published Wednesday, March 7th, 2012

Personal Finance: Crude oil prices depend on complicated factors

Christopher Hopkins

Global trade in crude oil is dominated by futures markets, wherein users such as refineries lock up supplies today at a fixed price for delivery at some time in the future. Supplies have traditionally been considered fungible, meaning that the source was essentially immaterial, and that oil from one supplier traded at the same price as oil of equal quality from anyone else.

A fascinating disparity has developed recently, resulting in widely divergent prices for crude oil futures depending upon geography.

Customers are presently paying substantially different prices depending upon where they are located. This imbalance reflects the rapidly changing dynamics of North American oil production and the resultant transportation bottlenecks impeding the efficient distribution of supplies.

Two main contracts have traded since the 1980s: Brent crude and West Texas Intermediate. Brent crude oil is a classification of low-sulfur petroleum grades that come from the North Sea, Africa and Europe. Refineries in the Eastern United States typically procure their supplies via the Brent contract.

West Texas Intermediate is a nearly equivalent grade of U.S. petroleum used by refiners on the Texas and Louisiana gulf coast and in the Midwest. Ordinarily, the price differential has been quite small. This relative parity has been upended over the past couple of years by the surge in North American oil production.

The benchmark WTI contract specifies delivery at the massive oil terminal in Cushing, Okla., the crossroads of the vast U.S. oil pipeline network. Thanks to a proliferation of new production in the Arklatex and the oil sands of western Canada, the Cushing facility is up to its eyeballs in oil.

The problem is insufficient pipeline capacity to move the oil from Oklahoma to end users on the Gulf. Production has simply outpaced the capacity to transport the stuff. This glut of supply at the delivery terminal has depressed prices of WTI relative to the Brent benchmark.

Enter the Bakken shale play in North Dakota. Technological advances in drilling have nearly quintupled production over the past five years, far outstripping the capacity to ship the oil to customers.

Bakken oil prices are based upon delivery at Clearbrook, Minn., and reflect an even more acute bottleneck than WTI at the Cushing hub.

As recently as mid-February, the discrepancy in prices was startling. Brent crude for East Coast refiners traded around $117 per barrel, while West Texas Intermediate was going for $99 at Cushing. But Bakken crude delivered in Minnesota sold at the bargain price of $70 per barrel, since the capacity to move it to market lags so far behind the surging output.

Eventually, infrastructure will catch up with output and level the prices. The Keystone pipeline, a recent victim of political maneuvering, will ultimately be approved and built, along with many others that will clear the backlog and move product to market.

Domestic energy production is an emerging success story and will be a powerful force in reviving the domestic economy. Meanwhile, it presents a classic study in supply and demand.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.

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