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  • Untitled Document
    Untitled Document

    The seven gates of hell for WTI crude traders

    Sandy Fielden, RBN Energy

    By the end of this week (Friday January 11, 2013) Phase 2 of the Seaway Reversal pipeline project that delivers crude from Cushing to Houston is supposed to have come online - expanding pipeline capacity from 150 Mb/d to 400 Mb/d. Phase 1 of the project was eagerly anticipated by the market but since then (June 2012) the narrowing in price differentials between WTI Cushing and Brent expected by much of the market has not materialized. Today we explain why Seaway Phase 2 is only one factor in today’s complex US crude market evolution.

    The Seaway pipeline runs from Cushing, OK to Freeport, TX (passing through Houston on the way) and originally moved crude from the Gulf Coast up to Cushing. The joint owners of the pipeline, Enbridge and Enterprise reversed the pipeline last June to flow crude from Cushing to Freeport. Phase 1 of the project provided shipping capacity of 150 Mb/d. Phase 2 of the project expands the existing pipeline capacity by adding more pump capacity to increase the volume to 400 Mb/d. Phase 3 of the project is to build a parallel crude oil pipeline alongside the original that will more than double capacity to 850 Mb/d and come online in 2014. RBN Energy Blog contributor Industrial Information Resources explained the project engineering in a post last August (see Seaway Reversal Project).

    The “Simple Theory” of WTI price recovery

    Market speculation about Seaway Phase 2 centers on whether or not the addition of another 250 Mb/d of crude oil capacity between Cushing and Houston will cause the price of West Texas Intermediate (WTI) crude at Cushing, OK – the Midwest domestic market benchmark and the crude delivered against the NYMEX futures contract - to recover lost ground against the Brent ICE futures benchmark. As pretty much everyone involved in crude oil analysis knows by now, WTI has been trading at a discount to Brent over the past two years. That discount has been hovering around the $20/Bbl level for the past six months  - even though the two crudes are of similar quality and WTI traded at a slight premium to Brent up until August 2010. It is generally accepted that the large WTI discount to Brent came about because of an oversupply of new crude production from Canada and US domestic shale plays such as the Bakken field in North Dakota into the Midwest market. The new production backed up supplies at the Cushing hub where WTI is traded, causing its price to fall relative to international crudes that are linked to Brent. Since that price dislocation occurred some have assumed that all it would take to end the WTI discount to Brent is for new pipeline infrastructure like Seaway to open up and let the Cushing crude glut flow out of the Midwest -where it is not needed - down to the Gulf Coast where there is plenty of refinery demand. At that point, theoretically WTI prices would resume parity with Brent, the clouds will part and the sun will shine on Oklahoma. For the sake of argument we are going to call that the “Simple Theory” of WTI price recovery.

    Unfortunately things are not working out the way the “Simple Theory” would suggest. In fact looking at the data since the Seaway pipeline opened in June 2012 we can see two distinct periods of activity where prices and inventories basically did the opposite of what the “Simple Theory” says should have happened. The chart below shows Cushing stocks and the WTI discount to Brent over the past year. The WTI discount to Brent is the blue line on the left axis and the Cushing crude stock position is the red line on the right axis. The first period to look at (green circle) is between June and November 2012 when Cushing crude stocks declined by about 4 MMBbl after Seaway Phase 1 opened. Instead of the WTI discount to Brent narrowing during that period as the “Simple Theory” expected the discount widened from around $11/Bbl in June to as high as $25/Bbl in November. The second period to look at is between November 2012 and this week (orange circle). During that period Cushing stocks increased by 6 MMBbl to reach another new record level over 49 MMBbl and the WTI discount to Brent fell back from $25/Bbl to $18.25/Bbl. During both these periods the data behaved inversely to the “Simple Theory” that says lower inventories narrow the WTI discount and higher inventories will increase the WTI discount.


    Source: CME and ICE Data from Morningstar

    In short the “Simple Theory” is not sufficient to explain how and when WTI prices will recover against Brent. Instead the US crude oil market is going through a complex transition that involves more variables than just Cushing inventories and WTI/Brent prices. In the rest of this blog we list seven variables (the “Gates of Hell” in our title) and their influence on crude prices.  Only by paying attention to these “gates” can we explain what is happening to crude price relationships. 

    Gate #1 – Midwest Refinery Demand

    Fluctuating refinery demand in the Midwest currently has more impact on Cushing inventory levels than crude flows from Cushing to Houston on the Seaway pipeline. During our last blog on the WTI discount to Brent  (see Place Your Bets on Narrower WTI/Brent Spread) we referred to the 400 Mb/d BP Whiting refinery in Indiana that makes up 11 percent of Midwest refinery crude capacity. A significant expansion project at BP Whiting took 250 Mb/d of refining capacity out of the Midwest market in November 2012 that will not be returning until the middle of 2013. That disruption helps explain the rise in Cushing inventories since November 2012. It could be argued that the Seaway Phase 2 expansion evens out the 250 Mb/d that BP Whiting is no longer consuming. That would mean Seaway 2 has no impact on Cushing stocks before BP Whiting comes back on line in mid 2013. Expect refinery demand fluctuations to continue causing temporary blips in crude pricing.

    Gate # 2 – The Crude Stockpile at Cushing

    Regardless of temporary refinery demand fluctuations in the Midwest the fundamentals suggest that the crude stockpile at Cushing (and oversupply in the Midwest) is going to be addressed by new pipelines – probably by the end of 2013 when Seaway Phase 2 and the Keystone XL Gulf Coast Extension project (700 Mb/d by 3Q 2013) will together have added 0.9 MMb/d of new capacity between Cushing and Houston. Reducing the Cushing stockpile will reduce the downward pressure on WTI prices and narrow the discount to Brent but it is not the only factor and may well be overshadowed by other variables.

