Yesterday the folks at Raymond James issued a great research piece titled “Hell Brent and Gulf Coast Bound, WTI Discount's Here to Stay”. Got to love those RJ titles. We won’t get into their numbers or the details of their analysis, but three of their points I’ll summarize here.
1) Don’t expect that the historical relationship of WTI over Brent, or even parity to Brent will return in a long, long time - if ever. The huge growth in U.S. light-sweet crude oil production plus anticipated increases in heavy crude imports from Canada will continue to put pressure on Midcontinent prices in general, and WTI/Cushing in particular. Yes new pipeline and rail facilities will provide capacity to move surplus barrels to the Gulf, and that will relieve that downward price pressure. But the relief won’t last long, because production is growing faster than new pipe + rail capacity. Not long after new facilities go into service, the capacity will be full and then the downward price pressure will reappear.
2) That translates to cyclical volatility in the Brent-WTI differential, similar to the cycles of basis volatility that we saw in the natural gas market as all the new pipelines were being built during the 2008-10 timeframe. Basis would widen as production increased, narrow when a new pipe went into service, widen again as production continued to grow, then narrow again as more pipeline capacity was completed. As with gas, it will take years for things to settle out in the crude market.
3) Even after the big new pipeline projects are completed to move Cushing barrels to the Gulf in 2013-14 (the Seaway expansion up to 850 Mb/d announced yesterday, plus the southern leg of Keystone XL at 700 Mb/d), the positive Brent vs. WTI differential still does not go away. It just shifts the oversupply of light-sweet crude from the Midcontinent to the Gulf, putting downward pressure on light-sweet crudes along the coast, including LLS at St. James. RJ calls this a ‘double discount’ of WTI vs. Brent.
Let’s explore this one in a little more detail, and I’ll give my take on some of the market implications. First some numbers.
Yesterday CME/NYMEX WTI for May was up 30 cnts/bbl to $107.33/bbl. Dated Brent was about $125/bbl, yielding a differential of just under $18/bbl. But LLS was higher still at about $127.60/Bbl – a $2.60/bbl positive differential to Brent and more than $20.00/bbl above WTI.
As noted here by Sandy Felden in You’ve got to know when to hold ‘em, know when to fold ‘em, LLS has historically been priced above Brent, reflecting at least the cost of delivering Brent crude to U.S. coastal refineries and some quality considerations. Even though little Brent moves to the U.S. today, light-sweet West Africa crudes pegged to Brent are still imported into the U.S. Gulf, and only move here because the USGC price justifies the cost of tanker transportation to get here. Thus the prices of light-sweet crude oils that move to the Gulf justify the cost of transporting those barrels to the Gulf.
But what if light-sweet waterborne imports are no longer required in U.S. Gulf refineries? That’s exactly what is likely to happen when the full blown Keystone and Seaway capacity comes online. Growing light-sweet volumes from the Bakken, Niobrara and other Midcontinent plays will be joined by the astronomical growth from the Eagle Ford to back out the need for light-sweet imports. Just about everyone’s U.S. crude production forecast predicts that outcome. When it happens, a positive LLS to Brent price differential will no longer be either necessary or justified. The U.S. will be providing all the light-sweet crude needed by Gulf Coast refineries. That will allow the relative decline of light-sweet crude prices along the Gulf, resulting in a narrowing of the LLS-to-WTI differential.
For you seasoned natural gas people, think of what happened when all the west-to-east pipeline projects like REX, Gulf South, Centerpoint, Gulf Crossing, Midcontinent Express, etc. were completed in the 2008-10 timeframe. It flattened the east-to-west basis, but at the same time crushed the price at Henry. The same thing is happening in the crude market except that it is north-to-south pipeline projects that will crush the price at St. James. The general rule: When you build a pipe from A to B, the differential between A and B narrows. But if the market at B becomes oversupplied, the overall level of prices declines. To belabor this point, in today’s crude market A=Cushing, B=Gulf Coast. The implication – light-sweet crude oil prices in the U.S. Gulf market will be below world price levels -- a very good thing for the economy and the economic viability of Gulf Coast refineries.
How far does this go? Surely this does not mean that crude prices are going to go the way of gas prices. No, because the U.S. will continue to import medium and heavy grades of crude from the global market, and those prices will continue to set marginal refinery input prices and thus the prices of petroleum products. At least for the next five years or so.
But you can build a production growth scenario where the U.S. + Canada could become essentially self-sufficient in crude oil supply of all grades in the next 6-7 years. (Assuming, of course, that governments don’t sc*&w it up). If that were to happen, it would theoretically be possible for crude prices in North America to disconnect from world crude markets. Probably not completely, but at least partially. And that would be a radically different world than we’ve known since the early 1970s. In that case we would really neither need it, nor want it.
