July 19, 2013 / 2:23 PM / 6 years ago

Funds favour Europe benchmark Brent despite U.S. crude oil rally

* Strength in U.S. crude (WTI) unlikely to reverse flows into Brent

* Investors move into front month of WTI to earn roll yield

* Extreme backwardation in WTI not expected to last

By Claire Milhench

LONDON, July 19 (Reuters) - Pension funds and hedge funds, which invest in commodities, have rarely been more in accord over which oil benchmark they prefer.

Despite a July rally in U.S. crude oil futures, which took most funds by surprise, investors say the momentum is behind European benchmark Brent even though the relationship between the two is expected to remain volatile.

Over the last week, front month Brent’s premium over the U.S. crude futures widely known as West Texas Intermediate (WTI) CL-LCO1=R has narrowed sharply. On Friday the premium touched 6 cents a barrel - its lowest since October 2010.

Many investors were caught out by the move, which followed large stock drawdowns at Cushing in Oklahoma, the delivery point for physical WTI crude that underlies the U.S. futures contract, partly due to floods cutting some of the supply.

Investors have preferred Brent to WTI as the oil production boom in the United States and the isolated inland delivery location, far from coastal refineries, has pressured WTI’s price performance. In contrast, Brent has benefited from a global geopolitical risk premium and regional tightness.

“Everyone had been expecting the fundamentals for WTI to improve, but perhaps not so quickly,” said Fabien Weber, co-manager of the Julius Baer Commodity Fund, which has some $255 million under management. “European pension fund investors have been more overweight Brent crude than WTI.”

These investors have done less well than if they had held a bigger WTI position. “WTI has outperformed Brent on the front month contract by about 10 percent,” said Weber.

But pension fund managers, which look after long-term money, say they are sticking with their overall Brent allocations as they expect commodities indices to rebalance further in favour of Brent at the expense of WTI at the end of 2013.

“The future trend will largely be determined by what the benchmark indices do - that’s where the market will go,” said Colin O’Shea, head of commodities at Hermes, which has some $2 billion under management in commodities.

Fund managers and pension funds use indices to benchmark their performance and asset weightings. Since 2010, investor momentum has been behind Brent, as this has increased its weighting in leading commodity indices the S&P GSCI and DJ-UBS at the expense of WTI.

O’Shea said he expected Brent to gain increased index share over the coming years. “The rate of growth may not be as marked as previously, but that trend is still in the favour of Brent.”

The S&P GSCI and DJ-UBS indices weight Brent and WTI based on world liquidity and production, using an average from the last five years. “Because it’s a five-year snapshot and Brent liquidity has been growing, when they do their calculation for next year, they’ll be getting rid of a year which is lower than this year,” O’Shea said.

George Hutson, chief investment officer at London-based IKEN Capital, which manages some $20 million in the IKEN Commodity Alpha Strategy, agreed. “Brent is unlikely to lose its role as the global benchmark because WTI is landlocked, making it vulnerable to flows in and out of Cushing,” he said.

Since 2011, the S&P GSCI and DJ-UBS indices combined have increased their weight in Brent over 12 percent while reducing WTI by 13.5 percent.


Last week’s abrupt compression in the WTI/Brent spread is a case in point. Many banks had expected the spread to remain stable at around the $8.50-$9 mark, but floods in Canada closed some of the pipelines to Cushing just as U.S. refineries such as BP’s Whiting ramped up their demand.

This led to the unexpectedly large stock draws at Cushing.

“The consensus is that the convergence is overdone,” said Hutson.

“With the ongoing disconnect between a fundamentally over-supplied crude market and the current price action, I would expect increased volatility in the weeks to come versus historical levels.”

This is expected to lead to more tactical plays, with investors changing positioning along the WTI futures curve.

“We are back at the front month, especially for WTI,” said Weber.

This is because the backwardation in WTI - where the front month contract trades at a premium to those for later dates - has steepened dramatically over the last few weeks as investors worry about tighter U.S. crude supplies.

In 50 days, the backwardation between the first and the 12th month has widened from $4 to $10. The backwardation between September and October is now at $1.55, whilst for Brent, the equivalent backwardation is 81 cents.

“We are not positioned further out along the WTI curve at the moment - if we had been, we’d have lost money,” said O’Shea. “With the curve in steep backwardation, you get a positive roll yield from just holding the front. People are thinking more about where to invest along the curve - they are not just blindly investing six and 12 months out any more.”


Hutson believes the backwardation will begin to weaken as it has reached an extreme and hedge funds are taking positions off.

“It’s become backwardated to a level we haven’t seen since 1990,” said Hutson. “A lot of traders have been taken out by the move and lost an awful lot of money, which has led them to stop-out of their WTI positions.”

Investors and banks believe the current WTI/Brent spread is not sustainable, because it is now less than the cost of taking oil via pipeline from Cushing to the U.S. Gulf Coast, where refiners have the option of using imported or coastal crudes.

“Over time, the price relationship between the two contracts should reflect pipeline tariffs between Cushing and the Gulf Coast,” said O’Shea. “But we do see volatility around that, so it can come in to parity and then go right back out again.”

O’Shea added that the Cushing glut could become a Gulf Coast glut: “You could just be moving the over-supply from one place to another.”

Commodities trading giant Goldman Sachs, which predicted a sharp narrowing of the spread, also said it saw it widening to $8-$9 in 2014 as a crude glut was again building up in the United States. Another major bank active in commodities, Morgan Stanley, sees the spread widening to $3-$6 per barrel. (Reporting by Claire Milhench; Editing by Anthony Barker)

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