The physical market and the WTI/Brent price spread

• Published date: 01 March 2018
• Date: 01 March 2018
• Author: Pan Liu,Reid B. Stevens,Dmitry Vedenov
• DOI: http://doi.org/10.1111/opec.12117

The physical market and the WTI/Brent price

spread

Pan Liu*

,

**, Reid B. Stevens* and Dmitry Vedenov*

*Associate Professor, Department of Agricultural Economics, Texas A&M University, College Station, TX,

USA. Email: vedenov@tamu.edu

**Senior Analytics Fellow, McKinsey & Company, 85 Seaport Blvd, Boston, MA 02210, USA. Email:

liupan925@gmail.com;

Abstract

West Texas Intermed iate (WTI) and Brent Crude are primary ben chmarks in oil prici ng.

Although produced i n different location s, WTI and Brent are of simi lar quality and are used

for similar purposes . Under the oil market glob alisation assumpti on (Weiner, 1991), price s of

crude oils with the same quali ty should move closely tog ether at all times. How ever,

empirical evidenc e shows that notable vari ations exist in the WT I/Brent spread, part icularly

after 2010, creating risks as well as potent ial arbitrage opport unities for oil market

participants. The pape r analyses the dynamics of WTI/ Brent price spread for the pe riod

between January 1994 and De cember 2016. A test for struct ural breaks in the WTI/Brent

price spread indicat es a change from a stati onary to a non-station ary time series in Dece mber

2010, which is also con firmed by the unit root and cointegration tests. The impact of

physical market funda mentals on the dynamics of WTI/Brent price spread is then analy sed

using the Structura l Vector Autoregres sion Model for each sub- sample period separ ated by

the structural brea k. Impulse response f unctions show that th e WTI/Brent spread i s mainly

driven by US production shoc ks.

1. Introduction

Crude oil is one of the most important industrial commodities. A variety of crude oils of

different characteristics are produced and traded around the world. Among them, West

Texas Intermediate (WTI), Brent, and Dubai Crude are the three primary benchmarks.

The most important characteristics of a crude oil are its density and sulphur content.

Generally, low-density and low-sulphur content crude oils are more valuable than high-

density and high-sulphur content crudes. WTI and Brent are both light (low density) and

sweet (low sulphur) crude oils, making them ideal for refining petroleum products.

Dubai/Oman is a medium sour crude oil, which means it has a higher density and higher

sulphur content than WTI and Brent.

©2018 Organization of the Petroleum Exporting Countries. Published by John Wiley & Sons Ltd, 9600 Garsington

Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

55

West Texas Intermediate is produced and primarily used as a benchmark in the

United States. The US crude market is divided into five regions called Petroleum

Administration for Defense Districts or PADDs. Cushing, Oklahoma is in PADD 2, and

is a key hub with many intersecting pipelines as well as storage facilities. It has served as

the price settlement point for WTI on the New York Mercantile Exchange since 1983.

The development of hydraulic fracturing and horizontal drilling technologies has caused

a boom in shale oil production over the last few years. According to Energy Information

Administration, the average daily production of shale oil is about 3.5 million barrels,

three times higher than the daily production in 2010 (EIA, 2014; Manescu and Nu~

no,

2015). The so-called ‘shale oil revolution’increased the availability of US domestic

energy availability and reduced its dependence on imported crude.

Brent Crude is extracted from the North Sea and encompasses four crude blends, viz.

Brent, Forties, Oseberg and Ekofisk (BFOE). It serves as an international crude oil

benchmark and is responsive to global market fundamentals. Norway and United

Kingdom are two major oil producers in the North Sea. The Brent and Forties blends are

produced offshore in the waters of the United Kingdom, and the Ekofisk and Oseberg

blends are mainly produced offshore in the waters of Norway (EIA, 2016). The North

Sea region is experiencing faster-than-expected decline in production, mainly due to the

ageing fields and increasing production costs. Brent production fell by 38 per cent

between 2010 and 2013—a fall of 500 million barrels per day of oil production (CME,

2014). Even though the Brent benchmark itself accounts for only a small portion of total

world crude production, it remains a key indicator for world crude oil pricing.

The concept of ‘globalisation’in oil market was introduced up by Weiner (1991). This

oil market globalisation theory claims that supply and demand shocks to oil prices in one

region quickly transfer into other regions, which means that prices of crude oils with same

quality will move closely together. Based on this hypothesis, price spread between crude

oils with similar quality should consist of only three components: quality discount,

transportation cost, and time discount. WTI and Brent are both light and sweet forms of

crude oil, therefore, the spread between WTI and Brent should be nearly constant over time

(Fattouh, 2010). However, empirical evidence shows that notable variations exist in WTI/

Brent spread, particularly after 2010 (see Fig. 1). In this paper, we study the dynamics of

WTI/Brent price spread by investigating two questions: (i) is WTI/Brent price spread

stationary over time?; and (ii) what factors are driving the variations in WTI/Brent spread?

The properties of the WTI/Brent price spread as a time series have been studied in the

prior literature. Before 2010, the literature confirmed the predictions of the oil market

globalisation theory. Most authors find WTI/Brent spread to be a stationary process.

G€

ulen (1997, 1999) finds that oil prices in different markets move closely both in the short

run and in the long run. Fattouh (2010) also finds that several pairs of different crude oil

price differentials follow stationary processes. After 2011, a different pattern has been

OPEC Energy Review March 2018 ©2018 Organization of the Petroleum Exporting Countries

56 Pan Liu, Reid Stevens and Dmitry Vedenov