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 end.
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 Cushing crude.
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 these pipelines.
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 example.
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 barrel.
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 Maginot Line.
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 glut.
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.