Market Report: Coming Off the Benchmark

The combination of two rare occurrences helped send the energy complex falling. The dollar actually got stronger and gasoline supplies increased! Yes, that can actually happen! I know, I was amazed myself.

Well it does seem amazing as in recent weeks the dollar has been getting hammered and refiners looked like they had refined their last gallon of gas. I am exaggerating of course but that has been the market mood. But with an unexpected 3.6% drop in new home sales and a 1.7 million barrel increase in gasoline supply, it made some people question some of the things they had believed in. But now the question is whether the NYMEX West Texas Intermediate is a contract the world can believe in.

In today's Financial Times comes a story that may change oil trading forever. The FT reports that, "Saudi Arabia yesterday decided to drop the widely used West Texas Intermediate oil contract as the benchmark for pricing its oil, dealing a serious blow to the New York Mercantile Exchange." The FT says that, "The decision by the world's biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world's most heavily traded oil futures contract. It is the main contract traded on Nymex. The move reveals the growing discontent of Riyadh and its US refinery customers with WTI after the price of the benchmark became separated from the global oil market this year. The surge in oil inventories in Cushing, Oklahoma, where WTI is delivered into America's pipeline system, depressed the value of the WTI against other global benchmarks, throwing the global oil market into disarray. In January, WTI, which usually trades at a premium of $1-$2 a barrel to Brent, fell sharply, leaving it at a discount of almost $12 -- a record gap. This dislocation in the market continued well into the summer. From January, Saudi Arabia will base the price of oil for its US customers on a new index developed by Argus, the London-based oil pricing company. The Argus Sour Crude Index will track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon. Argus said the change in policy reflected the, "increased importance of the US Gulf coast sour crude market, in which both production and trading activity was rising sharply."

The NYMEX has made progress working out some of the problems that created the crude backlog. The problems that were created had to do with problems at Valero one of the world's largest refineries. That created the discount on West Texas Intermediate as the crude had no place to go when the refinery was shut. At that time the International Energy Agency even wondered about the persistent weakness of the West Texas Intermediate (sweet crude) to other domestic and international crude, raising questions about its viability as a regional benchmark. It warns that if the volatility persists then volumes may shift to a more stable environment. The IEA said that Cushing, OK should build larger storage facilities and more pipelines to assure that a localized refinery problem won't distort the price of oil.

The Cushing benchmark has served the world well over the last decade and to be honest with you I would not give up on the WTI just yet. This is a market that has brought stability and clarity to the global market and if the problems at Cushing are fixed then WTI should regain its benchmark status. Still the NYMEX/CME Group may want to get ready to create a sour crude contract or buy the trading rights to the Argus contract just to be sure.

As long as we are talking about big picture changes in energy trading and trends, I would like to call your attention to this week's "This Week In Petroleum" article put out by the Energy Information Agency and some interesting longer term trends in the distillate markets. The EIA says that, "Distillates (including diesel) is the second largest petroleum product consumed in the United States, used for everything from fuel for trucks and trains to residential heating and even a small amount of power generation. Although still overshadowed by gasoline consumption within the United States, global trends have been rapidly increasing the demand for distillate. This is causing major changes in the United States' role in the world distillate market." The EIA says that for many years, the United States was a net importer of relatively small volumes of distillate, primarily from Canada and the Virgin Islands. Imports were generally seasonal, coinciding with greater demand for heating oil during the winter heating season when additional supplies from areas like Eastern and Western Europe and Latin America would occasionally surge.

Yet the EIA says that this trade pattern changed significantly in the spring, summer, and fall of 2008 as wholesale prices for distillate soared above those for gasoline. Distillate prices have rarely been higher than gasoline during the summer months but, the summer of 2008 saw an unprecedented and sustained premium for distillate. A variety of factors were behind the unusually high margins. In South America, price controls were limiting Argentina's production and export of natural gas, and a severe drought in Chile was reducing its hydroelectric generation. Distillate fuel for electrical generation was a convenient short-term substitute for these shortages. Prices began to rise quickly in the face of this extra demand, but several prominent distillate consumers, including China and India, shielded their domestic consumers from the increased costs through fuel subsidies and price controls. The normal economic process of higher prices encouraging reduced consumption was therefore muted or absent in these countries.

The EIA goes on to point out that, "With distillate selling for more than gasoline from August 2007 through February 2009 (except during the hurricanes in September 2008), domestic refiners continued to increase distillate yields in 2008, nearly reaching an unprecedented 30 percent by the end of 2008. From June through August 2008, distillate yields averaged almost 3 percent higher than typical, which resulted in about 380 thousand barrels per day of additional distillate production -- a volume that was more than 10 percent of total U.S. distillate demand during those months. This extra production was occurring despite the fact that domestic demand had fallen over 9 percent compared to the previous year. Refiners were responding to a global, not a domestic, opportunity, continuing a dynamic that began in mid-2007. The United States became a distillate exporter, especially to South America and Western Europe. Net exports peaked in August 2008 at about 740 thousand barrels per day, before falling to some extent later in the year in the face of the coming winter heating season and a significant decline in wholesale prices due to the global economic downturn."

In 2009, the distillate market has returned somewhat toward earlier behavior. Distillate has once again been selling at a discount to gasoline this year as the world economy struggles. However, the United States has remained an exporter of distillate fuel. Net exports through July have averaged about 350 thousand barrels per day compared to almost 275 thousand barrels per day for the same period in 2008. The results of these market changes are not easy to predict. Many of the issues that led to last summer's distillate market swings are not expected to repeat regularly, but the broad trends are informative. The Energy Information Administration, the International Energy Agency, and others continue to project global distillate demand growing much faster than gasoline, especially in the developing world. The United States may therefore remain a distillate exporter for some time." That was some good work and good news from the EIA. That should help the trade deficit a bit. Ok maybe not a lot but it is something.

Oil today is all about GDP growth. A weaker than expected GDP may raise fears of a slowing recovery driving traders back to the safety of the dollar. That would send energy tumbling as a strong dollar and weaker demand outlook could have us test the breakout level area of $75. Do we believe that a recovery is under way? We may rest those ideas after the GDP release.