Over the past couple of years, the sharp increase in crude oil stockpiles at the nation's main oil storage hub in Cushing, Okla., has been one of the most notable developments in the energy space. The glut at Cushing mainly reflects the rapid increase in domestic crude oil production and the inadequacy of existing pipeline infrastructure to alleviate it.
This combination of factors has contributed to the wide disparity between the price of domestic oil, whose main benchmark is West Texas Intermediate (WTI) and the price of global oil, whose benchmark is Brent. This price differential, as captured by the WTI-Brent spread, soared to more than $20 per barrel by December of last year – significantly higher than its five-year average – and continues to hover above this threshold.
Many energy analysts are arguing that this spread will narrow significantly by the end of the year, as new pipeline projects are brought on line to relieve the glut at Cushing. However, they may be underestimating the magnitude of U.S. oil production growth, or overestimating the effect of these new pipeline projects. Let's take a look at both factors.
U.S. oil production as strong as ever
One major reason to be skeptical of a sharp reduction in Cushing stockpiles is the fact that domestic oil production is as robust as ever and shows no signs of slowing down anytime soon. According to the U.S. Energy Information Administration, crude oil and condensate production averaged 6.4 million barrels per day last year, representing an 800,000 barrel per day increase from the year earlier. The agency projects further increases, forecasting domestic production to average 7.3 million barrels per day this year and 7.9 million barrels per day in 2014.
As more and more oil has been pumped out from "tight oil" plays in North Dakota and Texas, stockpiles at Cushing have risen sharply, surging from 29.3 million barrels to nearly 50 million barrels over the course of 2012. While they fell recently, they remain significantly above historical averages, standing strong at 50.7 million barrels as of the week ended Feb. 15.
But now, two major projects – the Seaway Pipeline expansion project and the Keystone XL Gulf Coast Extension project – planned for completion by the end of this year are expected to relieve the glut at Cushing. Together, they should add some 900,000 barrels per day of new capacity between Cushing and Houston, which analysts expect should contribute to a narrower spread between Brent and WTI. Let's take a look at both these projects.
The Seaway Pipeline, which is operated as a 50/50 joint venture between Enterprise Products Partners (NYSE:EPD) and Enbridge (NYSE:ENB), is the main channel for oil from Cushing to be moved south to Houston. After the direction of its flow was reversed in May of last year, Seaway's operators are planning on increasing the line's takeaway capacity substantially this year, from 150,000 barrels per day to 400,000 barrels per day.
However, the argument that this capacity boost will lead to a sharply lower WTI-Brent spread may have some flaws. First of all, many analysts made this exact same argument last year, when Seaway's flow was reversed. Some even argued that the spread would narrow to as little as $5 per barrel by year's end. Yet, contrary to their projections, the spread continued to widen as the year progressed, going from under $10 a barrel in June to over $20 a barrel by December, as Cushing stockpiles surged.
Secondly, if there's one thing you can count on when embarking upon such massive capital-intensive projects with so many moving parts, it's unexpected setbacks. Not surprisingly, Enterprise Products Partners recently announced that the Seaway expansion would have to be scaled back to 175,000 barrels per day, due to "unforeseen constraints" that have led the Jones Creek delivery point to reach maximum capacity.
To relieve the congestion, Enterprise will have to construct and complete a lateral pipeline from the Jones Creek delivery point to the Enterprise Crude Houston, or ECHO, crude oil terminal. As a result of congestion at the Houston end of the Seaway system, capacity may remain well below the initially targeted 400,000 barrels per day until late in the year. So that's one big reason right there why the WTI-Brent spread may remain wide throughout the year.
The Keystone XL Gulf Coast expansion
The second relief valve is expected to be the proposed Keystone XL Gulf Coast expansion project, which is operated by TransCanada (NYSE:TRP). The project consists of a 1,660-mile pipeline that will run from Alberta through Saskatchewan, Montana, South Dakota, and Nebraska and will end up at refining centers along the Texas Gulf Coast. As the name suggests, it is an extension of the current Keystone Pipeline system that went into service in June 2010 and transports Canadian crude to Midwestern markets.
TransCanada expects the Keystone XL and Gulf Coast Project to have a combined initial capacity of 700,000 barrels per day and a potential capacity of 830,000 barrels per day. However, the project isn't expected to be operational until late this year. In the most recent earnings conference call, TransCanada CEO Russell Girling said the project is 45% completed and should be in service late in 2013.
So it looks like the Keystone Gulf Coast expansion may have little impact on relieving swollen Cushing inventories this year. And as with Seaway, the possibility of setbacks that could postpone its completion shouldn't be taken lightly.
For instance, thousands of people are opposed to the project on environmental grounds. Girling acknowledged these activists in the conference call: "As many of you might be aware as well, many out-of-state sort of professional, or what we call activists, have done their best to slow down the project and stop our project, primarily in Texas."
These activists show no sign of relenting to oil companies' concerns, either. Last week, tens of thousands turned out at the National Mall, with many of them voicing their concerns about Keystone's greater greenhouse gas footprint and its impact on the environment. If the movement grows, it could pose a serious threat to the completion of TransCanada's ambitious project.
Given the combination of rapidly rising domestic oil production and the tenuous impact of the Seaway and Keystone expansion projects, there is a good chance that Cushing stockpiles may not decline as fast as some are expecting. Hence, there is also a good chance that the WTI-Brent spread remains in the $15-$20 per barrel range for the remainder of the year.
If this happens, it should mean the continuance of good times for refiners with access to cheap WTI. For the past couple of years, these refiners – most of them located in the Midwest – have benefited handsomely from the price disparity between WTI and Brent. Basically, they get to use the cheaper WTI as feedstock, while selling the refined product into global markets, where it fetches a higher price.
As a result, their margins have been more attractive than ever. For instance, per barrel gross refining margins for HollyFrontier, Marathon Petroleum, and Western Refining were among the highest in the industry last year, with all three benefiting from access to cost-advantaged inland crudes. If my theory plays out, margins at these companies should remain attractive for the rest of the year.