Oil glut silences calls for US crude exports

Ignacio Sotolongo

18-Sep-2014

Crude oil glut silencing calls for US crude exportsFocus story by Ignacio Sotolongo

HOUSTON (ICIS)–The chorus of calls to end the longtime ban on US crude oil exports has quieted in recent weeks as crude prices have fallen precipitously due to a global oversupply.

Thanks to a wealth of oil production unlocked in recent years by the shale oil revolution, recent data from the Energy Information Administration (EIA) showed US crude oil production averaging 8.5m bbl/day, the highest level since 1987. In its monthly short-term energy outlook, the EIA expects production to average 9.3m bbl/day in 2015. By comparison, top global oil producer Saudi Arabia produces around 11.5m bbl/day.

There are two widely recognised global benchmarks for pricing crude oil production. In the US, West Texas Intermediate (WTI) light sweet crude trades as a commodity on the CME/NYMEX and can be delivered physically against the contracts at the Cushing, Oklahoma, hub. Global benchmark Brent trades as a commodity on the Intercontinental Exchange (ICE) but there is no physical delivery mechanism against the contracts.

On Thursday, WTI for October delivery settled at $93.07/bbl, while Brent for November delivery settled at $97.70/bbl. Both benchmarks are more than 10% below their summer high water marks, when WTI topped out at $107/bbl and Brent touched above the $115/bbl level in June.

In 2008, WTI hit an all-time high above $145/bbl as the theory of peak oil gained popularity on the theory that global crude supplies were declining sharply. But just a few months later, prices plunged towards $30/bbl as the 2008-09 global financial crisis took its toll on demand destruction. Eventually WTI recovered towards $90/bbl due to the continuing dependence on expensive foreign imports and continued to creep upwards on the back of demand from China and geopolitical events.

Then came an unexpected renaissance. Thanks to the shale revolution in North America, oil and natural gas production from the various unconventional formations contributed to make the US, if not energy independent, at least energy secure by cutting down foreign crude imports to just over 7m bbl/day from about 14m bbl/day in 2005.

Canada has been the top foreign crude supplier to the US, exporting close to 3m bbl/day, while Mexico and Saudi Arabia have been leapfrogging each other for second place, each averaging 800,000 bbl/day and maintaining their market share. Eventually, the biggest losers turned out to be west African, South American and Middle Eastern OPEC producers who have found their product displaced by US shale oil.

Overwhelmed logistics
Getting the shale production to market became a logistical problem since, historically, the US pipeline system ran south to north in order to move foreign barrels from ports along the Gulf coast to mid-continent refiners. A major realignment had to take place in order to accommodate the rise in domestic production as well as Canadian imports moving south.

Most of the new oil being produced, the Canadian imports and other foreign barrels moving north created a bottleneck at the Cushing NYMEX delivery hub, and inventories rose to around 50m bbl at one point due to insufficient infrastructure to move the material down to Gulf coast refiners or to the western and eastern US coasts.

The Cushing bottleneck took a toll on the price of WTI, and it started to trade at a steep discount to Brent. A wide, negative trans-Atlantic arbitrage made foreign barrels extremely expensive to coastal refiners, while end-users in the US Midwest enjoyed the attractively priced discounted Cushing barrels.

Canadian production, unable to be traded in the open market due to the single destination, failed to capture the economics of the wide Brent-WTI arb. Every Canadian barrel sold into the US left a substantial amount on the table.

Of the major unconventional liquid plays, the Bakken in North Dakota and southern Canada and the Eagle Ford in south Texas are the better known and could be considered kings, while the less publicised – although older and becoming new again – Permian Basin in west Texas and New Mexico is extending its claim to the throne, with recent production recorded at around 1.7m bbl/day.

As foreign imports declined and practically stopped moving north from the Gulf coast, various operating pipelines were reversed and expanded to move the material south. New pipeline projects, too many to enumerate, went into service, and many more are seeking regulatory approval.

There are two main pipeline systems exporting Canadian crude into the US. Because they cross an international border, they required approval from the US State Department.

Enbridge’s main line runs through Clearbrook, Minnesota, to Flanagan, Illinois. An extension, Flanagan South to Cushing, is being completed and about to become operational. It is expected to connect with the lines going south.

