What the Narrowing WTI/Brent Price Gap Means for Investors

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Increasing pipeline capacity in the U.S. is expected to help close the troubling price differential between West Texas Intermediate and Brent prices.

 

The Energy Report: U.S. oil prices hit their third peak of 2012 soon after your last interview with us, then bottomed around $85 per barrel ($85/bbl) in early November. Now they’re back in the mid-$90s. What’s causing the recent strength?

Elliott Gue: New pipeline capacity is alleviating some of the supply crude glut in places like Cushing, Oklahoma. As a result, West Texas Intermediate (WTI) has gained ground against Brent, which is now trading just under $114/bbl and has been in that same $107–115/bbl range since August. Over the next year or so, a number of other pipelines will open up to the Gulf Coast, which will help narrow the spread between Brent and WTI.

TER: Will the increased oil supply at the Gulf refineries be good for gasoline prices?

EG: Gasoline and diesel prices have historically tracked Brent prices more closely than WTI because not all refiners have access to WTI or the other inland crude oil benchmarks. Refiners don’t really benefit from rising oil prices because they purchase crude oil as a raw material. But those U.S. refiners that are able to access WTI and other inland crude oil benchmarks can buy that raw material very cheaply and sell gasoline and diesel at very high prices, earning a very high spread, or what we call a crack spread.

But the boom in U.S. energy production is benefiting the U.S. economy in general. Natural gas prices in the U.S. can be as much as one-fifth of what they are in Europe. That is sparking a renaissance in manufacturing and other energy-intensive businesses. One of the most obvious examples is the petrochemical processing business. The boom in gas production has seen a commensurate boom in production of ethane and propane. Now it’s actually cheaper to produce base chemicals and many plastics in the U.S. than it is even in the Middle East, which is a dramatic change from just five or 10 years ago.

I wrote recently in High-Yield International about LyondellBasell Industries NV (LYB:NYSE), a multinational chemical company that produces a lot of ethylene and propylene. It’s really benefiting because of its access to really cheap propane and ethane in the U.S. That trend is going to continue.

TER: Do you expect general improvement in the global economy to continue fueling higher oil prices?

EG: The near-term outlook appears much more bullish in Europe than the U.S. Countries in southern Europe have made strides toward fiscal austerity, bringing their budgets somewhat under control. It appears that the worst of the European fiscal crisis is behind us.

China, however, has been a drag on the global economy over the last couple of years. Its very strong growth rates caused the government to get concerned about inflation and hike bank reserve requirements to cool overheated areas of the market, like property. As a result, the Chinese economy slowed down throughout the latter half of 2011 and into 2012. I believe it’s reached a bottom now. The government is now supporting growth by cutting interest and bank reserve requirements and doing additional fiscal spending. Over the last 10 years, more than 95% of global growth in oil demand has come from emerging markets, not the U.S. and Europe, so Chinese growth is very important to global oil demand.

In December, Japan, the world’s third-largest economy, elected Shinzo Abe on a platform of aggressive stimulus for the Japanese economy. He wants it to adopt an official inflation target and start pushing the Japanese economy into an inflationary position to get out of the stagnation and periodic bouts of deflation it has suffered from since its property bubble burst back in the early 1990s. That will probably be positive for commodity prices.

TER: How do these projections affect your investment outlook?

EG: I’m really excited about international markets now because I think that’s the best place to be. A company like Eni S.p.A. (E:NYSE), which was originally a state-sponsored Italian oil company, is far cheaper than a Chevron Corp. (CVX:NYSE) or an Exxon Mobil Corp. (XOM:NYSE), and has faster production growth. It yields almost 6% compared to 2–3% for the U.S. majors, yet it’s getting punished simply because it’s an Italian company even though its main product, oil and natural gas, are internationally traded commodities that are priced in dollars. Moreover, it doesn’t have that much exposure to Italy or even Europe. Many of its main oil- and gas-producing facilities are located in regions like North Africa, the Middle East and Norway. Markets like Europe are much cheaper than the U.S. As European economies emerge from recession, stocks should do very well.

East Africa is one of the very interesting emerging offshore regions, and Eni is one of the main players in Mozambique. Eni is a company that has been a favorite of mine for a while. I actually think now is an even better time to get involved in it because Europe is really going to start pulling its weight.

TER: What are you expecting for oil prices in the foreseeable future?

EG: My oil outlook is pretty flat this year. I’m calling for Brent prices to average around $110/bbl, and WTI to range between $90–100/bbl. Of course, there are risks. One of the biggest risks for Brent is the geopolitical climate. Recent events in Algeria have raised concerns over potential disruption to global oil supplies. Another factor is simply that the global supply of oil is actually very tight. All of the world’s growth outside of OPEC has come from the U.S. and Canada in recent years, as well as the deepwater Gulf of Mexico.

The main risk to U.S. oil prices is that if drilling activity remains very strong, we could see U.S. oil production ramp up more quickly than expected. That would likely put downside pressure on WTI. But unless WTI prices remain relatively high, there will be a drop-off in drilling activity and a consequent drop in supply.

TER: What does that mean for energy stocks?

EG: It’s actually going to be a really good year for companies, particularly those leveraged to Brent. One of my favorite areas remains deepwater, due to the activity boom in different basins such as the U.S. Gulf of Mexico. One of my favorite deepwater rig plays that I’ve had for a while is Seadrill Ltd. (SDRL:NYSE), which has about an 8% yield. This company owns a fleet of deepwater and ultra-deepwater rigs that are going to be in extremely high demand. The market is very tight and should remain so for at least three or four years. There are only one or two rigs available for all of 2013. Operators are willing to lock in those rigs at very high rates. Seadrill is a company that’s well placed to benefit from a very modern fleet. Seadrill has been a good winner for us. It’s pulled back a little bit from its highs lately, but has continued to benefit from the ability to purchase new rigs and put them out at very high contracted day rates. As a result, it has been able to continue to grow its dividends, which have supported the stock.

TER: How have some of your favorites performed over the last year or so?

Some of the companies that I’ve talked about in the past, such as some of the U.S. royalty trusts, like the SandRidge Permian Trust (PER:NYSE) and SandRidge Mississippian Trust II (SDR:NYSE), have been on a roller-coaster ride, the main reason being that most of those trusts are producing WTI oil where prices are much lower. But new pipeline capacity coming into play is really going to help those stocks. In particular, the SandRidge Permian Trust remains an excellent buy at current prices.

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