Oil Traders Ask "What Glut?" as Midwest Stocks Shrink

The latest U.S. oil inventory data contradict 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.

Over the past two years, 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.

Many analysts have struggled to explain Brent's spectacular premiums to WTI, since the two crudes have similar specifications and WTI often held a slight premium in the past.

But Brent's gap has been growing since January, and the most commonly cited factor is a growing surplus of oil 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.

Now, some are questioning why Brent is at such a large premium with Midwest stocks falling. Some say big financial speculators may be to blame, and others are convinced that falling Midwest stocks are a temporary blip that will soon give way to another tank-busting glut.

"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," said Peter Beutel of U.S. energy trading consultancy Cameron Hanover.

Brent traded at above $113 a barrel on Wednesday while WTI traded below $92. (Graphic: http://r.reuters.com/cum92s)

The CEO of the IntercontinentalExchange Inc -- 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 a persisting huge spread shows Brent is being distorted by speculators, possibly to a greater extent, Beutel said.

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

MIDWEST STOCKS IN DECLINE

Commercial crude stocks in PADD 2, the U.S. Midwest, 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 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 future, 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.

The fall 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.

Some say Brent's advantage is justified. While the U.S. Midwest faces a surplus, supplies in Europe's North Sea have grown tight, a factor that 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 Midwest drawdowns are only temporary, believes a glut 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."

Stocks in the Midwest region 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 argument that a surplus in Midwest and Cushing crude is what's pressuring WTI down is coming apart," Beutel said.

Brent held a huge $21 a barrel on Thursday, not far off from a record $23.57 reached last month.

That Brent premium comes even after Cushing stocks have dwindled by more than 14 percent from record levels of 41.9 million barrels in early April. Total PADD 2 crude stocks have also fallen, by more than 9 percent from a record 107.2 million barrels in early April.

"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."

Since oil liquids output is soaring in plays like North Dakota's Bakken Shale, and a massive Cushing-to-Gulf Coast pipeline known as Keystone XL faces delays in getting approval, Smith doesn't expect Brent premiums to narrow to single digits for at least a year.

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 to $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."

To see bank price estimates click here:

(Editing by Lisa Shumaker)