Analysis: Some ask "what oil glut" as Midwest stocks dip

The latest U.S. oil inventory data contradicts a widely held notion among oil traders that a huge glut of Canadian and U.S. shale crude oil is accumulating in the middle of the United States and causing the record gap in global oil benchmark prices.

Instead, U.S. commercial crude oil inventories in the Midwest and Cushing, Oklahoma, fell last week to their lowest this year. Midwest, or PADD 2, stocks are now lower than they were a year ago, the first time in over 12 months that they have fallen below year-earlier levels.

Since 2009, falling U.S. Midwest inventories have usually resulted in a narrowing of the Brent-WTI spread.

But this time the spread between Europe's benchmark crude and U.S. benchmark West Texas Intermediate -- which stood near parity a year ago -- has held at a near record of $21 a barrel in favor of Brent.

A Reuters poll released on Thursday shows that the majority of 29 analysts and oil traders surveyed expects that spread to widen further, and surpass $30 at some point in the next year.

But a vocal minority still views Brent's spectacular premium to WTI as dubious, especially since PADD 2 stocks are declining and the two crudes have similar specifications. Historically, WTI has traded higher than Brent.

"The argument that a surplus in Midwest and Cushing crude is what's pressuring WTI down is coming apart," said Peter Beutel of U.S. energy trading consultancy Cameron Hanover.

"The huge spread tells me that some big banks or a few of the biggest oil traders/refiners are speculating on spreads and have been able to push Brent unjustifiably high."

Brent's gap has been growing since January, and the most commonly cited factor is a surplus of crude in the Midwest, which is receiving more supply from booming oilfields in North Dakota and Canada, but hasn't built pipelines to pump the incoming crude further south.

(Graphic: r.reuters.com/cum92s )

After a recent flurry of bearish global economic data, Brent oil fell more than $3 to around $110 a barrel on Thursday, and WTI fell more than $3, to below $89. That left the gap between the crudes at $21.42 a barrel. The spread spiked to a record over $23 last month.

"WTI/Brent is so out of whack it's unbelievable," said Dominick Chirichella of New York's Energy Management Institute. "It's surprising we haven't seen a downward discounting to maybe the $10 to $12 a barrel range."

The CEO of IntercontinentalExchange Inc (ICE.N) -- the leading exchange for Brent trading -- told reporters on Wednesday that WTI contracts, traded on rival exchange CME, no longer reflected global oil prices, slamming WTI's benchmark status.

But others say Brent prices are being distorted by speculators.

"Which contract is now a good global benchmark? Neither one," Beutel said.

MIDWEST STOCKS IN DECLINE

Commercial crude stocks in PADD 2 fell 2.1 million barrels to 97.4 million barrels, their lowest level of the year last week, according to U.S. Energy Information Administration data released on Wednesday. That's down 9.9 million barrels from their all-time high in April.

Stocks at Cushing, Oklahoma, the Midwest delivery hub for CME's heavily-discounted WTI futures, fell by 1.2 million barrels to 36 million barrels, the lowest since December, and dipped 14 percent below a 41.9 million barrel record in April.

Midwest region stocks fell last week in spite of an overall build in U.S. crude stocks, including a 3 million barrel crude build in Gulf Coast PADD 3, where local crude grades trade closer to Brent prices.

The Midwest drawdown comes even as tank operators at Cushing have quickly expanded the massive tank farm there to accommodate an expected onslaught of crude from further north. Production in the Bakken Shale of North Dakota has gone from virtually zero to around 400,000 barrels a day in the space of a few years, and U.S.-bound shipments from Canada have surged.

Blessed with cheap feedstock, PADD 2 refiners have been running close to flat-out in recent months, processing 3.5 percent more crude into oil products over June and July than the five-year average.

PREMIUM JUSTIFIED?

To be sure, others argue Brent's advantage is justified by tighter supplies in Europe's North Sea, which has helped push Brent into backwardation, when near-term oil trades at a premium, while WTI remains in contango.

U.S. oil economist Phil Verleger, who says U.S. Midwest drawdowns are temporary, believes a glut there will soon reassert itself, and Brent's premium could still more than double from current levels.

"Long-term the U.S. Midcontinent just has a huge problem, and that is too much oil coming in, not enough going out, and not enough demand," Verleger said.

"Buyers have lost confidence that these two crudes will converge. There's really no upside limit to the Brent premium, which might get to $50."

A massive Cushing-to-Gulf Coast pipeline project known as Keystone XL has faced repeated delays in getting U.S. government approval, potentially keeping more crude locked in the Midwest.

"There's still lots of concern that growing shale (oil) production and delays for the Keystone pipeline will keep the spread wide," said Matt Smith of Summit Energy in Louisville.

"But we are now seeing decent drawdowns in the Midwest. It does seem speculation could be playing a role."

SPREAD CALLS DIVERGE

Citigroup analysts expect Brent to stay at a huge advantage to WTI, around an average $17 this year and $20 in 2011, according to the bank's latest price forecasts.

It is conceivable the spread could spike above $40, Citi analysts led by Edward Morse wrote last month.

Some other bank estimates foresee the spread narrowing sharply next year. Bernstein's price estimates for the two benchmarks imply a spread of $5 a barrel in favor of Brent in 2012, as do Barclays'.

But Barclays analyst Amrita Sen told clients last month that it had become impossible to predict Brent-WTI spread levels based on market fundamentals, writing that the spread was now "simply a number".