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Outlook 2017: Wider Brent/WTI Spread Should Encourage U.S. Crude Exports

U.S. crude exports could pick up in 2017 as many analysts have forecast a wider Brent/WTI spread.

U.S. crude production is already on the rise, and will likely face fewer hurdles under a Trump administration, especially at a time when much of the rest of the world's producers are planning, in theory at least, to curtail output.

Further, a radical shift in U.S. tax policy could be on the horizon, with the potential to roil energy markets, at least according to some analysts.

Analysts at Barclays expect the spread to widen to around $2/b through February, while Credit Suisse sees $1.25/b in 2017 and $2.50/b in 2018. Likewise, Goldman Sachs sees $1.75/b in 2017 and $3/b in 2018.

So far in 2016, the prompt ICE Brent/NYMEX WTI spread has averaged just over $1/b.

The key factor to keeping WTI at a discount to Brent in the year ahead is U.S. production, which has already risen in some shale areas, such as the Texas Permian basin, and this with prices hovering just around $50/b. With many breakeven costs suggesting U.S. shale is profitable at lower levels, current prices are more than enough to keep producers happy.

S&P Global Platts Well Economic Analyzer data shows Permian basin shale offers internal rates of return of between 18-21% at current prices, with those for North Dakota's Bakken not far behind, near 16%.

Further, the ability of U.S. producers to apply technology makes shale production likely even more profitable going forward. Energy economist and long-time oil market analyst Philip Verleger has suggested that technological improvements in the shale patch will eventually "swamp" the deleterious effects of cumulative production.

"Improving technology is offsetting traditional factors by a ratio of 10 to 1," Verleger said in a recent report. "This means that wells not drilled in 2016 can be drilled in 2017 for 70 or 80% of the costs that might have been incurred in in 2016."

What Will This Mean for Exports?

Should the Brent/WTI spread widen, the incentive for U.S. producers to maintain production should not go away, as export markets will be all the more attractive.

A similar dynamic has played out in years past -- a sharply discounted WTI long offered U.S. producers an incentive to export crude -- but until December 2015, these flows were heavily restricted, even if the economics of exporting crude were envy-inducing compared with those seen currently.

Even before restrictions were lifted, a wider WTI discount often went hand in hand with robust exports. At that time, the major hurdle -- aside from official restrictions -- was inadequate pipeline infrastructure to bring North American crude to places it could be exported, such as Houston and Corpus Christi. Spreads were often wide enough to account for more expensive rail economics, which, in isolated cases, even saw test volumes of Western Canadian Select re-exported from the USGC to Spain.

A major breakthrough likely to boost U.S. crude export capabilities was the start up in November of Occidental Petroleum's 300,000 b/d-capable Ingleside Energy Center Terminal in Corpus Christi.

The terminal is currently only capable of loading Aframax-sized cargoes, but plans are underway to deepen and widen the Corpus Christi channel, leaving the door partly open to possible Suezmax-sized cargo loadings.

Papers Spreads Only Part of the Story

Considering U.S. crudes desired in the export market often trade at a discount to WTI, delivered spreads to Brent-based spot crudes are often narrower than the futures market implies. This means arbitrages are often worked despite seemingly unprofitable paper economics.

While it is clear that a wider futures spread in August -- around $1.88/b, the widest since November 2015 -- laid the groundwork for U.S. crude exports hitting a record 692,000 b/d in September, according to U.S. Energy Information Administration data, Platts data drills more deeply.

For example, U.S. exports were so strong in September because spot WTI was delivering near parity with international rivals in both Northwest Europe and the Mediterranean. WTI FOB Houston plus freight delivered the crude into the Mediterranean near parity with Nigerian Bonny Light, and at a slight 66 cent/b premium to Med sweet mainstay Azeri Light. WTI delivered spread to Forties and Urals in Rotterdam tell a similar story.

Refinery cracking yield values also can shed light on the desirability of U.S. crudes abroad, because they quantify the value of a basket of products a refiner can potentially produce with a particular grade of crude.

Cracking yields in Italy for WTI have averaged over $58/b so far in December, on par with Russian Urals, Azerbaijan's Azeri Light and Kazakhstan's CPC Blend. In Rotterdam, WTI yields are competitive with those for North Sea Forties as well as Saudi Arab Light.

Who Has Been Buying U.S. Crude?

Although thus far the lion's share of U.S. crude exports have chiefly gone to Europe, Latin America -- in particular Venezuela -- and Asia have shown interest as well. In fact, cheap freight in August likely helped boost U.S. exports to Singapore, which hit a record 99,000 b/d in September, EIA data showed.

Platts data shows WTI regularly delivers into Singapore at a discount to local sweet grades like Malaysia's Kikeh and Vietnam's Bach Ho. Eagle Ford has also shown itself to be increasingly competitive on a delivered-cost basis with condensates like Qatar's deodorized field condensate.

Potential U.S. Border Adjustment Tax Changes

But lurking on the horizon is a potentially drastic change to U.S. tax policy, one that could be intended to benefit U.S. crude producers through taxing imports and by encouraging exports.

Some analysts, Verleger in particular, suggest such a proposal would have the unintended consequence of driving up U.S. retail gasoline prices, as well as putting WTI at a significant premium to Brent.

In a joint study with economists at the Brattle Group, Verleger stipulates that such a proposal -- which would tax crude imports at 20% but leave crude exports untaxed -- could drive a 25% wedge between WTI and Brent prices. This is a substantial deviation from the expectations outlined above as it would close the export arbitrage as defined by the current relationship between WTI and Brent.

Still some analysts are remiss about the potential for any significant impact.

"We see little likelihood that [U.S. House of Representatives Speaker Paul Ryan and House Ways and Means committee Chairman Kevin Brady's] proposed U.S. border-adjustment tax will move forward," analysts at Barclays said this week.

"The border-adjustment tax would comprise a large share of revenues in Ryan's tax plan, so even if it does not go through, something else has to give. The border-adjustment tax would likely increase domestic crude oil and product prices, which is positive for U.S. crude oil production and negative for product demand (all else equal)."

While a policy to stimulate and reward U.S. crude producers is in line with President-elect Donald Trump's campaign rhetoric, it remains unclear if the congressmen's proposal will have any impact on the oil industry.

Titled "A Better Way: Our Vision for a Confident America," the plan does not mention oil specifically. Further, should it be put into effect, there is room to believe oil imports and exports could be exempt, considering such a plan would punitively affect not only refiners -- whose hands would be tied in terms of more profitable, but imported, heavy sour grades -- but also U.S. drivers.

A plan such as the one proposed will likely affect other aspects of the U.S. economy, some which could offset the possible increase in gasoline prices for U.S. drivers. Still, the prospect of triggering such a change and the potentially flammable political consequences render the proposal, at least as far as it would affect U.S. oil markets, as increasingly unlikely.