TransCanada’s original Keystone Pipeline moves barrels all the way to the Cushing hub. A southern leg to the Gulf coast, which did not require government approval, recently became operational.

A proposed third line, TransCanada’s Keystone XL, remains held up by politics and environmental issues despite at least one completed impact study by the US State Department.

In 2012, the reversed Seaway Pipeline, a project of Enterprise Products, began moving crude oil from Cushing down to Gulf coast terminals, and the capacity was recently expanded by Seaway Twin.

Rising production in some areas as a result of innovation and advanced technology overwhelmed the existing infrastructure because of the lack of take-away capacity, and new ways of getting the oil to the market had to be devised.

Crude-by-rail transport distribution businesses, although more expensive than pipeline tariffs, were developed and expanded as an alternative to pipeline capacity constraints to meet the growing demand, mainly to the east and west coasts.

The Eagle Ford production in south Texas, which is mainly extremely light condensate, moves by pipeline to refineries in the Corpus Christi, Texas, area or can be transported by barges or small tankers to refineries in the upper Gulf coast or to the east coast.

Among other crude oil hubs, Hardisty, Alberta, in Canada is the centre for pipelines and railcars (700 bbl/car) for export to the US while waiting for a decision on Keystone XL, and also to move the material to eastern Canada.

The advent of new logistics patterns caused crude oil inventories at Cushing to eventually decline sharply as barrels moved to the coasts and pipelines from the Permian Basin bypassed the hub. But the supply simply relocated to the Gulf coast, and at one point the region was referred to as Cushing South as oil was moved down for refining.

As a result, the US is now a net exporter of refined products, mainly from the Gulf coast where close to 50% of the country’s refining capacity is located. Export volumes can vary by season and geographical region depending on supply and demand. EIA data shows the US exporting more than 4m bbl/day of petroleum products, with distillate fuels averaging 1m bbl/day and gasoline exports averaging 550,000 bbl/day. Most of this material is heading to South America and Europe, taking advantage of the economics.

With the US awash in oil to the point of it becoming discounted to global benchmark Brent, the calls began from some producers and politicians for the lifting of the longtime ban on crude oil exports of domestic production.

Commenting on the shift, Karl Bartholomew, vice president of ICIS Consulting, stated: “Since it is entirely possible that North America [Canada, Mexico and the US] could become energy secure, if not independent, this has created a chorus for exporting some of the oil.  Similar to the scene playing out with natural gas and [liquefied natural gas] exports, upstream companies want to maximise their return by being able to export crude oil, while downstream consumers [refiners] do not want to see domestic oil prices go from advantaged discounts to reaching closer parity with global crude markets.”

Following the Arab oil embargo of 1973, the US Congress enacted a ban to prevent the export of domestic production. Also, the Jones Act of the Merchant Marine Act of 1920 regulates shipping and requires domestic crude and refined products, or any other goods, to move between US ports by American-flagged vessels.

It must be noted that crude oil exports to Canada are not affected by under the crude oil export ban, and some small cargoes are sent regularly to refineries there.

The US Commerce Department stirred the pot earlier this year by granting permits for two companies to export condensate, the extremely light type of crude, if the material is processed through a stabiliser and not through a splitter or a refinery distillation tower in order to qualify as a refined product.

This created some confusion about the definition of crude oil but also raised the industry’s expectations that the ban to export crude oil would be lifted. The issue of permits for condensates, however, slowed down after the initial euphoria.

The rapid expansion in US and Canadian oil production amid an infrastructure not immediately able to move it effectively, as well as lacklustre demand for refined products in the US, top global consumer, led to WTI trading at a steep discount to Brent since WTI could not be exported globally.

WTI started trading at a discount to Brent in 2010 and has not reached parity since. Brent soared to as high as a $27/bbl premium to WTI in 2011 and for much of 2012 and 2013 stayed at a significantly higher level than WTI.

The premium and the rising crude production helped lead to the chorus of calls for US crude exports to global markets, but 2014 has seen a steady decline in that premium as Brent has fallen faster than WTI. The spread between the grades now is just above the $4/bbl mark on the current front-month contracts (above $5/bbl on comparable November contracts) and not nearly as enticing to prospective US crude exporters as in recent years.

