The Death of the Brent-WTI Spread: Are Refiners Going to Get Crushed?

With TransCanada Corporation's (TRP 0.54%) Cushing Marketlink pipeline coming online in late January, inventories at Cushing -- the storage hub of the West Texas Intermediate -- have further eased. The pipeline, which connects Cushing, Okla., to the Texas Gulf Coast, is capable of carrying 700,000 barrels per day of crude. Not surprisingly, the dynamics of crude oil movement have been altered and have caused WTI prices to move past the $100/barrel mark for the first time since October. However, more importantly, the Brent-WTI spread has shrunk to less than $7 a barrel at the time of writing.

"Pipeline Crossroads of the World" monument at Cushing. Source: Wikimedia Commons.

Not a good sign for refiners
Since the two most widely traded crude oil benchmarks diverged in late 2010, a narrowing spread between Brent and WTI has never been a good sign for refiners. For example, the first half of 2013 saw gross margins tumble as refiners struggled with higher input costs. As takeaway capacity at Cushing increases and WTI prices move north, the question is: Are U.S. refiners in for trouble? Let's take a look.

Source: Data from Energy Information Administration, author's graphics.

We notice from the above chart that Brent crude has been trading in a narrow range of $107-$109 per barrel since January. However, WTI prices have risen sharply since mid-January (circled area on the blue line). The net result is that the spread narrowed more than 50% -- from $14.60 to $6.40 per barrel at the end of February.

Are the good old days numbered?
Throughout 2012 and during the fourth quarter of 2013, U.S. refiners enjoyed a solid run -- thanks to the availability of the deeply discounted West Texas Intermediate crude oil when compared against the internationally traded Brent. As a result, refiners such as HollyFrontier Corp. (HFC), Marathon Petroleum Corp. (MPC -3.67%), Valero Energy Corporation (VLO -2.86%), and Phillips 66 (PSX -2.51%) could buy cheaper feedstock, while maintaining global prices for refined products. This ensured higher gross margins per barrel (or crack spread in technical terms) for these refiners. In short, the higher spread between Brent and the WTI ensured a greater profit margin for these refiners.

But with the reversal of the Seaway pipeline in 2012 and its expansion in January 2013 to 400,000 barrels per day, crude inventory levels at Cushing have been gradually falling. The Cushing Marketlink pipeline has further eased the glut at the WTI storage hub. Below is a chart showing crude oil inventory levels at Cushing using data obtained from the Energy Information Administration:

Source: Data from Energy Information Administration, author's graphics.

It's clear that falling inventory levels at Cushing have a reverse effect on WTI crude prices. But the billion-dollar question is: Are refiners going to be affected?

From a historical perspective, refiners having access to cheaper crude oil as feedstock have had the best returns. Among the best in terms of refining gross margins were HollyFrontier and Marathon Petroleum. However, going forward, this may not necessarily be the case. The major refiners are reconfiguring their refining capacities.

Crude by rail: The next frontier for cheap input costs
The ability to process heavy and sour crude oil will be one of the defining factors to gauge the profitability of refiners in future. Why? Because sour and heavy variants of crude oil are much cheaper than their light and sweet counterparts. This works out to be a massive advantage for big refiners. In fact, the big names are already working toward this. Their large economies of scale to process heavy crudes should ensure that their gross margins will be significant.

Marathon Petroleum, for example, upgraded and expanded its Detroit refinery to process more heavy oil. Phillips 66, on the other hand, processed 1.1 million barrels of advantaged crude oil per day -- or 61% -- out of its total U.S. refining capacity of 1.8 million barrels per day.

Higher volumes of heavy crude -- or bituminous crude -- from Canada's tar sands are slowly making way by rail to the Gulf Coast where most refineries are located. A Canadian investment bank, Peters & Co., estimates that 200,000 barrels of crude are leaving Western Canada by rail for the United States every day, and the bank is expecting it to go up to 500,000 bpd by the end of the year.

Phillips 66 is expecting 2,000 railcars to be delivered in 2013-2014. These high-capacity railcars will be used primarily to deliver Bakken crude oil to its Bayway and Ferndale refineries. Out of its 11 refineries in the United States, eight are capable of refining heavy sour crude.

Foolish bottom line
As the Brent-WTI spread narrows and current crude oil prices being heavily backdated, refiners may not be in an enviable position right now. But the leadership that looks at the long term and invests accordingly should be the clear winner. Both Canadian crude and the price-advantaged Bakken sweet crude are trading at a discount to the West Texas Intermediate. So while the Brent-WTI spread may be narrowing, there's a different market force at work -- that of directly transporting cheap crude by rail. The better prepared refiner is well on its way to take advantage.