What the Arab Summer and price spreads say about the oil market

Holding true to the notion of an “Arab Summer,” social unrest continues to surge in regions of the Middle East. It seems like only yesterday that tensions in Egypt as high as the Egyptian Revolution gained steam ultimately resulting in the ousting of Hosni Mubarak as President after serving for 30-years.

That was the winter of 2011. During that time, the price of oil remained largely unchanged before sliding into normal springtime increases, which is seen on a regular basis.

This time, only two and a half short years after deposing their leader, the people of Egypt are once again engaging in military action against their elected government. Only this time, oil traders were looking.

Unrest in the Middle East is nothing new. Most American citizens may have difficulty remembering a time when there was no tension in the contested region. While it may be common for conflict to emerge here. Most of the time that it does, economies across the world are impacted.

Conflict in the Middle East often pushes the price of internationally produced oil skyward as traders begin to worry about supply constraints following violence in the region.

In conjunction, as international oil prices rise, other prices follow suit. Nowhere is that more true than here in the United States. Since hitting recent lows around $93 per barrel in late June, prices of domestically produced oil have rocketed straight upwards to levels unseen in over a year as of July 24th.

After reaching a high-point around $104 per barrel, this increase represented a 12% increase in oil prices in just over two weeks (June 24th to July 8th). For most, the most significant impact stemming from these increases can be felt at the gas pump.

Typically, with an increase in oil prices comes an increase in gasoline prices since crude oil is a main feedstock for the fuel. However, the rising price of domestically produced oil can have impacts reaching beyond the physical wallet carried with you every day.

The rise in oil prices prompts investment managers to adjust strategies to combat fluctuating pricing on the world’s most popular commodity. This is especially true for the managers of The Bakken and U.S. Energy Shale portfolio.

Before pushing forward, let’s take a step back. In order to more fully understand this strategy, it is important to know what exactly it is that we are talking about. Predominantly, in regards to investing in U.S. oil, there are two separate oil prices that an investor should be concerned with.

On one hand, there is the Brent Crude ICE oil price. This oil is routed through and priced in the North Sea, just off the coast of the United Kingdom. This price is significant because it is the de-facto price given to a majority of oil traded throughout the world.

Roughly two-thirds of all oil being traded is priced at the Brent Crude price. Simultaneously, Brent serves as a benchmark for worldwide oil prices.

On the other hand is the domestically derived West Texas Intermediate (WTI) price. This pricing hub is located in Cushing, Oklahoma which is a major storage location for much of the crude oil produced in the United States.

Similar to how Brent crude is regarded as the International benchmark, WTI is oftentimes regarded as the domestic oil pricing benchmark.

Now, when comparing these two prices together, another term is used. This term, the “crack spread” or simply the “spread,” represents the difference in price between Brent crude prices and domestic WTI prices.

Still with us? The price spread between these two oil pricing structures is of significant importance to oil investors because it provides a look at just how high (or low) United States produced oil is in relation to other established oil networks.

So how does the spread make a difference in the eyes of investors? The answer to this question is a common answer to most other questions; it all comes down to money.

It comes as no surprise that oil companies are looking to make the most money possible, just like most of us. They do this by playing the spread. The spread between WTI and Brent crude prices is important for domestic oil producers because this spread effectively dictates which markets they will sell their produced oil into.

If Brent prices remain at a much higher premium when compared to WTI prices, there is more incentive for these producers to move oil to the U.S. coasts where they can have their oil priced at Brent prices and make a few extra dollars per barrel.

At the same time, a tighter spread (resulting in Brent and WTI prices being close to the same) makes transport to the coast uneconomical, and producers opt to transport oil to mid-continent areas subjecting them to WTI pricing.

In terms of making an investment in this market, it is important to understand the methods of transportation being employed in each situation. When oil is being moved towards the coast, the easiest way to accomplish this task is via railways. When it is preferential to keep oil in the mid-continent, pipelines are oftentimes the preferred method of transport since significant pipeline infrastructure exists in the middle of the country.

In the current market, investors are seeing oil spreads at the lowest levels since January of 2011. Since witnessing a yearly high spread of $23 in February, the spread has tightened to only $4.31 (as of July 2, 2013).

This tightening has evoked some detrimental effects on the Bakken and U.S. Energy Shale portfolio, especially in holdings that participate in the rail industry and the oil refining business.

The less attractive Brent prices have deterred domestic producers from moving oil to more advantageous pricing environments, and the rising cost of feedstock for domestic refiners has put pressure on their refining margins.

The Egyptian coup of 2013 has made an impact all the way over in America once again. But all is not lost. As tensions die down, and oil prices retreat to seasonal norms, these two industries will become more attractive once again.

Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.

Photo Credit: El Mosquito