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brent crude premium over wti here to stay.v.1 by pragcap

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									Diapason Capital Markets Report
Special Report – October 15, 2011

                                                             Robert P. Balan

 Brent Oil premium over WTI: it's here to stay
 The "marginal buyer", "marginal market" in crude will be in Europe for a decade

 The crude oil market has become almost like a surrealist Dali painting -- it just seems all
 warped, distorted and twisted out of shape. Here are some examples: do you want crude oil
 delivered in the future, say a year from now? You can have your pick. If you want West Texas
 Intermediate (WTI) crude, get ready to pay up substantially higher-- crude has jumped almost
 $15 in the past 8 trading days after it became apparent that the U.S. economy was not at risk
 of falling into another recession soon, and the eurozone might be finally getting its act

 And not only that -- WTI oil for delivery in a year from now costs about $2.20 more per barrel.
 The market is in contango, a sign of semi-plenty current supply, so there is a storage premium
 embedded in the price structure.

 However, if you want Brent crude oil, you are actually in luck. Yes, it is more expensive and
 yields less energy, (relative to WTI) but delivery in a year would actually cost you about $5.10
 less per barrel. That is backwardation, and it signifies a very tight spot market, where oil
 commands no storage premium. Unlike WTI, people want their Brent crude now and are
 willing to pay up.
Seemingly chaotic, but the spread matrix has its own internal logic

The net result is that the spread between Brent and WTI ("quality spread") for December 2011
delivery reflects a $25.30 premium for Brent – a spread that had usually been negative in the
past. Moreover, the price of those same two oils contracts 12 months out are “only” $17.30
apart. So essentially the spread between Brent and WTI is in its own weird backwardation as

Arbitrage between Brent and WTI has become even more difficult now with the matrix of
correlations seemingly chaotic. However, this is not really the case, as the spreads have their
own internal logic -- and this logic stems from the fact that the "marginal buyer" of crude oil
and his/her physical location are again in a flux. A change at this time will likely be more
lasting than other similar episodes in the past. The change from a "leader" to a "follower", and
back, impacts a crude oil futures contract in subtle ways that goes past the metrics that
determine price differentials. We see that in the introduction of Brent Crude Oil to the DJ-UBS
Commodity Index, which is provoking some angst in investment vehicles which have to adjust.

The implications of this flux is critically important to understand, as the marginal price being
paid by the marginal buyer will determine the price of distillates (heating oil, gasoline, jet fuel,
kerosene, etc.) a consumer pays for, regardless of his/her location in the globe.

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This is undoubtedly painful for a U.S-based consumer, who will naturally expect some relief
from the relatively lower (vs. Brent) prices of crude oil benchmarked against WTI, and won't
get it. This will be most vexing to heating oil consumers in the Northeast who will be paying
this coming winter at higher Rotterdam-influenced energy prices rather than the lower land-
locked WTI crude oil rates available at Cushing, Oklahoma.

There is an emerging trend within which prices for crude oil produced in areas that allow
movement by ocean-going ship may permanently diverge from prices of crude produced in the
US mid-continent and Alberta and Saskatchewan in Canada. To be more specific, Brent prices
may diverge from WTI prices for a long while. Furthermore, over the following years the price
divergence could be similar to the historical gap that has developed between natural gas and
crude oil. Indeed, it is theoretically possible for the Brent price—or whatever crude traders use
to measure crude value— to rise to $150 per barrel while crude oil trapped in the
northernmost parts of Canada sells for $75 or less. These anomalies could last for days, weeks,
months, years, or even decades.

The marginal buyer in crude oil determines its price

One of the most important contributions of the Victorian era’s Alfred Marshall was that one
must go to the margin of the market to determine prices. Marshall knew, as do most modern
economists, that the marginal buyer in the marginal market ultimately determines the price of
a good. Prices will fall in a competitive market if the marginal buyer in the marginal market
buys less. Prices will rise if the marginal buyer in the marginal market buys more. We use the
term "marginal buyer" here in the context of someone who is willing to buy at the present
price, but would be deterred by any increase in price.

What is less discussed in literature is that the marginal market and the marginal buyer are not
fixed -- the marginal market may move from one city to another, from one state to another, or
one country to another over time. One day, the marginal buyer in the marginal market can be
in City X, the next day in City Y; the following day in City Z. Worse, City X can host the
marginal buyer on Monday and again on Friday. In the case of crude oil, the marginal market
can and has moved from Europe to the United States and back frequently. Within the United
States, the marginal market is usually, but not always, found on the East Coast. Within Europe,
the marginal market is usually, but not always, found in Rotterdam.

This movement of the marginal buyer in the marginal market from one market to another
complicates the analysis of oil prices -- a task that had been tackled by some crude oil analysts
to a great success (e.g., Phillip k. Verleger Jr., 2010). At times, prices are set by buyers in the
United States. At other times, prices are set by buyers in Europe. The shift confounds those
who seek a simple, straightforward way to analyze market behavior. The shift also allows
astute traders to profit at the expense of those who believe relationships are fixed.

