When Will the Brent-WTI Spread Close?

Brent crude has traded at a significant premium to WTI since 2011 -- when will it narrow?

Feb 6, 2014 at 2:32PM

Due to the recent global market correction, the Brent-WTI spread, which at times neared the $20 mark, has narrowed meaningfully.    

The two benchmarks traded at parity for much of the decade until 2011, when Brent, the global benchmark for oil, started trading higher than WTI, the U.S. benchmark. The spread has been a welcome boon for refiners, which use cheap WTI as feedstock, and a bane for pure-play domestic oil producers. 

Brentwti

Source: U.S. Energy Information Administration.                                                                                         

When will the gap narrow again?

Another consequence of the shale revolution
Much of the gap in pricing is due to the enormous increase in domestic production of crude oil due to advances in horizontal drilling and hydraulic fracking. Because production increased so quickly,  the pipelines needed to transport oil and gas cannot be built fast enough.  

A lot of oil is stranded due to infrastructure bottlenecks while a lot of natural gas is still flared. Because of these bottlenecks, the laws of supply and demand have lowered the price of domestically produced oil.

Some possible scenarios that could cause the spread to close
There are some possible outcomes that could actually cause the spread to close permanently. 

One is if OPEC loses its discipline. In an attempt to maintain high oil prices, OPEC currently has a maximum production cap of around 30 million barrels of oil a day. 

Given Iraq's increasing oil production and Iran's soon-to-be-ended sanctions, the cap may be tenuous, however. Saudi Arabia itself has stated that it will not unilaterally cut oil production unless other OPEC countries do as well. 

The spread could also narrow if the United States begins exporting crude oil. While the total amount of crude oil exported may not have a significant effect initially, the mere fact that the United States can export crude could be a catalyst that causes the spread to close.

The bottom line
In the short term, it is uncertain how long the spread can stay as wide as it is. Many believe the gap will hold as long as the U.S. continues to increase oil production. According to the EIA, domestic crude oil output should grow annually by 800,000 barrels a day until 2016 when it tops out.

In the long term, the spread will likely close. Once the red tape is cut and enough infrastructure is built, WTI will trade for the same price as Brent again. 

In that event, domestic pure-plays such as EOG Resources (NYSE:EOG), Continental Resources (NYSE:CLR), and Pioneer Natural Resources (NYSE:PXD)will benefit on a relative basis versus the international oil producers. If WTI increases to Brent's level, the domestic pure-plays will see higher gross margins and greater profits as they realize more for each barrel of crude they produce. 

On the opposite side of the coin, domestic refiners and chemical companies that use WTI as feedstock will see lower margins.

Even though the domestic WTI pure-plays are currently leaving a fortune on the table, the eventual closing of the WTI-Brent spread is another reason to be bullish on their long-term prospects.

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Jay Yao has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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