Wednesday, February 18, 2009 1 comments ++[ CLICK TO COMMENT ]++

NYMEX WTIC crude futures contract losing relevance? my thoughs on oil

As if oil investors don't have enough problems with wide contango--at least the longs; shorts are likely a happy bunch these days--we are starting to see the pricing of West Texas Intermediate Crude oil deviate sharply from other lower quality oil. The vast majority of the time, the WTIC futures contract should trade at a premium because it represents higher quality oil (light & sweet). This is a story that has made the round over the last month but the gap seems to be large. MarketWatch has a story detailing the situation and has the following chart of WTIC vs Brent crude contracts:

(source: MarketWatch)

It's not clear to me if WTIC represents the real economy better or if the other prices (Brent, OPEC, etc) represent reality better. The article quotes many analysts that say that the WTIC contract is not reflecting reality. They attribute the problem to shortage of storage space at Cushing, Oklahoma, the delivery hub for the WTIC contract.

The weakness in WTI futures has stemmed from excessive inventories at Cushing, Okla., the delivery point for Nymex futures. WTI has traded lower than Brent before, but this time the gap is particularly wide: It hit more than $10 last month, the most since Brent and WTI began trading in the futures market.

The artificially low WTI prices mean oil users could pay a much higher price than WTI when they trade physical oil with producers. It also means investors putting money in Nymex futures or oil exchange-traded funds linked with Nymex could see prices rally when Cushing inventories wane, as the Nymex contract rises back above levels of Brent and other global contracts.

The article suggests that oil investors that are long will profit when the oil inventories decline. Since I'm bearish on commodities--but not bearish enough to short them--I'm not sure how likely this is. Isn't it just as likely for the other oil contracts to decline? After all, the macro situation in Asia, a big consumer of oil, seems to be deteriorating with some calling for a worse 1st quarter than the 4th quarter last year. It is possible that other types of oil, a big chunk of which is sold to Asia, could decline. However, working in oil's favour is rumblings from OPEC of another production cut.

I suspect that oil will stabilize between US$25 and $45. That's a big range but it's better to be more accurate with a wide range than pick a narrow range and miss completely. If you look at the long-term price of oil in real terms it is in the low $20's (source: WTRG; chart not up to date):

If you ignore the secular commodities supercycle theory and assume things are cyclical, then the most conservative estimate of marginal cost of production is probably around $21. Although I deem it unlikely, oil can go down that far, especially at the trough of a severe recession--we are definitely experiencing a severe recession but it's not clear how much demand will drop.

Oh, I should note that, contrary to my views, George Soros' funds seem to be making a bullish bet on commodities, including oil&gas companies. I don't know much about Soros' actual strategies but he is not known as a long-term investor. He is also not a value investor (in the classic Warren Buffett or Benjamin Graham sense) and is, instead, a macro speculator. Therefore one can assume that he is bullish on the sector, or at least companies like Petrobras, in the short to medium term. I suspect he sees oil rebounding.

Anyway, going back to the WTIC issue, analysts suggest that NYMEX should expand the delivery options:

To revive Nymex futures' importance as a valid international benchmark, the Nymex needs to pick a second delivery point along the Gulf Coast, analysts said. Building more pipelines linking Cushing to the coast could also alleviate storage pressures.

But both probably will take years. For now, "record stock levels at Cushing, anemic oil demand and plans by refiners to sharply cut throughput rates" will continue adding downward pressure on WTI prices, the IEA said in the report.

The disconnect between WTI and the international oil market could slowly disappear once oil demand rebounds and Cushing inventories starts falling, analysts said.

For the time being, investors probably should look at Brent as a more valid benchmark for the world market, said WTRG's Williams. Unlike WTI, the delivery point for Brent futures sits near the North Sea, a much flexible place for oil shipping.

Analysts tend to hold herd-like opinions and tend to lag so it remains to be seen how right they turn out to be. Are we actually witnessing a flaw with the NYMEX system or is the American situation reflected by WTIC the reality that will spread to the rest of the world?


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