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The Run on Global Oil Prices is Probably Overdone

Recent market panic has caused US and Global crude oil prices to converge. Commodity fundamentals suggest they have converged too much.

Crude oil prices have gone for quite the ride since the end of August with spot prices falling 15% first on a weaker global economic outlook, especially in China and Europe, and then on news that the Saudi government would not cut production to support global prices. The indication from Riyadh is that the Saudis will accept oil prices below US$90/bbl and even US$80/bbl for up to two years. This strategy is in part Saudis learning from their mistakes in the 1980s when OPEC cut production, North Sea supply and the combination of economic troubles and an efficiency push in the US caused prices to fall still. It wasn’t until OPEC boosted production; pushing prices down further did crude oil prices see some relief (link). On the supply side what the Saudis are interested in doing by pricing their production to preserve market share is slow down the growth of US shale oil production. What is most interesting though is on the forward markets, Brent futures have been pushed down more than WTI futures. Front months of the Brent curve are in line with pricing received waterborne crude of similar quality on the US Gulf Coast.

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Given that the US remains the largest supply side threat to the Saudis, it would make sense that they would look to price their product to compete in American markets (i.e discount their product in American markets to retain market share). Just because Americans are receiving a discount from the Saudis doesn’t mean that all (global) buyers are going to receive the same. Supplies of light oil from the Persian Gulf have held up remarkably well compared to other sources of light supply (such as Nigeria).

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Given this backdrop, it seems strange to see the prices of WTI and Brent to converge like they have. The WTI-Brent discount has dropped from around $8/bbl to $2/bbl. The discount between US Gulf Coast waterborne light crude (LLS) and Brent has gone away completely. This doesn’t make sense in a world where the US has prohibited crude exports to markets not named Canada. Fundamentals suggest that Brent should re-strengthen relative to US light benchmarks – not good for North American light oil producers, but not necessarily bad news for producers in Canada’s oil sands provided they have access to US Gulf Coast markets. (For more explanation of why see Refining’s Renaissance).

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