Crude, Cushing, and Crack Spreads: How to make sense of it all?

Posted on: Tuesday, June 24th, 2014

This has been a fascinating year for followers of petroleum markets.  There has always been a level of confusion—if not distrust—over the ability of gasoline and diesel prices to change with no apparent connection to underlying crude oil prices. Lately, that disconnection seems greater than ever.  Fuel prices seem to be much higher than the underlying price of crude oil would suggest, at the very time of the year when they ought to be relatively low due to reduced seasonal demand, especially for gasoline.  What gives?

The single most important reason is the difference between the price of West Texas Intermediate crude oil (WTI), and the price of Brent crude: the former originating in the Texas oilpatch, the latter originating in the North Sea. The two are of similar quality and, all other things being equal, should trade more or less at parity to each other. Historically that has been the case, but more recently, the price “spread” between the two has been significant. Why?

The fundamental cause lies in the fact that WTI moves by pipeline within the US, with little ability to reach global markets, whereas Brent—and other “waterborne” crudes—can move by oil tanker to just about any crude receiving marine terminal in the world, including those in the US and Canada. Most of the time, supply and demand for each of these two benchmark crudes are in balance, thus resulting in their respective prices being similar.  What has changed is this: there has been far more crude supply going into the Cushing Oklahoma storage and trading “hub” for WTI than there has been demand for that product to leave Cushing.  High inventories equals depressed prices. Brent does not suffer from those conditions, hence the spread.

This unprecedented price spread has played havoc in North American refined products markets. Many large institutional buyers of fuel have historically bought WTI futures contracts as a hedge against any unexpected rise in fuel prices.  Fuel prices did go up, driven by higher Brent crude prices, but the underlying WTI futures contract lagged behind. Ouch!

For everyday consumers, rising fuel prices made no sense at all, given the apparent lack of upward movement in the price of crude oil as reported in the popular press, who generally refer to WTI, not Brent, as “the price of oil today”.  Brent and other waterborne crude prices did rise significantly however, are very much used as feedstocks at a multitude of North American refineries.

The relatively low WTI prices have also created some anomalies with respect to refinery margins, also known as “crack spreads”—the difference between the revenue from a barrel of gasoline (for example) leaving the refinery, and the cost of that barrel of crude oil going into the refinery. Crack spreads tend to be low when wholesale inventories of a fuel are plentiful and vice versa—exactly as one might expect. Lately, however, crack spreads appeared to be high, despite healthy gasoline inventories across North America and, until recently, high diesel inventories.

The key word is appeared.  Crack spreads, as measured by outside observers, historically used WTI as the crude basis in US markets, even in regions that in actuality rely on “waterborne” crudes such as Brent. Similarly, Canadian industry watchers often used a western Canada benchmark crude basis, one that bears more of a logistical resemblance to WTI than it does to Brent. So, Brent and other relatively high priced waterborne crudes—the actual feedstocks used by coastal refineries logistically isolated from cheaper “landlocked” crudes such as WTI—have actually caused depressed crack spreads in those regions. So, while WTI served as a handy benchmark for crack spread analysis in the past, it now grossly overstates crack spreads in refining regions not able to gain access to WTI crude.  Many firms—mine included—have consequently re-visited their methodologies for calculating crack spreads.

It is important to note that the Brent/WTI spread has eased recently, from close to $30 a barrel in October to just over $10 today. In the long run, this spread will diminish to historical levels of near-parity.  For starters, the likely reversal of the Seaway pipeline between Cushing and the US Gulf Coast will improve the flow of crude oil out of Cushing, and that can happen in a matter of months, not years.  This will firm up WTI and western Canadian crude prices—good news for those producers, albeit at the likely expense of lower Midwest refiner margins. Future additions to pipeline infrastructure, the Keystone XL in particular, will further allow Midwest crudes to compete more directly on the global market.

Given the past and (to a reduced degree) current price divergence between Brent and WTI, one might expect to see fuels refined from the lower priced “landlocked” crude oils to sell at lower prices than those refined from pricier “waterborne” crudes. This has not been the case however.

The reason for this is quite simple: products such as gasoline and diesel fuel are not priced on a “cost-plus” basis in their wholesale markets.  This is not an industry practice; this is simply how any commodity market works.  Because refined products can more easily flow out of western Canada than they can flow in (all of the trans-regional pipelines carry crude and refined product away from Edmonton, not into it), lower wholesale fuel prices in western Canada can quickly reach parity with those in eastern markets.  Unfortunately, when supplies of gasoline or diesel in western Canada are tight and prices rise, the west is less able to access less expensive eastern fuel markets—pipeline directions can’t be changed on a whim.

This means that in western Canada, while wholesale fuel prices can be significantly higher than in the east, they are seldom significantly lower. While westerners live in a region blessed with oil resources and an accompanying refining industry—both exporting the majority of what is produced to other regions—pipelines run in one direction only, a limitation that should be addressed in discussions about a Canadian energy strategy.

This article originally appeared on letstalkenergy.ca (an initiative of the Canada West Foundation).