By Robert Campbell
NEW YORK, Nov 21 This week's stunning collapse
in the price of West Texas Intermediate crude oil at Midland,
Texas, is a stark warning to those betting on a narrowing
Brent-WTI spread for the New Year that a lot can still go wrong
on that trade.
WTI at Midland sank $13 a barrel to change hands near
$20 per barrel below the price of WTI at Cushing earlier
this week as traders dumped barrels ahead of December pipeline
Sister grade West Texas Sour , which is still a
component in some price formulas for foreign crude oil, suffered
a similar meltdown.
Dramatic moves indeed and worth closer examination. To be
sure, the magnitude of the weakness seen this week is mainly due
to the limited liquidity and volatility in U.S. physical crude
oil markets ahead of pipeline scheduling.
But the fact that such a huge decline can occur is
instructive. While a few years ago it would have been remarkable
for WTI at Midland to trade more than $1 below WTI at Cushing,
discounts are getting larger and larger.
What has happened? For a long time pipeline capacity out of
Midland exceeded demand. So that was the case the price of WTI
at Midland would be held by arbitrage forces at the Cushing
price less the cost of shipping.
But now pipeline capacity out of Midland is no longer
sufficient to meet demand. Growing oil output in the Permian
Basin has turned Midland into a "mini-Cushing."
This is a critical point. When shipping capacity at a
pipeline hub is in surplus, market power accrues to the oil
producers who are able to charge top dollar for their product.
Yet once pipeline capacity is no longer enough to clear
demand market power swings violently to those with control over
the capacity. Anyone with more oil than pipeline space is at the
mercy of market forces.
FROM MINI-CUSHING TO MEGA-CUSHING
OK, no problem though, many may say. The problems at Midland
this week are of a one-off nature and besides, help in the form
of new pipelines that will send crude to Houston instead of
Midland and Cushing is on the way in early 2013.
There is nothing wrong here. The three-day period each month
when physical traders balance their books and dump odd lots of
oil always produce wild price action but very little oil
actually changes hands.
Moreover the extension of maintenance at Phillips 66's
146,000 barrels per day Borger, Texas refinery cut
regional crude demand more than expected in November, leading to
a surplus of oil on hand.
And yes, there will be new pipelines. Lines out of Midland
will add a combined 80,000 bpd in capacity to Houston and
another 90,000 bpd to the Port Arthur area next year.
Similarly, the Longhorn project near El Paso will allow up
to 225,000 bpd of Permian oil to bypass Midland and Cushing
altogether and move directly to Houston starting in the first
And finally, the 250,000 bpd Seaway pipeline expansion will
increase offtake from Cushing that should improve pricing at
But hold on. All of this assumes that these new pipelines
clear the market and return pricing power to the hands of
Notice that these pipelines all add a huge amount of
capacity into Houston, most of which will be light oil. And this
all comes as Eagle Ford crude capacity into Houston keeps
In other words, is there not considerable risk that the
"Cushing problem" spreads from Cushing and Midland to engulf
Houston as well?
If that happens, will we not simply see light crude prices
plunge in Houston to levels well below the global market?
Indeed, Eagle Ford barrels and initial Seaway flows have
already displaced almost all of the imported light sweet crude
from Houston-area refineries, according to U.S. government data.
Some 150,000 bpd of foreign light-sweet crude was processed
in Houston-area refineries in August, far less than the expected
flood of new barrels into Houston from Cushing, the Permian
Basin and the Eagle Ford crude oil play.
That suggests light sweet crude in Houston will have to
compete on price to push out other foreign imported crude. How
much of a discount is anyone's guess but due to restrictions on
U.S. crude oil exports, local refineries will hold considerable
sway over pricing.
That in turn means big discounts could be needed to sway
buyers, especially during periods of refinery maintenance. Next
year's pipeline expansions will ensure a bigger market for North
American light sweet crude, but will it be big enough? And if
Houston is not big enough, can the market be sure that adding
more Gulf Coast outlets will be enough?