Measuring the Oil Price Premium for Mideast Turmoil

People are starting to ask: How much of a premium is in the price of oil due to the turmoil in the Middle East?

The answer is harder to guesstimate than usual. That’s because U.S. benchmark West Texas Intermediate crude oil (WTI) has lost its prime status.

Several factors have contributed to a steep discount in prompt WTI prices relative to prices for WTI in future month contracts and compared to prices for other crude oil grades like North Sea Brent. Inventories in the Midwestern “PADD 2” where WTI storage and usage resides are chock-full as regional refiners cannot absorb rising regional supplies from the Bakken shale and new Canadian pipeline expansions. WTI, Bakken flows and Canadian oil is in effect “stuck” in PADD 2 as there are no existing pipelines to move the oil out to other refining regions like the U.S. gulf coast. Some firms are choosing to truck oil surpluses to other refining regions, but it is hard to see how that will hit critical mass.

This sui generis PADD 2 oversupply situation has made deflated WTI a poor indicator of international turmoil. Fund managers and other financial players are starting to look elsewhere to place their bets on oil as an appreciating asset. So far, it looks like IntercontinentalExchange (ICE) North Sea Brent futures contracts are catching the wave. Open interest in ICE Brent contracts has been on the rise since January, leading some commentators to conclude that Brent is becoming more of a bellwether for international price trends than WTI.

Brent prices, now hovering at $103 a barrel, have been more responsive to news reports about Egypt’s Suez Canal and unrest in the Middle East. That may be, in part, because the European market would initially bear the brunt of any diversion of oil away from Suez transit. European refiners would also be the ones most hit by any first shockwaves of a cutoff of exports, should turmoil cause that to happen in Algeria, Iran, or Libya. Speculative longs might also feel more comfortable parking their funds in ICE Brent, given the Obama administration’s ongoing hearings about new position limits rules for the New York oil futures exchange.

Given that Wall Street was already comfortable with a $95 oil price for early 2011, perhaps there isn’t much of a premium in prices yet from the news from the Middle East. There probably should be a higher one, since history would tell us that most sudden changes of government in oil producing countries, no matter how they derive, usually lead to a drop in oil production. Examples are ample: Iran in 1979, the Soviet Union (Russia) in 1991, and Venezuela in 1998.

Perhaps the price of Brent would have been even higher, had Saudi Arabia not signaled the market in February that it might produce higher volumes. But with major riots just across the causeway in Bahrain and an ailing King and crown prince, Saudi Arabia may have bigger fish to fry than worrying about how to get oil prices back down to its previously declared $75 target.