Light-heavy oil spreads may widen on a forward basis as light crude output declines relative to heavy over the next 18 months, as per a new report by BofA Merrill Lynch Global Research. Global crude oil prices have finally broken out of their range, with Brent surging to $54/bbl in the past few trading days. The rally has been supported by a substantial tightening in near-dated timespreads, signaling an improved physical backdrop.

“The latest move-up in prices reinforces our view that the worst is now behind us in the global oil markets . Interestingly, while all global crude oil benchmarks benefited, lighter benchmarks have been racing ahead, pricing in a larger premium to heavy crude,” the report said.

“ As light output will likely fall by more than heavy output around the world over the next 18 months, we expect this weakness in heavy crude to spread. More broadly, we see light-heavy spreads widening out on a forward basis.”

Heavier global slate should lead to wider light-heavy spreads

The global crude oil slate is becoming heavier again, in our view. Most of the contraction in non-OPEC production in 2016 likely will be in light crude oil, primarily in the US and the North Sea. “Meanwhile, we believe intermediate to heavy non-OPEC producers like Canada, Russia and Brazil will only experience shallow declines.”

“In fact, most of the 0.6 million b/d output decline in non-OPEC we expect next year is in light crude, while the 0.9 million b/d expansion we expect from OPEC has a distinct medium to heavy crude bias. Saudi is trying to make up in volume what it lost in price, Iraq has recently ramped up new heavy production in the South, and Iran will likely start to ramp up heavy production towards end of this year as sanctions are lifted.”

US production decline is positive for WTI-Brent spreads

US imports of light crude oil have been in a freefall since 2010 on soaring domestic production. A steep upcoming decline in US production, by 1 million b/d from 2Q15 to 1Q16, will likely see US light imports rising again for two key reasons. First, US crude inventories currently in place are mainly heavy, especially in the Gulf Coast, as refiners have been relying on direct supply of light grades from the shale basins.

Second, structural investments have recently turned some refineries into light grade units such as splitters. Therefore, early signs of light crude oil imports rising again are likely to continue in the short-term. This reinforces our call for WTI to trade above Brent at some point next year to attract these foreign light barrels in the US Gulf Coast.
Source: BofA Merrill Lynch