Price Differentials

Price differentials are the difference between a market price, such as the NYMEX futures spot price for oil and the price received when the actual physical production is sold (commonly referred to as the “wellhead price”). The difference can be positive or negative depending on numerous factors.

The main factors that determine the price differential are product quality and regional market dynamics. Although the crude oil market is a global market there are regional dynamics that affect the price of crude of differing qualities. The highest quality crude oil is not always the most valuable.

Product Quality

Two of the most important quality characteristics of crude oil are sulfur content and density. Oil with high sulfur content is called “sour” and, conversely, low sulfur oil is considered “sweet.” Typically the lower the sulfur content, the more valuable the crude oil.

The most common measure of the density of a petroleum liquid is the American Petroleum Institute (“API”) gravity. The API gravity is an inverse measure of the relative density of a petroleum liquid. If one petroleum liquid floats on another it is less dense and therefore has a higher API gravity. Typically the higher the API gravity—or less dense oil—the more valuable it is. The reason lighter, sweeter crude oil is more valuable is because gasoline and diesel fuel, which typically sell at a premium to residual fuel oil, can be more easily and cheaply produced using light sweet crude.

Classification API gravity
Light Crude Oil > 31.1
Medium Oil 22.3 – 31.1
Heavy Oil 10 – 22.3
Extra Heavy Oil <10 

 

There are several benchmark crude oils around the world and within the US. In Europe, the benchmark crude oil that is most actively traded is Brent Crude Oil. Brent is a light, sweet oil produced from the North Sea. In the US, the benchmark crude oil is West Texas Intermediate (“WTI”) which is a light sweet crude oil from west Texas. Although no two reservoirs produce identical oil, reservoirs in the same region often produce similar crudes. Therefore there are numerous international and regional benchmark crude oils to help determine field and wellhead prices.

Crude Oil Prices (WTI vs. Brent)

Source: EIA

Source: EIA

Regional Market Dynamics

In terms of quality, WTI is slightly superior to Brent (North Sea) oil. It has less sulfur and is less dense (higher API). However due to various market dynamics, the relative price has not always reflected this fact. In the past, the two crudes traded as one would expect based on their respective quality characteristics. Until the last few years, WTI traded at a slight premium to Brent. This has reversed in the last few years.

The reason for the recent divergence is increasing US supply overwhelming current infrastructure. America’s oil infrastructure has been built around declining domestic production and a large and growing amount of imports. Since the majority of oil in the US has been imported for the last 20 years, much of the oil infrastructure was built around refining imported oil, then moving the refined products—such as gasoline and diesel—around the country. Refined products from the Gulf Coast flowed north, and refined products from both west and east coasts refineries flowed inland. The US infrastructure was not designed to move oil from the interior of the country to the coastal refineries. The US oil pipeline system is not completely interconnected, so increased supply in certain areas can create a regional glut, which can cause significantly high price differentials.

Recent US oil “posted” prices are displayed in the accompanying chart. The price of crude oil in the Bakken (i.e., North Dakota) is represented by the Williston Sweet price. On November 28, 2014, the price was approximately $12 per barrel less than WTI, although the quality of the oil on a sulfur and density basis is very similar. Because North Dakota has limited refinery capacity, the vast majority of the oil produced is shipped out of state.

Crude Oil Prices (11/28/14)

Source: Plains Crude Oil Price Bulletin 2014-211

Source: Plains Crude Oil Price Bulletin 2014-211

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