What's the real price of oil? What a dumb-ass question, you might reply. Oil is the most global of global commodities. Dozens of countries produce it in vast quantities. So just look at the benchmark price, which perfectly reflects global supply and demand, and there you go.
Uh-oh. You're already in trouble because there are many grades of oil and more than one oil price barometer. The two biggies are the prices of West Texas Intermediate (WTI) crude oil and Brent crude. The former reflects the price at Cushing, Oklahoma, the "Pipeline Crossroads of the World" and nexus for the delivery of American and Canadian crudes. The latter reflects the price of North Sea oil.
You'd think that the two prices would be pennies apart, maybe a buck or two at most. In fact, the difference has been so great recently that you wonder whether they're the cost of the same commodity. In early September, WTI traded at about $89 (all currency in U.S. dollars) a barrel while Brent traded at about $115. Some oil futures traders think the spread could go to $40.
When prices for the same product get so out of whack, you know that someone is making an indecent amount of money. No points for guessing who. Anyone selling oil (OPEC, Big Oil) is advocating Brent as the proper and legitimate benchmark. Of course, anyone buying oil—American and Canadian refiners, in particular—like the price of WTI.
As it turns out, both benchmarks are seriously flawed, but Brent, in some ways, is more flawed than WTI. The fundamental price of oil is probably not as high, and certainly not as volatile, as recent Brent quotes suggest. Too bad Brent is emerging as the global standard.
The Brent benchmark took off in the 1980s, partly in reaction to Saudi Arabia's effort to impose its own generally higher pricing on the global market. The Brent price was based on North Sea oil shipments, which were growing, giving it more legitimacy as a benchmark—the basis for prices for current delivery and those quoted in futures and options contracts.
But Brent no longer deserves that status. North Sea oil production is falling, turning Brent into a fringe product. According to a Citigroup report, output has dropped by about 40% since 1999. It will keep declining, giving Brent a scarcity value that, much to the delight of oil producers everywhere, puts upward pressure on the price.
WTI's problem is the opposite: too much oil. Soaring production from the Alberta oil sands and oil-rush U.S. states, notably North Dakota, have flooded the Cushing oil supply hub, which lacks pipeline capacity to move it efficiently to oil refineries on the Gulf coast. New pipelines are coming, but will take some time to build. In the meantime, the price spread between WTI and Brent has expanded to ridiculous levels.
In 2009, the Saudis dropped the WTI contract as their benchmark, dealing a blow to the New York Mercantile Exchange, which trades WTI futures. The era of WTI dominance now seems to be over. According to Houston oil consultancy Purvin & Gertz, Brent and derivatives that trade off it are the benchmarks for as much as 65% of the world's crude trade.
As Brent becomes the de facto global benchmark, it's becoming a physical and financial Frankenstein. As Brent production has declined, the custodian of the Brent contract, Platts, the commodities information division of McGraw-Hill, has scrambled to keep the benchmark relevant by shunting more North Sea oil fields into its calculation. If Platts adds non-North Sea crudes of various qualities—a move it is considering—Brent would become a mishmash of grades and geographies.
The potential for financial manipulation is the bigger problem. Brent futures contracts are traded on the global Intercontinental Exchange (ICE), but they're less liquid than the WTI contracts. That makes them more prone to manipulation by oil traders. Many of those traders are hedge fund managers who are testing their theories about the global economy and oil demand. The more impact they have on the Brent price, the further it may drift away from reality.
How does this affect consumers? For clues, look at the strong profits earned by American refiners of crude such as Marathon
Petroleum and CVR Energy, whose profit margins and share prices are soaring. The refineries are buying WTI crudes at depressed Cushing prices and selling at prices apparently linked to Brent. That goes a long way to explain why U.S. retail gasoline prices, at about $4 a gallon, are near the record highs set in 2008, even though WTI prices are well off their peaks. Fill-up prices in Canada are also close to their 2008 peaks.
The WTI-Brent price gap will probably narrow eventually, as pipelines are built between Cushing and the Gulf coast. Let the taps be turned on soon. Prices should reflect oil's true cost, measured by extraction and transportation expenses, not a financial game promoted by producers and hedge fund managers enamoured with Brent's bloated status and value.
(New York WTI futures Thursday closed over $82)
Eric Reguly