Time to Arbitrage Oil?

Hong Mu

By Hong Mu | June 14, 2018

Since February of this year, U.S. oil production has topped and has remained over 10 million barrels per day (mmb/d), a level of output we haven’t seen since 1970. This is primarily driven by the climbing oil prices that have occurred since the beginning of 2016. When oil prices are above $60 per barrel, it makes sense for the shale oil industry to increase the outputs for profit. If including natural gas liquid, the U.S. is the largest liquid energy producer in the world. Since 2012, U.S. oil production has grown more than 50%. However, on a net basis, the U.S. is still an oil importer.

The Brent Oil benchmark (white line of the chart) is the most popular oil price benchmark and is compiled based on 15 different oil fields around the North Sea area. It is referenced by two thirds of the world’s oil contracts. Another oil benchmark often referenced is the West Texas Intermediate (WTI). It represents the price of oil produced in the U.S. Since WTI oil has better quality than Brent oil, WTI oil should technically be priced at a premium. But since 2011, the relationship has been the opposite, thanks to a combination of the U.S. ramping up outputs, OPEC cutting outputs and geopolitical conflicts in Libya, Venezuela and Iran. The WTI to Brent spread is around -$10.8 as of June 8, 2018 (blue line of the chart, LHS).

Another point worth mentioning is the Midland crude oil differential (green line of the chart, LHS). It refers to the price difference between oil from the Permian Midland Basin and the WTI benchmark. The Permian Basin is the current driving force of the U.S. oil production growth. In 2017, the drilled but uncompleted (DUC) wells in the area increased more than 100%. In 2018, more than 50% of the U.S.’ newly added rigs are in the Permian Basin. Permian Basin production is projected to reach 6.4mmb/d by 2023. The differential reflects the fact that the takeaway capacity has fallen behind the production growth. The spread has been trending wider since the beginning of this year and is standing at -$9 as of June 8, 2018. Combined with the WTI-Brent spread, the sweeter Permian Midland Basin oil is almost $20 cheaper than the Brent oil.

Not only is time needed to build all of the takeaway infrastructure for the Permian Basin, but significant capital investment is required. Since it would likely take a long period of time to recoup any investment, investors face uncertainties such as how long will oil prices maintain at the level which makes sense for production growth, how soon will renewable energy more broadly replace fossil fuels, and the potential hurdles from environmentalists and/or political policy making.

Key Takeaways

Although U.S. oil production has reached a new record level this year, U.S. oil prices are lagging behind world oil prices due to the insufficient takeaway capacity. The issue is more prominent in the Permian Basin, which is the driving force of the U.S. oil production growth. Investing in takeaway infrastructure may look attractive in the short term. In the longer term, many factors will play in to influence the supply and demand relationship of the world oil market.



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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

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