M A R K E T

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OIL

The increasing divergence of WTI pricing from world markets
March 2011

MARKET ANALYSIS: THE INCREASING DIVERGENCE OF WTI PRICING FROM WORLD MARKETS

INTRODUCTION The key US Midwest benchmark, West Texas Intermediate (WTI), has lost its connectivity to world prices and its ability to act as a barometer of value in the US Gulf Coast, the main refining center in the United States. Crude prices in the USGC, US West Coast and US East Coast have recently risen and fallen in line with the European Brent benchmark not in line with WTI.The prices of US products have also lost their connectivity to WTI therby increasing the risk carried by refiner and consumer hedges. The usefulness of WTI as a broad indicator of US crude oil value is therefore in question and producers and refiners are looking for alternatives. Since May 2007 the behavior of WTI crude oil cash and futures markets has been erratic and has displayed extreme price deviations relative to other global crude benchmarks. The front month NYMEX WTI futures contract closed at a record low of $15.79/b under the respective ICE Brent futures on March 1, 2011 and at a discount to other world benchmarks such as Dubai, Oman as well as Urals and ESPO. The disconnect highlights how regional fundamentals and pipeline constraints at the New York Mercantile Exchange crude futures delivery point of

Cushing, Oklahoma have affected the NYMEX crude futures contract and its relevance as an international or even US crude oil benchmark. Market observers and participants have increasingly questioned the validity of WTI as a broad benchmark for pricing crude oil in the Americas, with some pointing to the Brent benchmark as a better indicator of global supply and demand fundamentals. Hedging and trading of some South American crude oil grades has switched to Brent as a result of the WTI volatility, according to industry sources. More US companies have become more receptive to negotiating transactions referenced to Brent than to WTI, with some traders also noting that when transactions are executed basis WTI the hedges are based on Brent in order to avoid the volatility and disconnects associated with WTI. WTI crude oil has traditionally been the most commonly accepted benchmark for crude sales in the Americas, and has typically traded at a premium to Brent. The premium has a fundamental premise as the US is a net importer of crude and therefore prices in the US Gulf Coast typically reflect the international cost of crude oil plus the cost of transportation. Between 2000 and 2006, WTI on average traded at around $1.65/b above Brent, but with increasing frequency and persistence, this differential has slipped into negative territory. In addition, WTI has recently traded not only below Brent but also below similar crude oils from the Gulf of Mexico. The disparity has been so large that WTI has also traded below the price of sour crudes, including Mars and other US domestic grades as well as broader indicators such as Dubai and the OPEC basket. WTI TRADES BELOW BRENT, AGAIN The latest in a series of deviations in WTI saw the disparity to Brent and other global benchmarks deepening in February 2011 with the large WTI discounts persisting into March. The US benchmark had begun to trend lower and slip below Brent back in August 2010 as stocks at Cushing reached new highs. The atypical inversion between the US and European crude oil benchmarks not only reached record proportions, but has remained in place for the longest period seen so far in the market. Furthermore, there are few concrete signs that the price of WTI will soon return to reflect broader world conditions. The errant behavior of WTI was clearly highlighted in relative values such as refining margins, differentials for other crude grades using WTI as a benchmark and correlations between WTI and other global benchmarks.

WTI/BRENT SPREAD
20 15 10 5 0 -5 -10 -15 -20 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 ($/barrel)

Source: Platts

DIFFERENTIALS BASIS WTI
25 20 15 10 5 0 -5 -10 -15 -20 ($/barrel) LLS Diff Mars Diff Escalante Diff

Mar-06

Mar-07

Mar-08

Mar-09

Mar-10

Mar-11

Source: Platts

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MARKET ANALYSIS: THE INCREASING DIVERGENCE OF WTI PRICING FROM WORLD MARKETS

