Oil spreads affecting producers’ decisions

A Stimulating Start

This is a legitimate argument and one that has to be looked at carefully. Effectively the producers worried about can be divided into two categories: those from the North (Canada and North Dakota) and those from the West (the Permian Basin in West Texas and New Mexico).  Look at both cases more closely. Worries about northern producers flooding Cushing ignore the current capacity limitations on pipelines to Cushing from northern markets. Even if Canadian or North Dakotan oil producers wanted to send oil to Cushing, there simply is not the southbound pipeline capacity available to do so. But even setting aside the availability of capacity on pipeline routes, it is far from clear the producers are poised to pump their crude to Cushing in place of other markets. While Canadian producers may be locked into their current markets by limited transportation infrastructure, the situation is different for Bakken producers in North Dakota. More oil is going to coastal markets via trains than on pipelines.

So the risk, in the north, is that producers currently shipping by rail opt instead to go to Cushing. This is the true effect of all the new crude by rail infrastructure in the United States. By giving Bakken producers access to Gulf Coast prices, they are effectively removed from the Cushing equation.

Using the Enbridge pipeline system would cost a North Dakota producer with access to the cheapest tariffs nearly $8 a barrel to move crude oil from the Bakken field to Cushing. In other words, the producer would receive a netback, the oil industry term for the value of oil after transport costs are deducted, of approximately $86 a barrel based on Thursday's settlement price for WTI. But even if rail costs to the Gulf Coast are double, what the pipeline costs to move oil to Cushing, a Bakken producer will still opt to move crude to the Gulf Coast.

Bakken crude at St James, Louisiana fetches prices similar to Light Louisiana Sweet LLS, which on Thursday closed near $105 a barrel, meaning a Bakken producer would get a netback of $89 a barrel, or $3 a barrel more than by shipping by pipeline at the best rates possible. Or put differently, it would not make sense for our hypothetical Bakken producer to ship oil to Cushing until WTI strengthened by at least $3 a barrel against world prices. And considering the fact that few producers or traders have confirmed capacity on the Enbridge system at the lowest tariffs all the way from North Dakota to Cushing, it is highly unlikely that a flood of Bakken barrels into Cushing will happen even if WTI does gain more than $3 a barrel against world prices.

Gulf Coast prices are the key. ”The foregoing analysis assumes a great deal. It assumes an inflexible (and probably too high) marginal cost for rail shipments. It assumes that all crudes are equal, which they are not. Even those that are roughly similar have different yields in different refineries. It also assumes that the market-clearing barrel is able to move on the pipeline at the cheapest possible rates, which is unlikely. Tariffs for uncommitted shippers on some systems are considerably higher than for committed shippers, so pipeline economics are likely less attractive than the example above. If so, the example understates the netback when shipping to the Gulf Coast and overstates it when selling on the inland market. And since the pipeline space into Cushing from the North is already full, the brunt of the impact from a stronger WTI price may fall on North Dakota oil producers who will have to accept lower wellhead values to keep rail economics working. But the critical assumption has been the resilience of Gulf Coast crude oil prices which have defied expectations of decoupling from the world market. A combination of infrastructure bottlenecks and much greater refinery flexibility than anticipated has helped keep Light Louisiana Sweet at a premium to Brent crude. With rail delivery terminals proliferating on both the East and West coasts this year, the pressure on the Gulf Coast from rail deliveries may abate, not increase.

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