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Will the Spread Between WTI and Brent Crude Continue to Narrow?

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The spread between WTI and Brent crude narrowed to around $4 per barrel this week, which is the smallest gap in nearly seven months. With oil stocks at Cushing still low and a possible recovery in exports from Libya, the spread could narrow even further in the near term. A smaller spread is bad news for refiners such as Valero Energy (NYSE: VLO  ) , Marathon Petroleum (NYSE: MPC  ) , and Phillips 66 (NYSE: PSX  ) . But will the trend continue?

Brent and WTI spread narrows
At last check in early trading on Thursday, Brent crude was trading at around $107.70 per barrel, while WTI was trading at around $103.48 per barrel. The spread between the U.S. and the global benchmark is now the smallest in nearly seven months.

The spread has narrowed as WTI prices have strengthened on the back of depleting stocks at Cushing, Oklahoma. According to the Energy Information Administration (EIA), stocks of crude at Cushing were 27.6 million barrels in the first week of April, compared to nearly 51 million barrels in the same period last year.

The fall in oil stocks at Cushing can be attributed to the Marketlink pipeline, which began transporting oil earlier this year. The Marketlink and the Seaway are the two pipelines that now connect Cushing to the Gulf Coast refineries.

While oil production in the U.S. rose sharply, lack of pipeline link between Cushing and Gulf Coast refineries created a supply glut at the storage hub in Oklahoma. The supply glut pushed WTI prices lower and created a significant spread between the U.S. and the global benchmark. The spread has benefited refiners on the Gulf Coast immensely.

As noted earlier, refiners such as Valero and Marathon have enjoyed robust margins due to a significant spread between WTI and Brent crude. Lower WTI prices result in cheaper feedstock for refiners. The finished refined products, though, are linked to Brent crude. In the fourth quarter of 2013, Valero, Marathon and Phillips 66 easily beat consensus earnings forecasts. But, all three companies' results for the first quarter of 2014 could show some margin pressure as the spread between WTI and Brent narrows.

According to the EIA's Short-Term Energy Outlook, the discount of WTI crude to Brent crude fell to $7 per barrel in the month of March. Between November and January, the discount had averaged over $13 per barrel.

The narrowing spread is a concern for refiners, at least in the near-term. One reason is due to potential additional supplies from Libya, which could keep Brent prices under pressure. Brent crude prices could also remain under pressure due to weakness in the Chinese economy. Trade data released on Thursday showed a drop in Chinese imports and exports.

While Brent crude is expected to remain under pressure, WTI prices could remain strong due to robust demand for oil products in the U.S. According to data from the EIA, gasoline demand averaged 8.81 million barrels in the four-week period ended April 4. Meanwhile, gasoline inventories dropped to 210.4 million, the lowest level since November 16.

Indeed, given the robust demand in the U.S. and possibility of additional supplies from Libya, the spread between WTI and Brent could narrow even further in the next few weeks. However, the trend might not continue in the longer-term, which is good news for refiners.

Although new midstream infrastructure has helped in reducing crude oil stocks at Cushing, an expected increase in U.S. crude oil production could once again create a significant glut since many of the refineries on the Gulf Coast are configured to handle heavier and sourer crude. Also, Brent crude prices could spike if Libya fails to increase supplies.

Additionally, there is a possibility of sanctions on Russia as crisis in the Ukraine has once again escalated. This could further push Brent crude prices higher. The EIA expects the spread between WTI and Brent to widen in the coming months and average $9 per barrel in 2014 and $11 per barrel in 2015. The forecast is certainly encouraging for refiners as they will be able to maintain their margins. 

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Varun Chandan

I have a Master in Finance degree from IE Business School in Madrid. I use the top-down approach when it comes to investing. I like to analyze macroeconomic factors and how they impact individual companies.

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