Evaluating robust determinants of the WTI/Brent oil price differential: A dynamic model averaging analysis

• Published date: 01 June 2023
• Author: Michail Filippidis,George Filis,Georgios Magkonis,Panagiotis Tzouvanas
• Date: 01 June 2023
• DOI: http://doi.org/10.1002/fut.22414

Received: 21 November 2022

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Accepted: 19 March 2023

DOI: 10.1002/fut.22414

RESEARCH ARTICLE

Evaluating robust determinants of the WTI/Brent oil price

differential: A dynamic model averaging analysis

Michail Filippidis

1

|George Filis

2

|Georgios Magkonis

1

|

Panagiotis Tzouvanas

3

1

School of Accounting, Economics &

Finance, University of Portsmouth,

Portsmouth, UK

2

Department of Economics, University of

Patras, Rio, Greece

3

Department of Accounting and Finance,

University of Sussex, Brighton, UK

Correspondence

George Filis, Department of Economics,

University of Patras, University Campus,

Rio 26504, Greece.

Email: gfilis@upatras.gr

Abstract

We investigate the robust determinants of the West Texas Intermediate/Brent

oil price differential by employing a time‐varying framework. To achieve this,

a dynamic model averaging framework is used, considering monthly data over

the period 1994:1–2021:3. Our results suggest that the convenience yield, the

global economic activity index, and the government bond yields act as the

main factors that exercise a persistent and significant impact, for the largest

part of the study period, although at different magnitude. More importantly,

though, we show that at different time periods there are additional factors that

exercise a significant impact on the oil price differential, such as refining

constraints, stock market volatility, trading volume, and geopolitical risk.

Thus, unless a dynamic modeling framework is employed, the full spectrum of

the related effects cannot be revealed. A series of tests confirm the robustness

of our findings. Several policy implications of these results are also discussed.

KEYWORDS

Brent, DMA, oil market, oil price differential, WTI

JEL CLASSIFICATION

C11, C22, C51, G15, Q40

1|INTRODUCTION

The aim of this paper is to investigate the potential dynamic impact of a set of robust determinants of the West Texas

Intermediate (WTI)/Brent oil price differential (also known as the WTI/Brent spread), by employing a dynamic model

averaging (DMA) time‐varying framework. Our study focuses on a wide number of factors such as oil spot and futures

markets related, financial indicators, global commodity demand factors, macroeconomic fundamentals, transportation,

and refining constraints, among others. Our decision to examine various key drivers in a time‐varying environment is

motivated by the fact that oil markets appear to be significantly affected by events that are not only necessarily related to

oil supply, demand, and inventory imbalances (see, Baumeister & Hamilton, 2019) but also geopolitical uncertainty (see,

Antonakakis et al., 2017) and speculative activity (see, Silvennoinen & Thorp, 2013), among others. Yet, these events do

not affect the oil benchmarks equally at all times and hence static frameworks may mask some important effects.

The investigation of the oil price differential between WTI and Brent is an important issue for energy traders and

investors in the oil market. Changes in the WTI/Brent oil price differential may be used by the energy traders for oil

risk hedging with the aim to handle market uncertainty. To be more explicit, with reference to hedging techniques, a

J Futures Markets. 2023;43:807–825. wileyonlinelibrary.com/journal/fut

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This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial‐NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non‐commercial and no modifications or adaptations are made.

© 2023 The Authors. The Journal of Futures Markets published by Wiley Periodicals LLC.

simultaneous price movement between WTI and Brent, eliminates the market uncertainty and limits the effectiveness

of hedging strategies. By contrast, market uncertainty is rising dramatically when a decoupling of the two markets is

observed and it consequently reinforces the effectiveness of hedging strategies. With reference to the relevant literature,

authors such as Scheitrum et al. (2018) argue that the price differential between WTI and Brent is an important metric

that impacts the refiner profitability in the United States against the world market. In addition to this, Caro et al. (2020)

opine that a good performance of the price differential between WTI and Brent minimizes the risks associated with oil

price fluctuations and hence secures the oil investments by economic agents globally.

