Arguably, the most important commodity in the world today is crude oil. The product and its derivatives 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 and ensures 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?].
One of the most important issues is the varying types of oil and the differing benchmarks for crude oil prices around the world. Many might not realize that oil that is pulled out of the ground in Texas isn’t generally the same as the product that comes from the North Atlantic. Instead, there are varying degrees of oil based on a variety of metrics such as the oil’s API gravity. This (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 generally 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 generally 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, then 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 it 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 generally produced in the central U.S., the North Sea region of Europe, as well as 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. So in summary, 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 then 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) crude oil 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 for 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 over the last few years [see also Brent Crude vs. WTI: The Best Performing Commodity]:
As you can see in the chart above, the prices tend to be highly correlated with each other over a long term period. However, at the start of 2011, right around the same time that the ‘Arab Spring’ began to take place, the prices of the two ETFs began to diverge 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, once again, mirror each other throughout the rest of the 3rd quarter of 2011 although BNO kept its hefty premium. Clearly, choosing the correct oil fund can have a huge difference on overall return, just as we have seen in this extreme, but very relevant, case.
Can this reversal collapse back into historical levels? It seems likely, especially given the recent events in Libya. The long dictatorship in the country is now over and the citizens of Libya are greatly incentivized to get their pipelines back up and running, as oil was one of the major exports for the nation. So while the end of the Libyan dictatorship is obviously good news for the people of the North African country, it could be even better news for petroleum users in Europe, although it remains unclear how long such a process might take. Should Libya manage to quickly return to normal and pump out vast amounts of their high quality crude, it could help to rapidly deflate the premium that Brent has over WTI crude and push the figures back towards historical means [see also 25 Ways To Invest In Natural Gas].
These events also demonstrate how impacted oil can be by geopolitical events and supply issues. Demand metrics alone clearly do not determine the price of oil across the world and investors need to be aware of this when considering buying into the crude oil market. A correct bet on a commodity might not be enough alone, often times investors must be sure to also select the correct type of commodity as well, as this can lead to vastly different returns far beyond what some investors might initially suspect.
Disclosure: No positions at time of writing.