By Robert Campbell
NEW YORK May 9 For two years the dominant story
in the North American oil market has been a shortage of pipeline
capacity, leading to the buildup of gluts of oil as producers
cannot get their crude to market. That era is coming to a rapid
The end of the pipeline capacity crunch means a sea change
in the way North American oil will be priced, traded, and
balanced. With many new pipelines under long-term contracts, oil
flows will be significantly altered, potentially creating new
gluts but also pockets of scarcity.
That means the balance of power in the market will shift
away from refiners in some places. Instead of plunging crude
prices being the factor that rebalances regional markets, the
rapid erosion of refining margins will now govern balances in
places where outbound pipeline capacity, much of it locked up
under take-or-pay contracts, exceeds inbound capacity.
This is not to say that there will no longer be regional oil
gluts or no more need for more infrastructure development. But
we are entering a new era. For at least the next 12 to 18
months, the North American market will be dominated by an excess
of pipeline capacity in key regions.
Cushing, Oklahoma, the delivery point for West Texas
Intermediate oil futures, will be one such market. For years the
story has been one of a structural surplus: too little takeaway
capacity versus too many inbound pipelines. That made downward
moves in crude prices the only way to balance the market. Oil at
Cushing had to get cheap enough to stop anyone from sending more
and to spur the construction of new export lines.
That is no longer the case. With the expansion of the Seaway
pipeline to a nominal 400,000 barrels per day capacity, Cushing
is now in a structural deficit when refineries connected to the
hub operate normally. Since the system is not in equilibrium, it
is again price that will regulate the local market. But now the
price has to go up to kill off demand from regional refiners for
Already the balance at Cushing is not as favorable as it was
a year ago. Stockpiles at the hub are poised to drift lower
through the summer and with not one, but two major new pipelines
requiring perhaps 8 million barrels of linefill between November
and March 2014, the imbalance between inbound pipeline capacity
and outbound capacity is becoming acutely visible.
Those refineries like BP's 405,000 barrels per day Whiting,
Indiana plant, which are directly connected to Cushing but have
the option of sourcing oil from many different markets, will cut
their demand for Cushing barrels as margins erode.
But if the imbalance persists, the blow will fall hardest on
refineries that have no alternative supplies. The golden age of
the refinery next door to Cushing is at an end.
It's not just Cushing that is going into structural deficit.
A similar situation is brewing in the Permian Basin in West
Texas and the Eagle Ford shale in South Texas.
Although oil production in both areas is surging, it has
been at least temporarily eclipsed by the buildout of new
pipeline infrastructure, much of which steers crude away from
Cushing. Suddenly there is a surplus of pipeline capacity.
Don't take my word for it. Listen to the people building
Plains All American Pipeline LP, one of the oldest
and most market-savvy pipeline firms in North America, sees a
turn of the tables.
"We went through a period of time where we had a ramp up in
production and not enough capacity in either (the Permian or
Eagle Ford) areas ... In the next twelve months or so you are
going to see more pipeline capacity than production in both
those areas," Plains President Harry Pefanis said on a
conference call this week.
So what does this all mean? Generally a surplus of transport
capacity means producers can get the best possible price for
their product, so it means WTI, Permian Basin and Eagle Ford
crudes should rise in price relative to the rest of the market.
But here the importance of the contractual undertakings that
support the construction of new pipeline infrastructure cannot
be downplayed. Pipeline firms never build new facilities on a
speculative basis. A substantial amount of the capacity is
locked up under long-term contracts that oblige the shipper to
pay whether or not the line is used for a given period of time,
usually a number of years.
This upends the traditional arbitrage calculations. All
things being equal, if a refiner can buy a barrel of oil on his
or her doorstep for $100 the most this firm would pay for a
barrel at Cushing is $100 minus the cost of shipping between
Cushing and the refiner's doorstep.
So if the cost of shipping is $2 a barrel that makes the
Cushing equilibrium price $98 a barrel. Below this, every
refiner will try to buy up the Cushing crude, moving the price
upward. Above $98 a barrel no one will buy it, pulling the price
down to a level where purchases begin.
Take-or-pay arrangements are the financial equivalent of a
wormhole. Why? Because suddenly in a simple arbitrage the cost
of shipping becomes irrelevant. And therefore the Cushing price
becomes equivalent to the refiner's doorstep price, in our
Why is this? Say Cushing oil costs $100 and refiner's
doorstep oil costs $100. Because the refiner has already agreed
to pay the $2 shipping cost whether or not it uses the pipeline
from Cushing the effective cost of either barrel is $102 a
Now imagine the impact of the logic of take-or-pay economics
on a situation where there is a structural deficit of crude oil
supply. Facing mandatory shipping costs whether pipelines are
used or not, shippers will have an incentive to maximize
throughputs on the newest pipelines as long as destination
markets remain attractive.
So a surplus of pipeline capacity in the Permian basin
should encourage more and more Permian basin oil to flow away
from the older pipeline network that is not under long term
contracts and onto the newer pipelines to the Gulf Coast.
That is to say the new Permian pipelines will tend to
accelerate the deficit at Cushing by shifting oil flows away
from the older routes to Cushing and other markets in the U.S.
Midwest. Permian oil will flow to the Gulf Coast until the
Cushing price rises high enough to compensate sellers for the
cost of their take-or-pay contracts.
By the same token, the new pipelines at Cushing will tend to
pull oil down to the Gulf Coast at the expense of older routes
to the north.
And since long-term capacity agreements on some of these
major new pipelines, including Seaway at Cushing and the
Longhorn line out of the Permian basin, cover up to 90 percent
of the available space on these lines the pull away from
traditional markets will be very great.
These two facts alone portend a great shift in U.S. oil
markets this year. Those who have bet on the existing paradigm
remaining in place have the energy market equivalent of the
NEW SAFETY VALVES
The effect is a sudden reversal of fortune for many inland
oil refineries. These plants have enjoyed bumper profits at the
heart of the supply glut and will now be on the leading edge of
the erosion of refining margins needed to combat the pipeline
But the implications of these developments are not limited
to inland refiners. The rapid collapse of the Brent-WTI spread
has also greatly reduced the appeal of switching to discounted
light sweet crude for more complex refineries.
When light sweet crude was in abundance, the profits from
refining these barrels were so high that inefficiencies in
complex refineries, such as underutilization of conversion
units, could be easily ignored.
To a great degree, this advantage is being wiped out.
Heavier, more sour crudes are regaining competitiveness with
complex refineries. That takes the market back to the old game
of squeezing out advantages in refining one crude over another.
But the return to a more normal refining market also implies
a return to more normal trading. A more efficient pipeline
network means a more efficient market, and one far more complex
than many traders have contemplated in recent years.
Opportunities for arbitrage will be more quickly eroded by
nimble firms. Price swings will be less dramatic.
All this means it is probably also the end to the hard-core
directional trade on the spread between Brent and WTI. The easy
money has been made. Now for the grind.