One of the most conversed, and certainly one of the most monitored metrics surrounding the oil market today is the concept of the “crack spread.” Outlined in a previous article produced by Split Rock Private Trading, the “crack spread” can essentially be summed up as the difference between oil prices in one market as compared to another market.
Traditionally, oil producing companies were at the whim of the “crack spread” when deciding into which market their product would be sold. Whichever market provided the highest prices (after all transportation expenses were subtracted) was where the oil predominantly would end up.
However, market efficiencies eventually catch up to those who are ahead of the curve. Over the past several months, a continual buildout of pipeline infrastructure and a surging amount of oil readily available has lowered the “spread” between two of the most popular oil prices (WTI and Brent Crude) to levels that haven’t been seen since the start of 2011.
While some analysts may see the meteoric rise in oil prices as a blip on the radar screen, there are many other analysts that suggest the day of the crack spread may very well be dead. Recent analysis states that the spread may widen, but only to a level around $6-$7.
With that information in mind, how are investors supposed to alter their portfolios given the fact that the spread was more or less an important metric in some of their decision making? The deterioration of the spread may finally be a reality, but, there is another crack spread situation developing in North America, and it may be as fruitful as the predecessor.
This emerging spread is known unofficially as the WCS/WTI differential. Western Canadian Select (WCS) price is a price given to a specific type of heavy grade crude oil harvested in Canada. The differential between WCS and WTI can roughly be translated to the price differential between heavy and light sweet crude oil arising in North America.
This differential fluctuates throughout time, but garnered specific attention earlier this year when spread pricing reached in excess of $32 per barrel. The significance of this event is that at the same time, the WTI/Brent spread was $20 per barrel, much higher than the current rate of $4.33 (as of 7/30/13).
All in all, the WTI/Brent spread has decreased a whopping 81% since the highest levels in February (as of 7/30/13). At the same time, WCS/WTI differentials have come down only 38% since the beginning of the year.
In fact, WCS prices were deteriorated earlier this spring due to massive flooding in Alberta, Canada as well as a seasonal “spring break-up” trend that occurs regularly.
So, in the event an investor decides that the WCS/WTI differential is just too juicy to ignore, where does the money go? Bakken and U.S. Energy Shale portfolio manager Tyler Kocon and Research Analyst Brian Michaud think potentially profitable opportunities for investors in that specific environment lies with independent Canadian heavy oil producers.
They believe that these companies stand to gain the most from the differential pricing treatment Canadian crude is receiving. Underlying this thesis, the fact that the United States imports more oil from Canada than from any country stands in staunch support.
With a demand for oil in the U.S. ceasing to waver, and a commitment on removing a dependence on OPEC-related oil imports, the only logical answer for American refiners would be to harvest more of the crude being produced by our neighbors to the North.
In fact, several large scale refineries have recently been upgraded and fitted with equipment specifically designed to refine the heavier Canadian oil. These refineries are all in close proximity to Illinois, which serves as a major distribution and storage hub for Canadian oil entering the United States.
One particular company in focus is Canadian Natural Resources. CNQ is a large scale Canadian oil and natural gas exploration and production company with a significant amount of focus on the developing oil sands play.
Split Rock Private Trading portfolio manager Tyler Kocon believes in their story because they are able to benefit from the differential spread by making their produced oil more marketable. Split Rock manages the Bakken Shale and Equity Rotation.
With the buildout of sufficient infrastructure already taking place, and demand for oil domestically not diminishing, companies that produce a cheaper, more readily available oil could be beneficiaries as domestic refineries with sufficient capacity clamor to fill their storage tanks and ultimately save money.
CNQ is a great play because of their proximity to existing pipeline routes making it easier to bring their oil to market, but additionally they avoid pricey competition, tight margins, and complicated accounting procedures by not operating any sort of significant refining operations using their own oil as feedstock.
This may make them a more attractive pure production play than oil sands heavyweights like Suncor and Cenovus Energy. Of course, only time will tell if the differential spread continues to exist or if prices are eventually brought in line like the spread between WTI and Brent Crude.
Until then, however, Canadian producers like CNQ may be able to utilize their unique position in the worldwide oil market to sell vast quantities of oil, reap the rewards, and return that value to the shareholders. It’s all in the market.
The investments discussed are held in client accounts as of July 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
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