Jim Cramer Is Wrong; The Spread Isn't Dead

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Is the spread dead? On Friday, U.S. crude oil benchmark West Texas Intermediate, or WTI, traded at a premium to Brent crude oil for the first time since October 2010.

Jim Cramer thinks this is a permanent shift. On Monday, he predicted domestic oil prices will remain tethered to the international benchmark now that the kinks in the energy supply chain system have been fixed. Here's an except from the segment:

"The spread is dead and I bet it will stay that way because there's so much new pipeline capacity coming in. In fact, I could easily see the West Texas Intermediate price going higher than Brent, because it's higher quality." Jim Cramer.

You can watch the full video here. Based on his thesis, Cramer recommends buying domestic oil producers including Continental Resources (NYSE: CLR), Whiting Petroleum, and Carrizo Oil and Gas. He also suggested selling refineries that have benefited from the supply glut like HollyFrontier and Marathon Petroleum

But Cramer is wrong. The the kink in the supply chain hasn't been fixed - it has just moved south. 

But first, what happened?

Historically, WTI and Brent traded closely to one another. But this relationship began to change when double-digit oil production growth from the Alberta oil sands and the North Dakota Bakken began to pile up in the Midwest. The U.S. oil logistic network wasn't built to accommodate the surge in production. All of this new output flowed into a key storage point at Cushing, Oklahoma, and couldn't easily be moved south to the main refining centers on the Gulf coast.

As a result, crude inventories at Cushing surged and WTI began to trade at a discount to Brent.

<img alt="" src="http://g.fool.com/editorial/images/59962/chart_large.png" />

But in recent weeks that spread has been erased. New pipeline capacity at Cushing has provided an outlet to coastal markets where oil can be sold at international prices. Production outages in Western Canada has also reduced supply. 

But here's the problem

The bottleneck in the energy supply chain haven't been cleared - it has just been moved south to the Gulf coast. 

For now, refineries can absorb the extra barrels from Cushing. Today there're still 250,000 to 300,000 barrels of light, sweet crude imports coming into the Gulf coast. Higher domestic production will simply offset this. 

But this relief won't last forever. According to Macquarie, there're 7 million barrels per day of new pipeline capacity set for completion between 2013 and 2015. This is a massive amount of new supplies entering the region and will likely overwhelm refining capacity.  

And remember Canada? Expect Alberta production to bounce back strong following those temporary outages. This means more competition for WTI. Lighter crudes will have to trade lower to compete against heavier oils like Mayan and Canadian Synthetic. 

Of course we're unlikely to see the WTI/Brent spread go back to the record $16 per barrel gap we saw earlier this year. But according to industry analyst Keith Schaefer, the discount could easily return to $5 - $10 per barrel. 

What does all this mean for investors?

If WTI begins to trade at a discount to Brent again, investors should do the exact opposite of what Cramer recommended on Monday.

First, this bottleneck creates an opportunity for U.S. refining stocks especially those with assets on the Gulf coast. Look at names like Valero Energy (NYSE: VLO) and Phillips 66 (NYSE: PSX). Both of these names sold off heavily when WTI/Brent prices converged. But if the WTI/Brent spread widens again, these companies will enjoy a cost advantage when they can buy discounted American oil and sell the refined product at international prices. That will mean wider profit margins and a higher share price for these companies.

Second, avoid landlocked producers like Continental Resources. Last quarter the company grew production 42% year-over-year to 121,500 barrels of oil equivalent per day. But all of that output was centered in the Bakken and the Midwest which must be shipped through bottlenecks in the supply chain. If the WTI/Brent spread widens, Continental and other mid-continent producers will receive a lower price for their output.

Foolish bottom line

What's most troubling about this new bottleneck is that it could be incredibly difficult for the industry to fix. Within the United States it's challenging to add new downstream capacity. In the past 20 years, only three new refineries have been built in the country. If the WTI/Brent spread widens, it could create a long lasting price advantage for Gulf refiners. 

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Robert Baillieul has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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