COMMODITIES

This isn't about the moral and extended implications of that question; it's simply the fact that there is no one price for crude oil, and if you know where the pricing is leveraged, you can make big money, notes Elliott Gue of Energy and Income Advisor.

There's no easy answer to the deceptively simple question, "What's the price of crude oil?"

Many US investors will tell you that oil fetches about $86 per barrel-the current price of near-month futures traded on the New York Mercantile Exchange (NYMEX). On the other hand, a European might tell you that oil goes for $108 per barrel. Both answers are partially correct, but neither quote truly encapsulates conditions in the global crude oil market.

Hundreds of different types of crude oil trade at various hubs throughout the world. The widely traded West Texas Intermediate (WTI) crude oil serves as the benchmark for US oil prices and underpins NYMEX-traded futures. A light-sweet crude oil, WTI has an American Petroleum Institute (API) gravity of 39 degrees, a sulfur content of 0.34%, and a pour point of minus-5 degrees Fahrenheit.

API gravity measures the density of crude oil relative to water. Oil with an API gravity of less than ten degrees exhibits a higher density than water; oil with an API gravity that's greater than ten is less dense than water. This metric enables the market to gauge the relative densities of various oil varietals, the majority of which range between API gravities of ten and 70 degrees.

Refining lighter oils into gasoline, diesel fuel, and other products requires less technical complexity and incurs lower costs than processing heavier varietals. Light crude oil exhibits an API gravity of more than 31.1 degrees, while the API gravity of medium-density oil ranges between 22.3 and 31.1 degrees. Heavy varietals have an API gravity of less than 22.3 degrees, and the appellation "extra-heavy" applies to crude oil with a specific gravity that's less than ten degrees.

Crude oils that contain higher levels of sulfur-a pollutant that must be removed from gasoline and other refined products to comply with environmental standards-requires additional steps to process. So-called sweet crude oil has a sulfur content of less than 0.5%, while sour varietals have a sulfur content of more than 0.5%.

The pour point refers to the lowest temperature at which the oil will continue to behave as a liquid; varietals with lower pour points exhibit less viscosity and tend to fetch higher prices.

Light-sweet crude oil usually commands a premium price relative to heavy-sour grades. For example, Arab Heavy crude oil, a heavy-sour benchmark used in Saudi Arabia, currently fetches $8 to $9 per barrel less than Brent crude oil.

Traders also tend to differentiate between various light-sweet crude oils. For example, Brent crude oil historically has traded at a discount of $1 per barrel to $2 per barrel relative to WTI because of its slightly lower API gravity and higher sulfur content.

But the traditional price relationships between various oil benchmarks in the Americas have deteriorated in recent years. WTI crude oil, for instance, commands about $20 per barrel less than Brent crude oil. Meanwhile, the price spread between Western Canada Select (WCS) and Mexican Maya-two heavy-sour crude oils with similar specific gravities and sulfur content-has ballooned to more than $20 per barrel.

These wide basis differentials reflect a larger trend underway in North America: rapidly growing oil production from unconventional fields in the US and Canada. Not only has US oil production increased for the first time in almost three decades, but domestic output has grown for three consecutive years.

With the exception of a short period in the late 1970s and early 1980s, US production has declined steadily. But over the past three years, horizontal drilling and hydraulic fracturing have unlocked vast oil reserves in unconventional fields such as the Bakken Shale of North Dakota and the Eagle Ford Shale in southern Texas.

The Bakken Shale contains light-sweet crude oil that has an API gravity of 39 degrees and sulfur content of 0.18%, making it of similar quality to WTI. Surging production from this play and Canada has overwhelmed available takeaway capacity in the Midcontinent region, leading to a supply overhang at the hub in Cushing, Okla., the delivery point for WTI crude oil.

This upsurge in supply, coupled with insufficient midstream infrastructure to transport oil to the Gulf Coast from the Midcontinent region, has depressed the price of WTI, Bakken UHC, and other landlocked grades of light-sweet crude oil relative to similar quality volumes delivered to coastal refineries.

The recent price history of WCS crude oil underscores the extent to which pipeline-capacity constraints and shifts in oil production patterns can widen basis differentials.

Since mid-2008, the price spread between WTI and WCS crude oil has averaged $16 per barrel, reflecting the latter's lower API gravity and higher sulfur content. But this differential has soared to $30 per barrel in recent months. This anomaly reflects temporary midstream and downstream capacity outages, not a durable trend.

Countries outside North America haven't experienced the same pricing pressures as the US and Canada, because they lack the benefit of a rapidly increasing domestic supply of oil. That's why Brent crude oil tends to trade at close to the same price as light-sweet crude oil from the Middle East or Africa.

Wide basis differentials for oil in North America have significant implications for several industries. Within the upstream segment, investors should keep an eye on where particular operators market their output. For example, a firm that produces oil in a coastal market such as California will likely enjoy price realizations that are closer to Brent, while an operator in North Dakota will sell the majority of its output at prices that follow WTI.

For midstream companies that own pipelines, storage and terminal capacity, wide basis differentials present an enormous opportunity.

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