The premium has narrowed and benchmark prices have fallen despite the US economy picking up steam and geopolitical issues that in years past have triggered increases in both.

WTI Brent prices

Mixed global economic indicators
Despite mixed economic data constantly being released in the US, the overall sentiment is that the economy is gaining traction and will provide underlying support to energy demand.

In the currency markets, the dollar has strengthened against a basket of currencies, impacting crude oil prices negatively. Actions by the US Federal Reserve and European central banks in an attempt to promote economic activity are closely being watched and could influence global equities and financial markets, as well as the crude oil markets.

Elsewhere in the world, the situation has not been as rosy, with the eurozone still struggling and several refineries there shut down due to poor profit margins and falling demand.

While the boom in shale oil production in the US has been remarkable, the steep fall in energy demand in Europe and Asia in recent months was unexpected.

The reduction in foreign sales to the US has also forced international producers to find other outlets for their oil.

Mixed economic data emerging from China, the world’s second largest energy consumer, has also disappointed.

Negotiations have stalled between Iran and the West over the country’s nuclear programme. If successful, these negotiations could ease sanctions against the Middle Eastern oil producer.

In the recently issued Monthly Oil Market Report, the Paris-based International Energy Agency (IEA) cut its forecast for the rise in global petroleum demand for a third month in a row and also lowered the estimate for demand from OPEC.

With the US beginning to take a comfortable position as a swing producer, geopolitical conflicts in key oil producers Iraq and Libya and sanctions against Russia over tensions in Ukraine have failed to provide the expected price support. An oil glut is being reported in the Atlantic basin.

Supply picture trumps geopolitics
Global benchmark Brent’s rise to about $117/bbl in June was in response to the Islamist insurgency in Iraq taking various oilfields and the country’s largest refinery, but the gains failed to hold. Recently, front-month Brent fell below the psychological $100.00/bbl barrier to hit two-year lows after Iraq’s infrastructure and oil exports were not affected.

Brent’s weakness has resulted in a contango market for the benchmark – or front-to-back weakness – where forward prices are higher than spot and the resulting time-spread is wide enough to encourage carrying inventory to be sold at a higher price in the future.

While also on a downward trajectory of late, WTI has remained in backwardation – front-to-back strength – on future contracts. While the negative trans-Atlantic arbitrage has narrowed substantially, making transportation economics work going the other way, potential sellers of domestic barrels may have to discount the oil substantially in order to find interested buyers.

In a recent conversation with ICIS, Manuel D’Ambrosi, commercial advisor to Pacific Rubiales, noted that a lot of the physical oil being bought has been placed into storage rather than used for refinery supplies.

“It is estimated that about 50m barrels have gone into floating storage or placed in tanks at Saldanha bay in South Africa,” he said.

News service Reuters recently reported that Chinese traders have taken long positions in Russian crude oil and Unipec had chartered a supertanker off Singapore that could store as much as 3.2m bbl until market economics improve.

The insurgency in various parts of the Middle East has failed to strengthen prices and in some instances poured more oil into the open market. In Iraq, the Kurds have been selling crude oil cargoes, bypassing the central government. Even though Libya is showing signs of falling apart, the rebels have also been bypassing what is left of the central government and selling crude oil in the open market.

The Islamic State (IS) which overran a number of oil producing fields in Iraq, as well as the country’s largest refinery, did not attempt to cause damage to the infrastructure, perhaps on expectations to generate revenue, suggesting that in these cases, religious ideology can take a back seat to greed.

Meanwhile, ICIS consultants expect that seasonal US refinery maintenance in the autumn could take between 1m-2m bbl/day of capacity down for a period of time, backing out crude and possibly adding to the market supply glut.

The chorus to export US production, other than to Canada, has quieted down since the domestic production will have to compete in the global markets in an oversupply situation.

Producers may have to discount their oil substantially from what WTI is commanding at Cushing in order to find interested buyers overseas.

Despite the reduced dependence on foreign oil and the US competitive position, WTI will remain a global commodity, responding to volatility in global supply and demand as well as geopolitical crisis which could trigger an unexpected spike in prices regardless of the geographical location.

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