Crude oil is arguably the most important commodity in the world today. The product and its derivatives have made their way into virtually every application of modern life from transportation to plastics.
This vital commodity also dominates politics in many parts of the world, ensuring that some top-producing nations have outsized influence on the world stage. In light of this, many might assume that most investors know everything about the product and how it trades around the globe. However, that is not the case, as there are several misconceptions about the various types of oil and how this commodity is priced [see also USA Oil Reserves: The World’s Largest?].
Brent vs. WTI Crude Oil
One of the most important issues is the type of oil and the differing benchmarks for crude oil prices around the world. Many might not realize that oil pulled out of the ground in Texas isn’t the same as the product from the North Atlantic. There are varying degrees of oil based on a variety of metrics, such as the oil’s API gravity. The American Petroleum Institute gravity is a statistic that is used to compare a petroleum liquid’s density to water. This scale generally falls between 10 and 70, with ‘light’ crude oil typically having an API on the higher side of the scale, while heavy oil has a reading that falls on the lower end of the range.
Beyond API gravity, investors also need to take into consideration how sweet or sour a petroleum is. This is based on the sulfur content of the underlying fuel, with 0.5% being a key benchmark. When oil has a total sulfur level greater than half a percent, it is considered ‘sour’, while a content less than 0.5% indicates that an oil is ‘sweet’. Sour oil is more prevalent than its sweet counterpart and comes from oil sands in Canada, the Gulf of Mexico, some South American nations, as well as most of the Middle East. Sweet crude, on the other hand, is typically produced in the central U.S., the North Sea region of Europe, and much of Africa and the Asia Pacific region. While both types are useful, end users generally prefer sweet crude as it requires less processing in order to remove impurities than its sour counterpart. Light and sweet forms of crude oil are heavily prized while heavy sour types of fuel often trade at a discount to their more in-demand cousins [read Analyzing Five High Yielding Oil & Gas Pipeline Stocks].
With these two key factors, investors can begin to price these different types of oil on the world market. Currently, there are two major benchmarks for world oil prices, West Texas Intermediate (WTI for short) and Brent crude oil. Both are light, sweet crude oils although WTI is generally sweeter and lighter than its European counterpart. As a result of this, WTI often trades at a premium, usually by just a few dollars a barrel. However, thanks to a Libyan crisis, which has decreased the supply of light, sweet crude in the European region, and a supply glut at the main storage facility of WTI in Oklahoma, the premium/discount situation has flipped and now Brent is more expensive than WTI.
Thanks to two ETFs on the market today, USO and BNO, investors can easily see how the two forms of oil have changed in price over time. Consider the chart below, which plots the two ETFs against each other from March 2010 to September 2011.
Prices tend to be highly correlated with each other over a long-term period. However, at the start of 2011, around the same time that the ‘Arab Spring’ began to take place, the prices of the two ETFs diverged, with BNO climbing far higher than its WTI-tracking counterpart. Once investors realized that more production wouldn’t be lost in the region, and that the Libyan situation was likely to remain an issue for quite some time, the prices of the two ETFs began to mirror each other throughout the rest of the third quarter of 2011, although BNO kept its hefty premium. Clearly, choosing the correct oil fund can have a huge impact on overall return, just as we have seen in this extreme, but very relevant, case.
Other Factors to Consider
Geopolitical events can also significantly impact oil and create supply issues. Demand metrics alone clearly do not determine the price of oil around the world, and investors must be aware of this when considering buying into the crude oil market. A correct bet on a commodity alone might not be enough; investors must be sure to also select the correct type of commodity, as this can lead to vastly different returns far beyond what some investors might initially suspect.
Disclosure: No positions at time of writing.