Texas Oil Falters in Performance as Benchmark

Apr 23, 2007 (From the Wall Street Journal via Dow Jones Newswires)

The mighty Texas crude-oil benchmark -- the per-barrel price watched obsessively by the markets and quoted by the media -- has diverged so drastically from prices of other grades of crude in recent weeks that some market participants are calling it a "broken benchmark."

Several factors have combined to push the price of West Texas Intermediate crude oil -- used as the basis for the world's most widely traded energy contract -- dollars below other desirable, so-called light sweet crudes.

On Friday, for example, the bellwether oil contract on the New York Mercantile Exchange closed at $63.38 a barrel, nearly 5% less than the $66.49-a-barrel close of North Sea Brent crude, the London benchmark quoted on the ICE Futures exchange.

The disparity, which is partly rooted in structural changes in the energy markets -- including how and where oil is produced and shipped -- means the standard barrel of oil no longer has a straightforward price.

Some experts say such disparities are likely to persist or even possibly worsen in the near term. Already they are upsetting economic forecasts, changing longstanding pricing relationships among commodities and increasing calls for the development of new oil benchmarks.

The divergence may make it harder for governments, multinational companies and even individuals to get a handle on energy costs -- with many assuming energy is contributing less to inflation than it actually is. The enormous ranks of those who trade West Texas crude on the Nymex as a way to protect against rising or falling prices are finding that task, known as hedging, more treacherous because the same price trends aren't showing up in other more widely used crudes.

"Spot WTI crude-oil prices no longer reflect international market dynamics," Edward Morse, chief energy economist at Lehman Brothers Holdings Inc., said in an April 13 report. "Rather, they represent local fundamentals for crude oil in the U.S. mid-continent, putting a question mark over the value of this inland U.S. crude as a world marker for hedging or speculation."

Changing benchmarks is no simple matter, however. West Texas crude is entrenched because a deep, popular, and efficient market has grown up around it. International oil markets are effectively structured around the Nymex contract, with many grades of oil and derivatives priced off the benchmark price, plus or minus a certain differential.

Many billions of dollars of investment products are built around the benchmark, too. In addition to Nymex, which is eager to remain the oil market's epicenter and collect the revenues that result from that status, derivatives dealers and energy traders, fearful of market uncertainty, might resist shifting away from West Texas crude.

In a transaction on Nymex, a trader agrees to buy or sell oil at a set price in the future. Not all trades result in exchange of actual barrels of oil. Speculators, for example, may close out a contract before it expires by making another trade that cancels it.

But if they do take or make physical delivery on the benchmark contract, they must do so in Cushing, Okla., a landlocked oil hub accessible primarily by pipeline. Nymex designated Cushing as the delivery location more than two decades ago when Texas and Oklahoma were bigger oil producers than they are today.

The immediate cause for concern is a glut of oil in Cushing storage tanks. The oversupply, which depresses prices for the benchmark oil, reached dramatic levels this spring when a Valero Energy Corp. refinery fire and outage led to a reversal of the flow of a pipeline back into Cushing, because the refinery couldn't process the crude into products such as gasoline.

Lehman Brothers estimates that, as of mid-April, Cushing had no space left for oil: the 28 million barrels of available storage there were full.

Longer-term factors are also at play. Canadian companies extracting oil from vast deposits of so-called tar sands north of the border are sending an increasing amount of crude into the U.S. through a network of pipelines. Those pipelines bring much of the oil to Cushing.

Yet another factor is the rise in recent years of a new class of commodity-market investors who have made it profitable for owners of oil-storage tanks to hold on to crude delivered at Cushing and elsewhere in lucrative trading strategies.

Nymex strongly defends the relevance of its benchmark. Bob Levin, the exchange's senior vice president of research, points out that daily trading volumes in its benchmark crude contract, combined with volumes of a financially settled WTI contract on the IntercontinentalExchange Inc., have risen to an average of 700,000 contracts a day, up from 500,000 six months ago, and have hit as high as 1.2 million contracts a day. One contract represents 1,000 barrels of oil.

"It's never been more traded, and we don't see that diminishing," Mr. Levin says. While the prices of WTI and Brent prices are currently behaving differently, he adds, "these markets always equilibrate." He also says that Nymex continues to use Cushing as the delivery point because it remains one of the global energy industry's delivery points of choice, due to its established and growing infrastructure and proximity to production and refining.

Nonetheless, Texas crude's relevance to global consumption has long been on the decline, because it represents just a tiny fraction of world production, and continues to drop. The Middle East holds 60% of the world's proven oil reserves and produces about 25 million barrels a day, mostly of a different type of oil, known as "sour" crude, a reference to its acidity. By contrast, WTI output is about 500,000 barrels a day.

Previous attempts to introduce Middle Eastern crude-oil benchmarks have failed, mostly because they allowed for traders to speculate but didn't allow for physical delivery of the oil. Now, Nymex is part of a joint venture that formed the Dubai Mercantile Exchange and will soon launch a new benchmark for Middle Eastern sour crude using physically delivered Omani crude. The organizers announced last week that the benchmark's May 1 launch date had been pushed back for a month so they could complete regulatory approvals.

Most oil analysts agree the price anomalies will eventually diminish when additional storage capacity is built in Cushing, as planned, and more pipelines come online to take crude other places. But at least two leading forecasters, Lehman's Mr. Morse and the energy-consulting firm PIRA Energy Group, say the discrepancies between WTI versus other crudes could persist until 2009.

In the meantime, some big energy consumers, such as trucking companies, airlines and Asian oil refiners may be losing out, says Philip Verleger, an independent energy economist who heads PK Verleger LLC.

Mr. Verleger says those users may have bought Nymex futures contracts to protect themselves against rising oil costs. They were right to anticipate strong demand for light, sweet crude, such as Brent, which is transported by tanker. But Nymex prices have fallen because of the glut at Cushing. At the same time those companies may have had to buy relatively expensive oil or gasoline on the open market.

Another loser: some large institutional investors, such as endowments and pension funds. They have more than $100 billion in index-linked funds with huge positions in the Nymex benchmark. Traders that own storage at Cushing have realized it is both easy and profitable to take physical delivery of the oil the index funds don't want to hold at the end of every month, when they sell their expiring contracts and buy new ones. Owners of storage fill their tanks with crude, and at the same time sell oil months into the future for much better prices, banking a profit.

Mr. Verleger, the economist, wrote a report April 16 that chided mainstream economists for focusing on the wrong benchmark. He said some economists were assuming a $2-a-barrel fall in WTI during the first week of April meant U.S. companies would be paying less for imported oil. In fact, he said, global oil prices were essentially unchanged that week.

"I might as well whisper into a gale," he said. "My experience . . . left me with little faith in the forecasts circulated by macroeconomists or the ability of central bankers to manage the situation."

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