Please refer to the risk and legal disclaimer at the end of the document           3
The marginal buyer in crude oil is now in Europe

As from the fall of 2010, the marginal buyer in crude oil is located in Europe, and Rotterdam is
the marginal market. This was the time the Brent and WTI quality spreads started to widen in
favor of the former. A year ago, the situation was different. The marginal buyer was located in
New York, and the WTI held premium over Brent. Understanding the implications of this shift
in marginal buyer and his/her location has become even more crucial.

Verleger postulated that the shift of the marginal market to Europe will have important
implications for those following the crude oil market, and subsequent events proved those
projections as valid:

   •   First, the gasoil (a middle distillate, like heating oil or kerosene) price has become a key
       leading indicator of the direction of oil prices.

   •   Second, the euro now plays an essential role in setting prices.

   •   Third, Brent crude prices will trade at a growing premium to light crude prices in the
       United States.

   •   Fourth, strikes or other disruptions in Europe will have an important influence on

   •   Lastly, a sharp hike in the U.S. dollar/euro exchange rate will cause an increase in the
       crude price; and vice versa.

Price levels are set when marginal cost and marginal revenues balance

Europe has been the marginal market before, most recently in 2008. European demand for
ultralow-sulfur diesel (ULSD) fuel that year caused crude prices to surge to $147 per barrel,
the high price ever seen for any contract of crude oil. Of course, Europe may not remain the
marginal market. It could be replaced by China or even by the United States. However, the
current environmental policies being adopted in Europe, particularly regarding global warming,
increase the likelihood that Europe will be the marginal petroleum market for a long time,
probably for the next ten years, maybe longer.

Microeconomics focus intensely on marginal costs and consumer demand. There is a good
reason for their interest. Price levels are set when marginal costs and marginal revenues
(determined by the price elasticity of demand) balance.

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The analysis of marginal costs and marginal revenues is relatively simple in a world with one
product, one group of consumers, and one group of producers, all operating in a single
location. The problem becomes much more complex when there are several products, more
than one input, a widely dispersed set of producers, and an equally widely dispersed set of
consumers. In such circumstances, the analysis and prediction of prices becomes more
difficult, sometimes impossible.

No market presents a greater challenge in this respect than the petroleum market. Consumers
are spread across the world, and their consumption patterns change. For many years,
consumption expanded most rapidly in the United States. Then Europe took the lead following
World War II. The United States forged ahead again in the last decades of the twentieth
century. Today, China and other Asian countries are the most rapidly growing markets, and
collectively will likely account for the largest share in crude oil consumption over the next

Important a priori statements frame the issues

In order to begin to understand how these issues impact crude oil pricing, several a priori
statements have to be set forth:

   •   Oil prices are NOT set by crude oil demand but by demand for petroleum products.
       Consumers do not buy crude. They buy gasoline or jet fuel or diesel fuel or distillate or
       residual fuel oil. And there is no single marginal market for all of these products.

   •   The United States is clearly the marginal market for gasoline. The United States burns
       43 percent of the gasoline produced globally.

   •   Europe is the marginal market for distillate fuel today.

   •   The marginal market for jet fuel is in Asia.

   •   The link between the various product markets and crude oil prices depends critically on
       the location of refining centers, their capacity to process the various crude types
       available to meet local demand for particular products, and the quality of crude oils
       available in local markets.

   •   The product in shortest supply in the market most dependent on imports will effectively
       set prices globally.

As noted earlier, the United States has been the marginal market in the immediate past. In the
United States, gasoline was the marginal product; and crudes offering the highest gasoline
yields, principally light crudes, became the marginal input.

Over the last decade, though, diesel fuel has emerged as the marginal product and Europe as
the marginal market.

Please refer to the risk and legal disclaimer at the end of the document          5
Gasoline is in surplus globally as use drops in the United States because of recession and
greater conservation. Diesel use, on the other hand, keeps rising globally. Diesel consumption
has increased most significantly in Europe, where incentives have prompted motorists to
change over to diesel-powered vehicles. The European dieselization policy has been motivated
by the greater efficiency of diesel engines. It is widely acknowledged that diesels get more
miles per gallon, and automakers reinforced this trend by developing better, cleaner and more
efficient diesel engine for cars.

Europe’s dieselization policy devastates its refiners

Governments in Europe have encouraged dieselization by imposing taxes on engine
displacement and by taxing gasoline at a higher rate than diesel fuel, and consumers have
responded. In many countries in Europe, diesel-powered cars outsell gasoline-powered
vehicles by a four or five to one ratio. In some areas in France, anecdotal evidence suggests
that the ratio may be as high as 10:1. Distillates, particularly diesel fuel, now account for the
largest increase in share of European petroleum consumption.

Ironically, the dieselization policy will tend to exacerbate the difficulties European refineries are
currently experiencing. European oil refineries, particularly the French ones, were not designed
to produce a high distillate yield. Instead, like most world refineries, the European facilities
were built to distill crude or to distill and crack crude, meaning they could best produce high
gasoline yields. These refiners also have produced significant amounts of residual fuel oil
because most lack coking facilities. As a result, they have not been able to adjust to the shift
to distillate fuel oil.

