NEW YORK/LONDON Oil traders are almost unanimously betting that Europe's Brent crude will retreat from its record $16 premium over U.S. benchmark oil. What they don't expect for years, however, is a return of West Texas Intermediate premiums that have been the norm for decades.
Shifts in physical oil flows and new supply risks -- increasing the chance of oil gluts in the U.S. Midwest and tighter supplies in Europe - mean that a highly unusual $5 to $10 a barrel premium for Brent could become the standard through 2013.
It's not the first time Brent has achieved wide premiums. WTI plunged to discounts near $10 a barrel for several brief periods in 2009, as traders sold off the contracts near their expiry dates due to sparse storage space in Oklahoma.
But this time could be different, traders and analysts say, with Brent sustaining a longer-lasting, structural premium.
Ample new oil storage capacity is being added to WTI's landlocked delivery hub in Cushing, Oklahoma. That means discounts are now less a function of tight storage capacity and more reflective of record volumes of shale oil and oil sands crude flowing in to create a supply cushion that may not be drawn down until new pipelines can siphon crude off to the Gulf Coast.
"A Brent premium is the new normal in oil markets," said Ed Morse, head of commodities research at Credit Suisse. "It's a combination of the ample supply situation in PADD II (the U.S. Midwest) and Brent's market tightening. WTI's once normal premium is over."
Until new pipes link Cushing to the coast around 2013, Europe's benchmark may sell for an average $5 to $8 a barrel advantage, Morse said, roughly reflecting the cost of moving barrels from Cushing to the coast by railroad or tanker truck.
Traders are resorting to these more expensive modes of crude transport to cash in on a regional arbitrage. Railroad shipments are already experiencing a boom.
The Brent and WTI futures markets are already pricing in a premium of more than $3 for the London-traded crude through most of 2012.
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In the last decade, WTI typically held a $1 or $2 a barrel advantage, reflecting the crude's slightly better quality as well as ever-growing U.S. demand for oil.
But sometimes huge Brent premiums in the past few years meant that WTI's average premium since 2005 has slipped to just 13 cents a barrel, Reuters data shows.
It's not only Brent that's affected. The Midwest crude glut has widened the spread between inland and coastal U.S. crudes to record levels, with U.S. grades like Light Louisiana Sweet on the Gulf Coast still trading above Brent levels.
Shippers have few options to transport oil south from Cushing, since pipeline capacity is full.
Against that backdrop, WTI has shed 4 percent of its value this year and traded below $86 on Friday. A record 38 million barrels of oil sat in storage in Cushing in late January, or enough to meet total U.S. demand for two days.
Brent prices have risen more than 7 percent this year to above $102 a barrel. The contracts represent oil from North Sea fields, where output has been declining.
"Building more pipelines is a multi-year issue. So I don't think there is an easy way of closing the gap," said Christopher Wheaton, fund manager at Allianz RCM Energy fund.
"The (WTI-Brent) spread will probably stay between $6 and $10 over the next two years. That could be the new norm," Wheaton said.
Benchmark crude prices are also diverging due to higher risk premiums for oil supplies to Europe, which is more exposed to any disruptions to global supply chains in such areas as Russia, the Middle East and Africa than the US market.
WTI premiums once pushed European barrels to the United States in a Transatlantic arbitrage. Today, those U.S.-bound flows have ended and growing demand in emerging markets is putting Europe in competition for oil with Asia.
Political turmoil in the Middle East, such as protests that unseated Egypt's president last week, are the latest wildcard, and may signal bigger supply risks for nearby Europe.
Harry Tchilinguirian, BNP Paribas' head of commodity markets strategy, has been predicting a pattern of Brent premiums since last year. Unrest in the Middle East may keep the premium higher than previously expected although a gap over $10 isn't sustainable, he said.
"We have an implied spread of $2 for the first quarter and $3 for the second quarter. These will probably be a couple of dollars higher -- at the time of the forecast, there was no tension in Egypt, and events there certainly play a role in delaying a narrowing of the spread," Tchilinguirian said.
Not everyone is so sure.
Some analysts, including Citi Futures' Tim Evans, expect the benchmarks to return to parity within a year, as arbitrage barrels find their way into tighter markets to balance supply and demand. OPEC countries, concentrated in the Middle Eastern Gulf, have plenty of spare output capacity to meet demand.
"A long period of Brent premiums? I don't buy it. There's enough physical oil that can flow anywhere to expect a unified pricing standard, if not a single, level oil price," Evans said.
One reason spreads haven't reached today's levels before is that oil and its fuel products are fungible commodities. Although U.S. law forbids most crude exports, Midwest refiners could still draw down inventories by processing more crude into fuel to ship elsewhere, including overseas.
CUSHING AND CONTANGO
Brent could also find support from increasing investment flows, since speculative long investors are weary of shouldering the steep cost of rolling WTI contracts from month to month due to a contango market structure, where near-term oil trades at a discount.
The Brent futures curve has recently flattened, while WTI remains in steep contango. On Friday, front-month WTI contracts traded at a $3.72 a barrel discount to contracts for delivery a month later.
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With an estimated 12 million barrels of capacity being added at Cushing this year, fears of tank space running out have eased.
But the scenario is also steadily creating an ever-larger supply cushion at the hub.
Last week, a new stretch of TransCanada's Keystone pipeline began sending oil to Cushing. According to JP Morgan, the line can move another 1.1 million barrels per week into the hub, raising delivery capacity to 4.1 million barrels per week.
TransCanada hopes to extend Keystone from Cushing to Southern Texas in 2013, when it could begin shipping a half million barrels per day to the Gulf Coast and reduce the glut.
Permits for that extension are still pending. Meanwhile, Canada has increased U.S.-bound exports by 40 percent over the last decade and North Dakota's oil output has tripled in 4 years.
"Markets for WTI appear to be pricing for acute distress and more regional producers may opt to send supplies elsewhere on trucks as well as trains," wrote Jan Stuart of Macquarie in a note last week.