    Gate # 3 – New Flows of Crude into Houston from the Permian and Eagle Ford

    New crude flows from the Permian will come via the Magellan Longhorn Reversal project that will flow 75 Mb/d in 1Q 2013 and another 150 Mb/d by the end of 2Q 2013 as well as the Sunoco Logistics (Energy Transfer Partners) additions to the West Texas Gulf pipeline that will add another 200 Mb/d of capacity from the Permian to Houston by mid 2013. 

    New pipelines out of the Eagle Ford basin in South Texas began delivering increasing volumes of crude to Houston refineries (Enterprise 350 Mb/d, Kinder Morgan 300 Mb/d) during the second half of 2012.

    Because the majority of Permian crude production has been flowing to Cushing, OK up until now - adding to the supply glut there - the new flows of West Texas crude to Houston will relieve pressure on Cushing. [The new pipelines will also reduce the heavy price discount against WTI that Permian producers have recently had to endure because supplies exceeded takeaway capacity and backed up at Midland, TX (see After The Flood).]

    The new flows of crude from the Eagle Ford and the Permian will initially be delivered into the Houston area and will not pass through Cushing on their way to market. The focus of trading and pricing for WTI will therefore likely gravitate away from its traditional hub in Cushing. Watch for a new crude trading market based in Houston.

     Gate # 4 – New Flows of Crude into Louisiana From North Dakota and the Eagle Ford

    Significant new domestic crude supplies are now reaching refineries in the Louisiana Gulf Coast region. We explained recently how 150 Mb/d of Bakken crude arrives by rail from North Dakota at St. James, LA (see Back to The Delta). There is also a growing coastal trade moving Eagle Ford crude by barge from Corpus Christi, TX to St. James. The newly reversed Shell Houston to Houma (Ho-Ho) pipeline begins delivering up to 300 Mb/d of crude from the Houston area to Louisiana Gulf Coast refineries this month (January 2013). These new supplies of light sweet crude into the Louisiana Gulf Coast market are already backing out sweet crude imports (see Thrown for a LOOP Part 1). The current Gulf Coast benchmark light sweet crude – Louisiana Light Sweet (LLS) is priced at a small discount to Brent because it competes with imported crudes that are linked to Brent. Once domestic supplies replace these imports then LLS prices are likely to switch to track domestic crudes linked to WTI rather than Brent.

    Gate # 5 – Crude Quality

    We have previously discussed the fact that the new supplies of domestically produced crude primarily from North Dakota, the Permian Basin and the Eagle Ford are considerably lighter in composition than the crudes that US refiners have been consuming for years (see Turner Mason and the Goblet of Light and Heavy). In addition, new supplies of crude from Western Canada are a blend of very light and very heavy components that again are not typical of existing grades. Refineries on the Gulf Coast that are configured for heavy crudes can only adapt to run these new crudes by reducing their throughput considerably or undergoing expensive alterations. 

    If there is a flood of light sweet crudes such as Bakken coming to the Gulf Coast from the Midwest via Cushing on the Seaway and Keystone pipelines then there is a very real danger that the supply glut in Cushing will simply be transferred to the Gulf Coast along with the attendant risks of price discounts that have dogged WTI over the past two years. That is because Houston is already receiving light sweet crudes from the Permian, the Eagle Ford and St. James, LA market is being supplied with North Dakota Crude. Once these flows exceed the demand for light sweet crude on the Gulf Coast (currently about 500 Mb/d) then producers will have to discount their light crudes to levels attractive for refineries configured to run heavier crudes. 

    Gate #6 Does Seaway Ship Light or Heavy Crude?

    It follows that an important influence on Variable # 5 will be whether the crudes flowing from Cushing to Houston on Seaway are mostly light sweet crudes such as North Dakota Bakken and WTI or mostly heavier Canadian crudes. Heavy Canadian crudes are more attractive to Gulf Coast refiners because there is greater refining capacity configured to handle them (although some Canadian light/heavy blend crudes are still not ideal for heavy crude refineries). Higher Seaway volumes of heavy Canadian crudes will therefore have less impact on WTI prices than higher volumes of light sweet crude because the latter will increase the risk of the light sweet glut scenario described in Variable # 5 

    Gate # 7 The Possibility of Crude Exports

    Last but not least we should mention the possibility that the US government will allow some volumes of crude oil exports from the Gulf Coast. Currently crude oil cannot be exported without a special License from the Bureau of Commerce (see Fifty Shades Lighter) and these have only been granted for limited exports to Canada. If crude oil exports are allowed at the Gulf Coast then the light sweet crude glut scenario described in Variable # 5 will be avoided.  Producers would simply export any light sweet crudes not needed in the Gulf Coast region to international markets. Refiners would continue to import the heavier crudes their refineries are configured to run. The crude export scenario seems politically unlikely but if it does happen it will have a dramatic impact on US crude prices because WTI and LLS will be linked back to international markets and track Brent prices directly.

    Summing Up

    Our seven “Gates of Hell” indicate just how complex the Gulf Coast crude supply situation is for crude traders and analysts to navigate today. The fate of the WTI discount to Brent is tied to many factors besides the level of crude stocks at Cushing. The WTI relationship with Brent will not resolve itself overnight through one or two new pipelines but rather by a gradual evolution over the next two years. Our belief (as explained in After the Flood - Gulf Coast Light Sweet Crude Pricing Beyond 2013) is that the WTI discount to Brent will decline over the next two years to arrive at a new level close to $10/Bbl. Along the way there will be plenty of hiccups caused by local demand fluctuations, crude quality issues and potentially a new supply surplus on the Gulf Coast. Stay tuned to RBN Energy for continued insight. 

     

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