This situation required the European oil industry to start exporting gasoline as it imported more
distillate. At the same time, it’s refining margins fell because global demand for European
gasoline was, with some exceptions, shrinking. The resulting drop in profits contributed to
refining plant closures in Europe, which boosted the region’s dependence on imported distillate
even more. We expect this divestiture trend to continue for some time.

Why so? The European Commission ruled that refiners operating in Europe would have to
purchase carbon emission allowances beginning in January 2013. The industry will likely pay as
much EUR4.4 billion in 2013 if refiners receive no free allowances. The refiners would pay
roughly EUR1 billion if they received free allowances totaling 105 million tons. Costs would
increase through 2020 because the EU plans to reduce the free allowances given and increase
the allowances sold.

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A carbon fee of EUR4.4 billion would translate into a charge of $1.25 per barrel. This amounts
to one-third of the complex refining margins and two-thirds of simple refining margins. The
imposition of such fees on the European refining industry cannot help but force more facilities
to close or operate at lower rates. Analysts estimate that operating costs could rise as much as
13 percent, which seems low to us. This implies that many European operators will close or
drastically scale back operations.

Europe's "green" initiatives will make it the marginal oil buyer for the next decade

Europe’s push to boost diesel use, the configuration of its refineries, and the likely imposition
of carbon tariffs will probably make Europe the marginal market for petroleum products for at
least the next decade.

This will have a number of implications for markets:

   •   Spot prices of European distillate products (ULSD, gasoil, and jet fuel) should continue
       to trade at a premium to prices in other markets, especially the United States. U.S.
       product prices must be lower than those in Europe to facilitate trade. This condition
       dictates that prices for equivalent crudes be lower in the U.S. than in Europe.

   •   Increasing volumes of distillate products should move to Europe from the U.S. and other
       regions. Europe will become a larger and larger buyer of distillate from the United
       States. U.S. refiners will enjoy a burgeoning competitive edge over their European
       counterparts. The key advantages will be the absence of fees on emissions, lower-cost
       natural gas, and, surprisingly, lower-cost crude oil benchmarked against the WTI.

   •   On the other hand, increasingly stringent environmental regulations will make it harder
       for European firms to export distillate products to the United States. European refiners
       today can still dump distillate products with relatively high sulfur content into U.S.
       heating markets. That will not be possible in a few years.

   •   North Sea crude oils should continue to trade at a premium to similar crudes in other
       parts of the world, as extraction volumes diminish. Refining capacity in Europe will
       decline at a rate that matches or exceeds the rate of decrease in North Sea production.

   •   Futures and swap markets for crude oil and petroleum products delivered in Europe
       should become even more important. The increased importance of the European gasoil
       futures contract relative to the NYMEX/CME distillate contract is probably inevitable.

   •   Correlations in fluctuations between the U.S. dollar/ euro exchange rate and petroleum
       product prices should increase. Decisions Europeans make on how much oil to purchase
       depends on the price of petroleum products measured in euros, not dollars. Thus, a
       fluctuation in the dollar/euro exchange will directly influence U.S. product prices,
       particularly the distillate fuel oil price.
Please refer to the risk and legal disclaimer at the end of the document          7
   •   WTI will continue to trade at a discount relative to Brent as long as Europe is the
       marginal market. A permanent change-over will occur when European refining declines
       to the point where its product exports stay constant at roughly 100,000 barrels per day.

The wide "quality spread" rekindles U.S. industrialization

Therefore, manufacturers of energy-intensive goods located in the United States will have an
enormous advantage over competitors in Europe or Asia, including China, in the next few years
from the point of view of costs. This might even hasten the return of manufacturing from EM
countries back to the U.S.

The impact of marginal buyer and marginal market shift to Europe

In summary, the most significant changes to expect from the shift of the marginal buyer and
marginal market back to Europe will likely be as follows:

   •   the shift of price setting from U.S. product markets to European product markets;

   •   the change in price setting for petroleum products from dollars to euros, even though
       crude oil will still be priced and paid for in dollars;

   •   the increased importance of the U.S. dollar/euro exchange rate in setting oil prices;

   •   the emergence of a permanent discount of WTI to Brent;

   •   an increasing squeeze on European refining margins as North Sea crude exports to the
       west come to a halt;

   •   better and better refining margins in the United States as U.S. refiners benefit from
       lower crude prices and higher product prices in export markets; and

   •   the increased importance of the European gasoil futures contract relative to the
       NYMEX/CME distillate contract

Please refer to the risk and legal disclaimer at the end of the document         8

Philip K. Verleger Jr.: The Margin, Currency and the Price of Oil, NABE Annual Meeting,
                            October 2010.

                            Crude Spreads: There is No Limit!: Petroleum Economics Monthly,
                            June 2011

Sumit Roy: WTI: A Shadow of Its Former Self, Hard Asset Investors, March 2011

Richard Bloch: A Surreal Oil Market: Simultaneous Contango and Backwardation, SeekingAlpha

Kenneth D. Worth: What Does The Record High Spread Between WTI and Brent Mean for Oil
                            Investors? , SeekingAlpha

Please refer to the risk and legal disclaimer at the end of the document     9

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Last update on 9 February 2011.

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