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The spread between West Texas and Middle Eastern oil is widening and that could be a good thing for these stocks

The spread between West Texas and Middle Eastern oil is widening and that could be a good thing for these stocks

I like to pay attention to oil prices on a daily basis, and to keep an eye on headlines about OPEC, production numbers, and inventory levels for oil produced both in the Middle East (Brent crude) as well as in the U.S. (most commonly referred to as West Texas Intermediate, or WTI). That also means recognizing the difference, or spread in prices between these competing commodities, and points in time where that spread has started to change.

The relationship between Brent and WTI crude is pretty fluid, but for the most part a premium for Brent oil versus WTI is pretty normal. For the last couple of years, WTI crude has run about $5 per barrel lower than Brent. That spread has actually been increasing over the last few days, and as of yesterday had risen above $10 per barrel for the first time since February of 2015. This morning, it’s widened even further to a little more than $11 per barrel.

Wider-than normal spreads are not common, and they usually reflect uncertainty or confusion about oil prices in general. There are a lot of different elements that can all come into play when you’re trying to figure out what’s going on in the oil market. Sometimes those concerns are political – think about the Persian Gulf conflict in the early 1990’s – and at other times they’re strictly economic. A complicating factor is that no matter whether what is driving price at the moment are political or economic, they can also be limited to either a regional or global scope. But how much do they impact the stock market?

Recent history isn’t really all that conclusive. Let’s look at the last time the spread was larger than $10 per barrel. The chart below is for SPY, an ETF that tracks the movement of the S&P 500; it covers the first six months of 2015.

The area highlighted in green is the last week of February 2015; the spread between WTI and Brent oil on the 24th of February that year reached a peak of almost $12 per barrel. At the time, the S&P 500 had been driving higher, but then dropped about 5% in the first week or so of March. It’s probably safe to say that uncertainty about oil at that time was a factor in some nervousness in the stock market, but look at the rest of the chart. After that initial drop, the market rebounded, and spent the next few months mostly hovering in a range of about 5% between support and resistance levels. The spread over that same period narrowed from that near $12 high in late February back below $10 and in fact by the end of June was less than $1 per barrel, implying that while the stock market didn’t ignore whatever was going on with oil, it wasn’t likely to be a primary driver form that point.

Let’s go a little further back to the next prior occasion the spread between WTI and Brent was unusually wide – November 2013.

The market had been following a strong upward trend for most of the year; one of the interesting elements about this period was that in July 2013, the WTI/Brent spread was as low as $1.34 per barrel, but then began increasing steadily to a high of $18.51 in the last week of November. We can see the stock market paused its upward rally in early December, but ultimately resumed its steady upward climb into the new year. In fact, the S&P 500 continued to move higher until July of 2014, with the SPY rising from about $180 in the first week of December 2013 to nearly $200 by the last week of July. It’s safe to say based on the short pause, but ultimate resumption of its upward trend, that the stock market really didn’t think too much about the WTI/Brent spread as a major influencer of its direction at that time.

If a wider-than-normal spread between these two competing oil markets doesn’t generally act as a significant factor in the broader stock market, why bother noticing the difference at all? The answer lies in the fact that aberrational activity in any market creates opportunity that anybody who is willing to take the time to pay attention to it can take advantage of.

Identifying the opportunity that I think exists right now the WTI/Brent spread requires looking at the price activity of both commodities over the last couple of weeks, and understanding some of the things that are driving them right now. The table below lists the closing values for each one since their highest recent peak at the end of May.

WTI peaked on May 21 and then began dropping, while Brent kept increasing until the 23rd, which prompted the initial widening of the spread. They both found a bottom on the 28th, but while Brent rallied from that point for the next few days (it dropped again today), WTI dropped even more, widening the spread even further. So what’s driving the change?

It might seem easy to suggest that trade tensions from looming U.S. tariffs are the big driver, and while that is likely to be a contributing factor, I don’t think it’s the biggest concern in this case. More important is that while U.S. crude producers keep driving production higher, pipeline and storage capacity to the Gulf Coast are being tested to their limits. That’s driving up inventories, which naturally puts downward pressure on the WTI price. Adding to that mix the fact that production in the oil-rich Permian Basin area of Texas has been increasing by around 70,000 barrels per day for the last several days. The problem is that pipelines from that area were already running fully at their capacity limits, and so producers are being forced to find other, more expensive ways to transport their oil, including by tanker trucks and railcars. In that case, the spread increases even more, pushing Permian crude as much as $12.50 per barrel below the current WTI contract price.

Since most experts and even the Federal Reserve Bank of Dallas are forecasting similar transportation issues for most of the year, and even into the middle of 2019, this is a situation that could persist for the foreseeable future. Where, then is the opportunity for investors? Downstream from producers. That means the companies that are being contracted to transport crude from these regions, as well as the refining companies that receive it and refine it to turn it into a consumable product are the ones that stand to benefit. Transport companies, like Enterprise Products Partners LP (EPD), Plains All American Pipeline (PAA), to name just a couple, can charge a bigger premium to producers, while refiners like Valero Energy (VLO), Holly Frontier (HFC), and Marathon Petroleum (MPC) are in perfect position to take advantage of the lower WTI (and Permian) price to get crude dramatically lower than their Brent cost and so improve their profit margins. These are the kinds of stocks that are likely to provide the best opportunities in the oil industry, both right now and moving through the rest of the year.

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