June 11, 2018, by Liam Denning
Energy dominance carries its own backlash, it turns out. Ground zero is the Permian basin in west Texas, where oil production has run ahead of pipeline capacity to get it to market, forcing some U.S. barrels to price at wide discounts. Thankfully, new pipelines should fix the problem by early 2020.
Apparently, though, the futures market is less convinced about that last bit.
This looks odd. There is about 3.1 million barrels-a-day of pipeline capacity to take crude oil out of the Permian basin versus production of about 3.3 million a day, according to Bloomberg Intelligence. Hence the problem. By early 2020, though, new pipelines should raise that capacity to around 5 million barrels a day. Even allowing for continued growth in output, that sounds like more than enough to let barrels flow and narrow those spreads.
The first thing to note is that futures are notoriously bad predictors of, well, the future. They’re for hedging, not scrying. And as I wrote here, while the volume of trading in oil futures has shot up in recent years, much of that reflects algos playing the near end of the curve – which has had the effect of pushing some specialist hedge funds out.
In that context, the latest blow-out in spreads between West Texas Intermediate and Brent prices looks a bit suspect. They have blown out far more in the past, such as in 2011. But those dislocations were mostly confined to near-term futures, which makes sense because they were perceived to be temporary ahead of, say, new infrastructure alleviating bottlenecks. Looking at spreads between contracts for one, 12, 24 and 36 months out, variation between the four pairs was wide in those earlier dislocations, with a standard deviation of typically 5 percentage points or more . That isn’t the case now, despite a similar expectation of new pipelines coming, with the standard deviation at less than 1 percentage point.
All of which is to say that those signals from the less-liquid, further reaches of the curve may well be a bit hazy. In which case, long-dated WTI looks underpriced relative to Brent, and the discount post-2019 ought to be more like $4 a barrel, not $8 or $9.
That no-one seems to be diving on that apparently free profit may be because of simple skepticism: After all, construction schedules don’t always run on schedule. Somehow, though, it’s tough to see new pipelines facing many delays in Texas in the middle of a production boom.
More likely, it reflects a mixture of those thin markets and some real potential wrinkles on the logistical side.
For example, while new pipes should alleviate the build-up of oil inland, that won’t solve the problem fully if more bottlenecks emerge at the coast. Peter Pulikkan of Bloomberg Intelligence highlights the risk of oil from the Permian basin and elsewhere inland barreling into storage and loading constraints at ports on the Gulf Coast. Right now, he estimates there’s effective export capacity of about 2 million barrels a day at those ports versus current crude oil exports of about 1.6 million barrels a day. More capacity is being built, including a major expansion at Corpus Christi, and other analysts estimate constraints wouldn’t emerge until exports hit something like 3 million barrels a day or more. Still, this presents a known unknown that could keep spreads wider for longer.
Another debate within the market concerns the battle between the relatively light crude coming from extra Permian production and heavier barrels such as those from Canada. The latter are often preferred by refiners on the Gulf Coast because they are cheaper and, as RBC Capital Markets points out in a recent report, they are now helping to fill the gap left as Venezuela struggles to export its heavier barrels. Moreover, these barrels yield more low-sulfur distillates when run through those refineries, which will be in high demand from 2020 due to tightening emissions standards for ships. While international demand for lighter barrels from the Permian will likely be robust, they could well be competing with heavier ones for space on pipelines to the coast. It’s possible that, as happened last year, barrels unable to reach the coast build up at the Cushing, Oklahoma, hub instead, depressing WTI prices.
The clear lesson of the past few years is that the Gulf Coast’s re-emergence as a major oil-trading hub has caught people out repeatedly, as those almost annual blow-outs in spreads attest. The current episode looks unusually extended. But with constraints set to remain acute for many months yet, and the curve moving with such coordination, betting on reversion is risky. Energy dominance, for the market at least, is very much a work in progress.