September 25, 2017 / 2:09 PM / a month ago

As Brent oil markets rebalance, U.S. lags behind

NEW YORK (Reuters) - New York and London oil futures are sending very different signals to market players about the state of global supply balances, with U.S. contracts weak even as physical crude markets rally and London prices indicate tightening supply.

FILE PHOTO: A pumpjack brings oil to the surface in the Monterey Shale, California, U.S. April 29, 2013. REUTERS/Lucy Nicholson/File Photo

The divergence in the two benchmarks is one that is puzzling some oil traders. The signals are key to determining whether the Organization of Petroleum Exporting Countries’ goal to rebalance markets by reining in supply is working.

Global marker Brent’s strength reflects tighter supplies due to those cuts. Yet the opposite appears true in the U.S. market, which continues to signal large oversupply.

Hurricane Harvey exacerbated the excess of domestic supply by forcing the closure of nearly 25 percent of U.S. refining capacity and half a dozen U.S. Gulf Coast ports and pipelines late last month.

The weakness in the U.S. market may not last, say a growing number of traders and analysts.

U.S. cash grades are trading at multi-year highs, led by strong exports and refining margins. With the wider premium for Brent over U.S. West Texas Intermediate arbitrage, U.S. crude has become increasingly competitive in foreign markets.

The Middle East’s Murban, a light sweet crude, recently widened its premium to $6 a barrel over WTI into Midland, Texas, according to Reuters Eikon data. A month ago, it traded at $1 a barrel over Midland.

“When you look at the Atlantic basin, supplies are getting tighter, especially with more West African (crude) moving to Asia and floating storage disappearing,” said Michael Tran, director of global energy strategy at RBC Capital Markets.

“In time, WTI will play catch up as North America balances firm,” he added.

Last month, the front end of the Brent crude contract curve <0#LCO:> flipped into backwardation, where prices in the near term are more expensive than those further out, while U.S. crude futures <0#CL:> remain in a contango, where near-term supplies are cheaper, through next year.

Last week, the backwardation extended past close-by months to contracts through December 2019. In a research note last Friday, Goldman said that they expected this to remain in place in coming months.

It is rare for the two benchmarks to tell different stories for such a long period, analysts said, as such discrepancies can create trading opportunities that make the original divergence disappear. Both Brent and WTI have largely traded in contango for the last three years.

There have been times in the past where the two diverged. Brent was in backwardation and U.S. crude in contango for much of 2011 through 2013 as a shortage of pipelines to the Gulf Coast, increasing production due to the shale boom and a decades-old export ban forced U.S. traders to sell off WTI.

U.S. DISRUPTIONS

There are several explanations for the current split.

Traders dumped U.S. crude spreads after Harvey disrupted U.S. crude refining and petroleum transport.

In the week prior to Harvey striking the U.S. Gulf, the WTI discount for the first to second month contracts tightened to as much as 12 cents but widened to 88 cents as the storm approached.

Some refiners continue to operate at reduced rates. There are a number of crude vessels also sitting off the U.S. Gulf Coast waiting to discharge, traders say, potentially adding additional barrels to the region.

The biggest unknown continues to be U.S. production, traders say, which is expected to rise this year and next.

U.S. crude output is forecast to reach more than 10 million barrels per day (bpd) next year, a nearly 1.25 million bpd increase from the start of 2017, according to the U.S. Energy Information Administration.

The forecasts, though, are too high, said Harold Hamm, chief executive at shale producer Continental Resources Inc. He told CNBC this month that the EIA’s estimate was as much as 500,000 bpd too high.

If he is right, U.S. storage could drain faster as higher refinery demand is coupled with exports picking up, which would narrow spreads and the Brent/WTI arbitrage, traders said.

At the U.S. storage hub of Cushing, Oklahoma, also known as the delivery point of the WTI contract, inventories are still near seasonal highs at nearly 60 million barrels. During the height of summer demand, stocks fell by around 2.5 million barrels per month. Analysts say those stocks will need to fall faster to allow backwardation to return.

In a recent note, Barclays analysts said that strength in the physical market and the Brent structure is adding to bullish market sentiment in oil prices globally, though it warned of possible additional supplies next year.

“There is scope for an upside surprise in prices, based on the flattening of the curves, the shift in the market balances, and the steady inventory drawdown,” it said. “But market bulls should look at the forecasts for 2018 with concern.”

Additional reporting by Julia Simon in New York; editing by Gary McWilliams and W Simon

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