New record highs were set on differentials to cash WTI for some US Gulf crude oil grades as spot crude oil differentials compensated for the plummeting benchmark. In this way, the rising differentials prevent Gulf Coast grades from losing ground against other crudes in the global market. In essence, while WTI was disconnected, other US crudes were not and respective differentials have moved up and down as the arbitrage has widened or narrowed. Brent meanwhile, has been the barometer used by the trading community to calibrate prices in the USGC. In February, crude oil differentials further demonstrated the dislocation of the WTI contract. The LLS differential to the front month WTI contract climbed to new highs of $20.80/b on February 16, while that for Mars hit a $14/b premium to the prompt futures WTI contract. February saw the premium for sour grade Mars trade at double digits for the first time. In January, Argentinean heavy sweet crude Escalante began to trade at a premium to cash WTI on an FOB Caleta Cordova, Argentina basis for the first time since Platts began to assess the crude oil grade in July 1995. The disconnect between WTI and the rest of the global oil market can be seen clearly by comparing this surge in premiums to those of the same crude grades basis other alternative global benchmarks, which have remained much more stable in comparison. For example, while the WTI-based differential for LLS soared to new record highs, the differential for LLS against other benchmarks was relatively steady, notably versus Brent. A similar relationship was noted with nonUS crudes such as Nigeria’s Bonny Light, which through 2010 was assessed by Platts at an average premium of $1.96/b to front month cash WTI. The premium averaged $8.55/b to WTI through January 2011 and reached a high of $20.72/b on February 14. The premium versus Brent and the OPEC basket meanwhile saw little change. Refining margins further showed the contrary behavior of the US benchmark. On February 9, the WTI Midwest refining margin was estimated at $13.36/b above the LLS Midwest margin, well above the $1.28/b average through 2010. The crack spread – the difference between refined products and crude oil – between RBOB (New York Harbor barge) and WTI also soared. Since 2007, this spread has generally been around $1.25/b higher than the crack spread versus Brent, but on February 9 the difference between the two crack spreads had ballooned to $14.64/b. The usefulness of WTI as a component in the calculation of crack spreads has diminished as the cost of crude in the New York area or the US Gulf Coast moves in step with Brent rather than WTI. The margins when calculated

LLS DIFFERENTIAL BASIS GLOBAL BENCHMARKS
25 20 15 10 5 0 -5 Mar-09 Jun-09 Source: Platts Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 ($/barrel) vs Brent vs WTI vs OPEC

BONNY LIGHT DIFFERENTIAL BASIS GLOBAL BENCHMARKS
25 20 15 10 5 0 -5 Mar-09 Jun-09 Source: Platts Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 ($/barrel)

vs Brent

vs WTI

vs OPEC

WTI MIDWEST MARGIN – LLS MIDWEST MARGIN
20 15 10 5 0 -5 -10 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 ($/barrel)

Source: Platts

RBOB (NYH BARGE) CRACKS
25 20 15 10 5 0 -5 -10 Nov-08 Source: Platts Mar-09 Jul-09 Nov-09 Mar-10 WTI Jul-10 Brent Nov-10 Mar-11 ($/barrel)

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MARKET ANALYSIS: THE INCREASING DIVERGENCE OF WTI PRICING FROM WORLD MARKETS

WTI, BRENT, OPEC BASKET
15 10 5 0 -5 -10 -15 -20 WTI-Brent WTI-OPEC Brent-OPEC ($/barrel)

versus WTI look very healthy but are misleading as the actual cost of crude for most US refiners is much higher. This disconnect increases the risk for hedgers of refining margins as the rise in product prices in the wake of the Libyan uprising was not replicated in the rise of WTI. Some refiners have subsequently been left to nurse large losses. On March 9, ICE, spotting an opportunity, informed its members in a circular that two new contracts reflecting crack spreads against Brent for heating oil and RBOB gasoline in New York Harbor would be introduced from March 14. WTI not only plummeted below Dated Brent but also lost ground against Dubai and the OPEC basket. Meanwhile, the correlations between Dated Brent, the OPEC basket and Dubai remained relatively stable. The relative weakness in WTI even made it appear competitive to Asia or Middle Eastern markets, an arbitrage the market is unlikely to ever see materialize. The decoupling of WTI in late 2010 and early 2011 is the latest in a series of troubles which began in 2007. Over time these deviations have become deeper and more persistent, while crude inventories at Cushing have steadily increased and problematic logistics at the storage location have put further pressure on the benchmark. But conversely, during the deepest inversion on February 9, the inventories in Cushing declined for the week yet WTI continued to fall relative to other crude oil markers. The fragmented infrastructure ownership, the relative opacity of information on oil storage available in the area and constraints surrounding accessing oil held in storage at Cushing have each contributed to the issue. The result is that WTI, usually viewed as a global reference price, is in fact functioning as a local, land-locked crude reference price with a dysfunctional relationship to the overall US and international markets. In early February 2009, following another period of inversion between the benchmarks, one London-based analyst said: “At the moment, the front of the WTI curve is not a good reflection of the light sweet crude markets. Brent has become a much better indicator. With regards to US crudes, the Louisiana Light Sweet blend has a tighter spread with Brent than the WTI crude. This is due to the positioning on the Gulf Coast which means the [Brent] benchmark is more closely linked to imports.” A senior executive at Valero was also quoted in the Wall Street Journal in late January 2011 as saying, “I think what we’ve got to do, perhaps, is quit looking at WTI as the benchmark by which to compare things, because it’s almost irrelevant.”

Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11

Source: Platts

WTI, BRENT, DUBAI
10 5 0 -5 -10 -15 -20 WTI-Dubai Brent-Dubai OPEC-Dubai ($/barrel)

Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11

Source: Platts

WEEKLY CUSHING STOCKS
50,000 40,000 30,000 20,000 10,000 0 Mar-05 Source: EIA Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 (’000 barrels)

MIDWEST IMPORTS FROM CANADA
1,500 1,200 900 600 300 0 Source: EIA (’000 b/d)

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

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MARKET ANALYSIS: THE INCREASING DIVERGENCE OF WTI PRICING FROM WORLD MARKETS

Later in the year, on March 2, Valero’s first quarter 2011 results estimate included an after-tax loss of $348 million on forward sales of refined products. The related positions were now closed, the company said, and added that commodity prices used in the estimate were based on market conditions to date as well as forecasted prices from the futures market. Refined product prices increased by around 25% between the beginning of the year and mid March so a short position opened on the front month RBOB contract at $2.42/gallon could be closed at around $3.02/gallon at the end of this period, resulting in a net result of around minus $0.60/gallon, or around $25/b. So, forward sales on refined products would have steadily lost value through the first quarter of the year. WTI crude oil prices meanwhile have increased by 15% over the same period from January to March. So a long position on WTI crude oil could be closed with the net result of almost plus $14/b. STOCK BUILDS – RISING IMPORTS AND US PRODUCTION Stock levels of crude oil at Cushing have hit a series of record highs since 2004, fed by rising imports from Canada and a boom in domestic production of Bakken Crude from the Williston Basin, which spreads across North and South Dakota, Montana and Saskatchewan. In early February 2009 stocks stood at more than 34 million barrels, more than double the level reported a year earlier. Reported stocks on March 4, 2011 stood at a new high of 40,263 million barrels. Canada’s development of its huge oil sands resources in Alberta and the subsequent rise in exports to the US led to it overtaking Saudi Arabia as the main supplier of crude oil to the US in 2004. In 2010, around 60%, or 1.2 million b/d, of Canada’s crude imports to the US were into the US Midwest (PADD II district and home to Cushing), where the imported volumes equated to around one third of the operable refining capacity. Oil pipeline capacity from Canada to the US is still undergoing much development but currently stands at an estimated 3.6 million b/d. Enbridge Energy’s 193,000 b/d Spearhead System which runs from Flanagan, Illinois, is connected to the cross-border pipeline system and is able to deliver crude oil directly to Cushing. A further 150,000 b/d of pipeline capacity able to feed crude imports from Canada into Cushing began operating on February 1 as part of TransCanada’s Keystone project, which also consists of adding 700,000 b/d pipeline capacity out to the Gulf Coast by 2013. At the same time as Canadian imports to the US, in particular to the Midwest region have increased, US domestic production has risen, and production from the Midwest region has been the main contributor to this rise.

