Turnover in ICE Brent futures has been catching up with NYMEX’s flagship WTI contract in recent weeks in what some see as a sign market participants are abandoning a regional benchmark in favour of one that more accurately reflects conditions in the Middle East and Asia.

Brent prices have moved to a large and variable premium over mid-continent U.S. crude – reflecting strong demand in emerging markets and supply disruptions in the Middle East, coupled with a plentiful supply of Canadian and U.S. crude trapped in the U.S. Midwest and unable to make it to international markets.

WTI’s discount has been driven by local factors causing it to partially decouple from world markets. Some observers suggest WTI is now best seen as a regional marker while Brent has become the global one. The reality is more complicated.

LEVELS AND CHANGES

In the last three months, Brent has moved from a small discount to a significant premium of $9-17 per barrel over WTI . As a result, U.S. crude futures are no longer a close hedge for petroleum consumers and producers outside the United States. Several important hedgers, including airlines, are reported to have switched hedging from WTI to Brent to obtain a better match with the prices they are paying in the physical market.

But most of the shift occurred in January and February. From March on, the spread between WTI and Brent has stabilised somewhat, albeit oscillating in a fairly broad range. In other words WTI and Brent are now roughly tracking one another once more – though with quite a bit of day-to-day noise.

The width of the spread and its noisiness mean WTI futures and options are no longer a close hedge for producers and consumers outside the United States. But WTI does seem to be reacting to broadly the same factors as Brent. It is important not to overstate the degree to which the contract has become localised and cut off from broader global trends.

SIMILAR VOLATILITIES

WTI’s continued integration into the global oil market is also evident from a comparison of volatility in the two contracts. Historically, WTI has been slightly more volatile than Brent. Volatility in WTI has exceeded Brent on average by just over 3 percentage points on an annualised basis since 2000, using either a close-to-close volatility measure or a Parkinson volatility estimator (which takes into account the whole daily trading range).Decade averages are distorted by the anomalous period in late 2008 and early 2009 when storage facilities around Cushing filled close to capacity and front-month WTI became exceptionally unstable. But WTI has still been slightly more volatile than Brent even if this period is excluded.

In the last month, Brent has been a bit more volatile than usual. On a closing basis, Brent has been about 1.5 percentage points more volatile than WTI. On the Parkinson measure, Brent is still 1.5 percentage points less volatile than WTI, but this is below the long-term average of 3.4 points. However neither shift is very significant as the attached chart clearly shows:

http://graphics.thomsonreuters.com/ce/WTI-BRENT-COMP-VLTY.pdf

NEWS EFFICIENCY

It is tempting to construct an argument suggesting Brent is a better proxy for investors wanting to get exposure to instability in the Middle East and growing demand in Asia because it has more direct links to affected regions. But the data does not support this narrative.

Surprisingly, WTI seems to be incorporating the news flow from the Middle East, demand from Asia and fears about geopolitical risk with almost as much efficiency as Brent. Investors wanting exposure to upside price potential and tails risks can acquire it from WTI about as effectively as they can from Brent.

There is still one fairly integrated global oil market. And WTI remains a global benchmark – albeit with local characteristics. Those local characteristics are important enough that WTI is no longer a good hedge for oil consumers outside the United States. But they are relatively insignificant for investors taking price risk rather than seeking to offset physical exposures.

For sophisticated investors, Brent remains the better option for taking price risk because its links with Middle East and African crudes are more direct. In a genuine supply crisis erupting in the Middle East, Brent’s price premium over WTI could increase further and provide more upside potential.

But for the majority of institutions and hedge funds WTI is proving an acceptable alternative, providing reasonably efficient exposure to the Middle East and a forecast tightening in the supply-demand balance.

Ends –

---

By John Kemp, Reuters market analyst – for Commodities Now.