent and WTI are completely different. Whereas the WTI curve is in Contango (forward prices are higher than spot prices) the Brent forward curve is in Backwardation (i.e. Prices are meant to fall in future). This may cause the spread to narrow as soon as Q1 2012 if crude forecasts on Bloomberg turn out to be correct. However, for the spread to narrow that would mean the Brent curve needs to remain in backwardation, and due to the sensitivity of commodity prices at the moment that cannot be guaranteed.

European risks:

While the Middle East is important for oil investors from a supply perspective, the European Sovereign Debt crisis could dent demand. The sovereign crisis remains unresolved and this is threatening to dent global growth. Germany, the US and China have all seen their economies impacted by austerity measures and stresses in the banking system in the currency bloc. Added to this the main pillar of the commodity story has been emerging market demand, But if global growth slows then this pillar may start to crumble, which would inevitably weigh on the oil price. It is hard to say if Brent would fall more sharply than WTI because it has appreciated more in recent months, or if Brent would be more protected due to supply concerns in Europe.


We don't anticipate any major change in trend in the oil price in the near-term. The situation in Libya remains unclear, the Eurozone debt crisis is still a threat to global commodity demand and we also can't forget that the weather phenomenon La Nina is expected to deliver a very cold winter to the East coast of the US and Europe...So there are many variables that determines the oil price and Libya is only one of many moving parts.

More important is whether the forward prices remain in Contango for WTI and Backwardation for Brent.

Brent-WTI spread:

WTI and Brent forward spreads (December 2011 = white line, December 2012 = green line) As you can see, according to forward contracts, the spread between Brent and QTI is expected to moderate throughout 2012.

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