A Quick Primer and Some Updates on Crude Oil

Have you ever wondered what’s the difference between Brent crude and US WTI crude? Are you wondering why Pip Diddy keeps bringing up oil-related events in his session recaps? Well, all that and more are covered in today’s little primer on oil.

If you were able to read-up on my end-of-the-year recap for the Loonie, then you already know how much of an impact oil has on the Loonie’s forex price action. And you most likely know why oil has such an impact on the Loonie, especially if you have gone through our School’s lesson on How Oil Affects USD/CAD.

Brent? WTI? What’s the difference?

Brent blend crude and US West Texas Intermediate (WTI) crude are what are known as oil benchmarks. And believe it or not, but they are but two of over a hundred, and you can see some of the major ones on the chart below from the US Energy Information Agency (EIA).

Oil benchmarks are essentially price references, and they are needed because crude oil actually varies in quality, namely in terms of density and sulfur content. Also, oil extraction areas and delivery points vary, which is another reason why oil benchmarks are needed.

These differences in quality and geographical locations are the main reasons why benchmarks are priced differently. The general rule (excluding location) is that benchmarks that are both light (lower density) and sweet (sulfur content below 0.5%) are priced higher.

According to the EIA, “This is partly because gasoline and diesel fuel, which typically sell at a significant premium to residual fuel oil and other ‘bottom of the barrel’ products, can usually be more easily and cheaply produced using light, sweet crude oil. The light sweet grades are desirable because they can be processed with far less sophisticated and energy-intensive processes/refineries.” In short, there tends to be more demand for light sweet blends because they are easier to process and they are ideal for fuel production.

Brent blend crude comes mainly from the North Sea while WTI is mainly extracted from the Southwestern US. Both are light sweet blends, although WTI is slightly more sweet than Brent. These two, together with Dubai crude (a light sour blend, has more sulfur content), are the three major benchmarks that are often referenced by media outlets like Reuters and Bloomberg because most of the other oil benchmarks are actually heavily pegged to them, with Brent being the major peg among the three. WTI and Dubai crude being the major pegs in the US and Asian markets respectively, as you can see on the below chart from the International Exchange.

I don’t trade the Loonie. Why should I care?

As you may have noticed, Pip Diddy usually includes a quick commentary on oil prices during his session recaps (like this one) along with the corresponding price action of equities. And Pip Diddy ain’t the only one who noticed this correlation since analysts from Bloomberg, the Wall Street Journal, and many others have noticed that as well. Heck, even former Fed Head Ben Bernanke noticed it.

That’s great to know and all, but why should forex traders who don’t trade the Loonie care? Well, that’s because equities are a good gauge for risk sentiment and risk sentiment is a major factor in capital flows.

Specifically, risk appetite usually pumps up demand for the higher-yielding currencies like the comdolls while risk aversion generally makes forex traders flee to the safe-haven currencies, namely the Japanese yen. Pip Diddy’s recent weekly recaps (such as this one and this one) offer good examples of how global equities and overall risk sentiment can influence the forex price action of currencies other than the Loonie.

So, what are the latest updates on oil?

I noted in an earlier write-up that OPEC and non-OPEC producers were having a little pow-wow on freezing production at January levels in order to help stop the slump in oil prices. Well, Russia and Saudi Arabia were able to come to an agreement on the condition that other producers follow suit. Unfortunately, Iran is playing hardball, with Iranian Oil Minister Bijan Namdar Zanganeh referring to the deal as both “laughable” and “ridiculous”.

Iran’s position is rather understandable given that the OPEC members have been ramping up production since December in a war for market share while Iran is just getting up to speed after the sanctions were lifted. According to a Bloomberg report, citing the International Energy Agency (IEA), “Iran is poised to raise output to 3.6 million barrels a day, an increase of 600,000 barrels a day, by the middle of this year.” That would be enough to “balance the decline in U.S. light, tight oil forecast for this year.”

And while US production has been slowing down, it’s not really by a lot given that the US entry into the oil market is one of the major reasons for the oil glut in the first place. Not only that, the US has just shipped its first “Liquid American Freedom” overseas despite the cut back on production.

In short, we’ve got problems from the supply side of the equation, and the demand side ain’t giving us any respite neither since there are some weak signs that the global economy is slowing. The outlook isn’t looking too rosy either since the latest report from the International Energy Agency (IEA) predicted that global demand growth for oil will “ease back considerably” from its peak of 1.6 million barrels per day last year to just 1.2 million barrels per day this 2016.

Given all that, where do you think oil prices are headed? Make sure to let others know by answering the poll or commenting below!