WTI rally offers limited upside to oil producers, say analysts

WTI rally may be short-lived, say analysts, while impact of backwardation is likely to be felt more strongly

Global benchmarks offer slim pickings, say analysts

Analysts say the recent rally in West Texas Intermediate (WTI) crude oil, which has sharply narrowed the spread between the benchmark and North Sea Brent crude during the past month, offers few opportunities for oil-producing firms.

Although producers might be expected to benefit from rising prices for North American crude, analysts argue the recent rally will be short-lived, while the impact of backwardation may also outweigh the benefits of higher front-month WTI.

One senior analyst at a European oil major notes that refiners are already well hedged, potentially limiting the impact of the move on physical market participants. "The impact will be limited for physical players, because most of the refiners are hedged, at least for most of 2014. So even if prices continue to narrow significantly, the pull should not be that much, because most players already hedged when the spread was wider,” he says.

WTI has experienced a significant rally in prices since the end of June, culminating with the front-month contract settling at $108.05 a barrel (/bbl) on Chicago-based CME Group’s Nymex exchange on July 19. On that date, the front-month Brent contract on Ice Futures Europe closed at $108.07/bbl, meaning the differential between the contracts stood at $0.02/bbl – the closest the two have been since late 2011.

Market observers say a number of factors are propelling high WTI prices, including physical supply constraints in the US, lower storage levels and an increasingly optimistic outlook for the US economy. On July 30, the front-month WTI contract settled at $103.19 on Nymex, while the front-month Brent contract settled at $106.91 at Ice Futures Europe – a premium of $3.72/bbl over the North American benchmark.

To us, this looks like a short term move, which is probably not going to last

Analysts expect to see a further widening of the WTI-Brent spread during the next couple of months. "WTI still needs to compete with other US crudes and competition obviously gets fiercer as production grows in the US, particularly for the lighter grades, so we think that there will be sustained pressure for WTI to trade at a fair discount to Brent over the long term," says Kevin Norrish, a London-based senior oil analyst at Barclays. "To us, this looks like a short-term move that is probably not going to last and we expect the spread to move back in the other direction before too long." In a research note dated July 12, Barclays analysts predict a $4–5/bbl differential between Brent and WTI until the end of 2013.

Other analysts agree and say it doesn't appear that the market is expecting WTI prices to be sustainable above the current levels. "Certainly for WTI you see a floor around $100/bbl and then back down to $95/bbl as well, and that's where you see a lot of call options and put options being triggered," says Kash Kamal, a London-based research analyst at brokerage firm Sucden Financial.

As front-month WTI has increased, the benchmark has also entered into steep backwardation – a move that analysts at Bank of America Merrill Lynch (BAML) expect to have a greater impact on hedgers. Backwardation describes a situation in which front-month contracts trade at a premium to longer-dated futures. "For producers, backwardation makes it increasingly challenging to hedge longer-dated output, as forward barrels need to be sold at growing discounts. For consumers, the opposite is true: the ability to buy oil forward at a large discount should encourage longer-dated purchases," the BAML analysts write in a July 11 report.

Among hedgers, firms say Brent has been gaining ground at the expense of WTI over recent years – something blamed on the dislocation in WTI amid a glut of North American shale oil. But market observers say firms hedging oil or fuel costs might now regret any decision to switch, given the strength of the uptick in WTI compared with Brent.

Nonetheless, Barclays' Norrish suggests most risk managers continue to view Brent as a more suitable hedge. "WTI has been very volatile and it's not really what you look for if you're trying to manage risk," he says. "If you're hedging, you're probably not looking for something that is quite as volatile and difficult to explain as WTI has been recently."