MIDWEST FIELD PRODUCTION OF CRUDE OIL
25,000 20,000 15,000 10,000 5,000 0 (’000 b/d)

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Source: EIA

KEYSTONE PIPELINE
Alberta

Edmonton Hardisty Calgary

Saskatchewan

C A N A DA
Manitoba

Hudson Bay

L. Winnipeg L. Manitoba

Regina Winnipeg Helena
Montana Idaho North Dakota

Ontario

Bismarck
South Dakota

Minnesota

Superior

U N I T E D S TAT E S
Great Salt L.
Wyoming

Wisconsin

Huron
Michigan

Michigan
Iowa

Nebraska Utah Colorado

Chicago
Illinois Indiana

Erie

Lincoln Steele City
Kansas

Spring eld Patoka Topeka St. Louis Wood River
Missouri

Ohio

Kentucky

Arizona New Mexico

Oklahoma City

Cushing
Arkansas Mississippi

Tennessee

Oklahoma

Georgia Alabama

Texas

Austin

Louisiana

Port Arthur

MEXICO
Keystone pipeline Proposed Keystone expansion

Houston Gulf of Mexico

Source: TransCanada, Platts

Production of light sweet Bakken blend crudes from the Bakken Shale has soared. Production in North Dakota surpassed 350,000 b/d for the first time in August 2010, having averaged a much lower 218,000 b/d through 2009, and is expected to surpass the 450,000 b/d mark by the end of 2012. Data from the US’ Energy Information Administration show that production from North Dakota accounted for around 6% of US total production in 2010, compared with less than 2% at the start of 2005.
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MARKET ANALYSIS: THE INCREASING DIVERGENCE OF WTI PRICING FROM WORLD MARKETS

Higher imports and local production have added new supply sources to the US and particularly to the Midwest and simultaneously reduced the Midwest dependence on US Gulf Coast imports. EIA data show a steady decline in flows from the US Gulf Coast to the Midwest region since 2005. Over this period flows have fallen by 65% to an average of 1.2 million b/d. Crude oil imports into Chicago were exclusively Canadian in 2009 and 2010, according to EIA data. In prior years there were imports of West African, Mediterranean and Saudi Arabian crudes. So as domestic supply and imports have boomed, stocks at Cushing have hit close to 70% of current capacity. Capacity currently stands at a total of 56 million barrels but is due to reach 70 million barrels over the course of 2011 according to Daniel Brusstar, from the energy research and product development department at CME Group, the parent company of NYMEX. CONTANGO PLAY Not all the crude stored at Cushing meets the grade and quality specifications of the WTI futures contract, with the precise breakdown of crudes in storage being unknown. Robert Levin, managing director of energy research and product development at CME Group, has confirmed this point, and also said there is a lot of sour crude in storage which does not meet WTI’s grade and quality requirements. Sources have also said that some oil in storage has been blended to meet the quality specifications ruled by NYMEX for futures contract delivery but has a high metal content. This may put further pressure on the value of WTI as barrels in storage are seen to have lower refining value. Stock levels have increased while market participants have been faced with a huge incentive to store crude oil as the contango market structure has offered a relatively risk-free and generous investment opportunity. So with weight on the prompt market, the prompt market structure on WTI has been in contango for a large part of the last three years. The front month WTI contract has hovered around a $1.50/b discount to the second month contract during this period. Through much of February 2011, the spread between the first and second WTI futures contracts stood below minus $3/b. Storage costs at Cushing meanwhile have been quoted by market sources as being in the range of $0.15/b to a maximum of $0.50/b per month and the cost of capital estimated at between $0.15/b and $0.30/b. So storing crude oil initially valued at around $85/b at Cushing and rolling positions on a monthly basis could present an investor with an annual return of just under 10% (based on storage at $0.50/b and capital costs of $0.30/b). However, the inverse situation is faced by any investor in index passive funds containing WTI as one of the index
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components. The cost of the monthly roll would consume investor capital and nibble away at any flat price gains. And once barrels are deposited in Cushing their exit is confined. Pipeline capacity for flows out of Cushing is estimated to be around one million b/d, which is around 75% of that feeding into the storage facilities. The pipelines feed a total of seven refineries in northwest Texas, New Mexico, Oklahoma, Kansas and Illinois. Of a total refining capacity of close to 18 million b/d across the US, a mere 1.5 million b/d is estimated to be logistically positioned to take delivery of crude oil barrels directly via pipeline from Cushing. This means that the vast majority of the country’s refineries are not able to benefit from bumper margins theoretically opening up as WTI lags behind other global benchmarks. Rail deliveries are constrained by limited infrastructure and a large proportion of rail car capacity is currently used to transport Bakken crudes to Cushing and to Louisiana. Market sources have quoted rail costs from Cushing to Texas as being in excess of $8, however these deliveries will compete closely with Bakken crude arriving by rail. Rail costs from North Dakota to Lousiana are quoted by sources to be around $13/b while the Bakken Blend discount to WTI on a FOB Guernsey, Wyoming basis has averaged minus $4/b through 2011 to date. In fact with prompt spreads falling to around minus $15/b in WTI futures, one industry source highlighted how the rail option from Cushing should be providing a floor to the price differential between WTI and US Gulf Coast crudes. CONCLUSION Industry sources have increasingly commented on Brent being a more relevant indicator of market value than WTI, with statistical comparisons of many key crude oils pointing to WTI as the crude out of step with the rest. Meanwhile, US buyers hedged against WTI become increasingly exposed to booming differentials and to inversions in natural price relationships. WTI seems currently best suited to pricing oil in Cushing, Oklahoma alone and does not reflect the realities of available crude supply to most refiners across the US. The divergence between the WTI benchmark and other grades is also expected to persist unless there is a change to the logistical constraints currently present at Cushing. “With few relief valves available via new pipelines to reduce the massive stock overhang in the Midcontinent, the inversion of the more normal WTI-Brent premium and the divergence in the two crudes’ forward curves may persist for months or indeed years to come,” the International Energy Agency said in its February 2011 oil market report.