WTI and Brent represent the two major benchmarks in the global crude oil market. WTI is a landlocked American

market settled in Cushing Oklahoma, whereas the Brent European market is sourced in the North Sea. WTI serves as a

regional oil benchmark reflecting supply and demand issues in the large North American market (the United States

and Canada), whereas Brent tends to represent supply and demand conditions in the smaller European market and

further is used to price crude oil that is produced and traded in additional regions around the world such as the Middle

East, the North Africa, and the Southeast Asian markets.

1

This indicates the importance of Brent as an international

crude oil benchmark.

A visual representation of the two oil price benchmarks and their price differential is provided in Figure 1in which

we observe some interesting monthly patterns during the period from January 1994 to March 2021. Indeed, it is evident

that the two oil prices move closely together until late‐2010. More specifically, WTI appears to consistently trade at a

small premium over Brent. Then, we observe the opposite pattern in which Brent begins to trade at a large premium

over WTI from the beginning of 2011 to mid‐2014. It is also evident that this price gap has considerably reduced the

next few years until late‐2017. During this period, we observe that WTI traded at a small discount over Brent. Then, the

period from late‐2017 and before the onset of the COVID‐19 pandemic, the gap between the two prices widens again.

Specifically, Brent begins to trade at a higher level over WTI, although in a lesser extent compared with the pattern

from early‐2011 to mid‐2014. On a final note, since the first half of the 2020 and the onset of the COVID‐19 pandemic

until March 2021 which is the end date of our sample, the price of Brent stands slightly above the price of WTI.

Historically, WTI was priced at a slight premium than Brent due to the slightly higher quality characteristics.

A quality price advantage for WTI may arise due to being lighter and sweeter than Brent.

2

A lighter and sweeter crude

oil produces products such as gasoline, diesel fuel, and jet fuel which are considered as high‐value products. However,

the traditionally trading of WTI at a small premium over Brent began to change towards the end of 2010 in the opposite

direction, where WTI began to sell at a large discount over Brent. This can be possibly attributed to the following

reasons: (i) the increasing US oil production from the Bakken Shale formation (North Dakota) and the Eagle Ford

Shale (Texas) as well as rising crude oil imports from Canada, (ii) the political instability in the Middle East and North

Africa (Algeria, Egypt, Libya, and Syria) known as the Arab Spring.

3

Overall, during the period from early‐2011 to mid‐

2014, WTI significantly weakened relative to Brent, whereas in the post‐2014 Brent maintains a higher price, relatively

to WTI, although at a smaller spread.

The observed regime change of the WTI/Brent oil price differential in the post‐2010 period strengthens the need for

a time‐varying approach to assess the potential drivers of the oil price differential between the two global oil

benchmarks, as opposed to the currently used static frameworks. Hence, having made a short eye‐ball examination of

the WTI/Brent oil price differential, we attempt to strength the existing empirical evidence in terms of its robust

determinants and to provide additional evidence, which fills voids in which the existing literature remains silent. In

particular, even though there are many attempts to explain the behavior of the WTI/Brent oil price differential,

4

and

several other studies that examine the determinants of this price differential,

5

there is a clear gap in the literature in

terms of the choice of determinants, as well as, the use of time‐varying frameworks.

Overall, we could summarize that the existing literature provides evidence that factors affecting the WTI/Brent oil

price differential include the oil inventory demand, oil market macroeconomic conditions, oil physical market

fundamentals, financial factors, weather conditions, and infrastructure bottlenecks among others. Nevertheless, factors

such as key macroeconomic indicators (e.g., industrial production), asset market volatility, and geopolitical uncertainty

1

For more information, see http://www.eia.gov/todayinenergy/detail.cfm?id=18571.

2

For details, see http://www.eia.gov/todayinenergy/detail.cfm?id=7110.

3

For further information, see http://www.eia.gov/forecasts/steo/special/pdf/2012_sp_02.pdf.

4

Some recent papers include Prest (2018), Scheitrum et al. (2018), Agerton and Upton (2019), Benedetto et al. (2020), Caro et al. (2020), Kaufmann

(2020), Mastroeni et al. (2021), and Plante and Strickler (2021), among others.

5

See, for instance, Milonas and Henker (2001), Büyükşahin et al. (2013), Liu et al. (2018), Caporin et al. (2019), Filippidis et al. (2019), and Geyer‐

Klingeberg and Rathgeber (2021). The study by Geyer‐Klingeberg and Rathgeber (2021) is the most comprehensive study to date.

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