MARKET ANALYSIS: THE INCREASING DIVERGENCE OF WTI PRICING FROM WORLD MARKETS

Some relief could come in the form of pipeline reversals. Pipelines such as the 350,000 b/d Seaway line which runs from the Gulf Coast to Cushing and the 1.2 million b/d Capline which originates at the Gulf Coast and ends in Illinois are running well below capacity. This has prompted market observers to question the economic logic behind the continued south to north flow and why there are no proposals pending to reverse flows. ConocoPhillips, the co-owner of the Seaway system has declined to comment on any possible plans to reverse pipeline flow. Such a move could ease congestion at Cushing as well as redirect barrels from the Midwest to the Gulf Coast, where about 50% of total US refining capacity resides. New pipelines from Cushing could also alleviate stock builds at the facilities. Blueknight Energy Partners reactivated the 32,000 b/d Eagle North crude oil pipeline from Cushing to Valero’s 91,500 b/d Ardmore, Oklahoma refinery in mid December 2010. TransCanada’s Keystone XL and Bakken Marketline pipeline projects which are set to link Hardisty, Alberta and Williston Basin respectively via Cushing to terminals in Nederland and Port Arthur, Texas. These projects are expected to open up the Gulf Coast refining center to Cushing barrels. The plan is for 500,000 b/d of pipeline capacity to begin service in 2013 from Cushing to the Gulf Coast. However, the projects are currently awaiting approval which is required for construction work to begin. Initially, the Keystone XL project could, however, exacerbate the build-up of stocks as a 150,000 b/d pipeline linking Steele City, Nebraska, to Cushing began operations in the first quarter of 2011, before the subsequent link from Cushing to Texas is ready.

In the meantime, the oil industry has begun to search for alternative benchmarks offering a closer representation of the value of crude oil in the broader Americas market. And as talk of Brent becoming a more representative measure of global supply and demand balances gathers momentum, the open interest in the ICE Brent futures contract is growing faster than that in the NYMEX WTI futures contract. The open interest on ICE Brent futures still lags behind that on NYMEX WTI by a ratio of around 1:1.6. Nevertheless, over the two-year period from January 2009, the open interest on Brent has increased by 46.8% while growth in WTI has been below half of this at 21.2%, reflecting the growing international acceptance of Brent as a price benchmark. The airline industry in the US is one which is significantly impacted by the currently sustained disconnect in WTI as price exposure is mainly hedged against the WTI crude oil contract. Several airlines including JetBlue Airways, Southwest Airlines and Virgin America have expressed concerns over the current price disconnect. Platts identified the issue in 2009 and in order to give the market a more representative US crude price indicator than WTI, Platts launched its Americas Crude Marker, which reflects the most competitive of mainly heavy, sour crude oil grades Mars, Southern Green Canyon, Poseidon and Thunder Horse. However, industry preference by and large, seems to point to the practice of valuing crudes using more established benchmarks with a long history and global acceptance, such as Brent.

For further details, please contact PriceGroup@platts.com
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