The U.S. oil infrastructure is the product of four decades of rising imports and falling domestic supply. As those trends have reversed over the last few years, America’s network of pipelines has failed to keep pace. Designed in part to ferry oil and refined gasoline from the coasts to the interior, those pipelines are now ill-equipped to handle the enormous amount of crude gushing from shale reserves in North Dakota and Texas. Which is why so much of that oil ends up trapped in the central Oklahoma town of Cushing, the primary crude oil storage hub for the U.S.
Cushing developed as an oil trading center and then as the official price settlement point for West Texas Intermediate, the benchmark that most types of North American crude are priced against. Cushing is now best known as a bottleneck for the energy industry: Oil rushes in, but trickles out. There are now more than 44 million barrels of oil stuck in Cushing, a record, and 60 percent more than was stored there just five months ago. Overall U.S. crude inventories now sit at a 21-year high.
Pipeline companies are racing to build new projects aimed at pushing more oil through Cushing toward refineries as part of a larger effort to revamp America’s oil infrastructure. The first of those projects goes online this week when the flow of the 500-mile Seaway pipeline is reversed. Seaway, with a diameter of 30 inches, was built in 1976 to take crude south from the Texas Gulf Coast north into Cushing. On May 17, about 150,000 barrels of oil will be injected into Seaway at Cushing. Twelve days later, that oil will start arriving in Freeport, Tex., along the Gulf Coast, where refiners can access it. As the pump stations provide more horsepower and increase the pipe’s pressure later this year, the oil will travel faster, taking just five days to reach Freeport and increasing Seaway’s capacity to 400,000 barrels per day by early 2013. By mid-2014, that flow is expected to reach 850,000 barrels a day.
By the end of 2013, TransCanada (TRP) should be finished building the $2.3 billion southern leg of its Keystone pipeline, extending from Cushing to refiners on the Texas Gulf Coast. By 2014, Canadian pipeline company Enbridge (ENB), a part owner of Seaway, plans to connect Cushing to a system of pipes that converge around Flanagan, Ill., southwest of Chicago, with its Flanagan South pipeline.
It’s difficult to predict what impact these pipeline projects will have on gasoline prices. The biggest effect will be to supply Gulf Coast refiners with more cheap domestic crude, which gets at the heart of what the Seaway reversal attempts to address. The glut at Cushing has created a large price spread between WTI and the international Brent benchmark, the world’s two most widely traded oil contracts. For years those contracts traded within $1-$2 of each other. Since 2011, though, WTI has traded well below Brent, by as much as $27. The spread is now just over $17.
This price differential has rippled through the domestic oil market, giving Midwestern refiners such as HollyFrontier (HFC) access to supercheap domestic crude, providing them some nice profits while their East Coast counterparts have been stuck taking delivery of more expensive Brent-priced oil from places such as Nigeria.
It’s also created a bizarre arbitrage opportunity that’s persisted far longer than most thought possible. Railroad traffic of crude oil has tripled over the last year. Midwestern trucking companies are in high demand as well. Yet when it comes to moving crude oil to refineries, pipelines are still by far the most efficient method.
With Seaway sending WTI oil south, analysts essentially break into two camps: those who think the pipeline reversal will go a long way toward squeezing that spread back to its historical norm, and those who think that ultimately the Cushing bottleneck will remain and that oil from Canada and the U.S. mid-continent will still have trouble finding its way to refiners and consumers. Energy analysts at Goldman Sachs (GS), led by David Greely, think that Seaway will narrow the spread to about $5 by the end of 2012. Another analyst, John Parry of IHS Herold (IHS), thinks the Seaway reversal will also get Brent and WTI to within $5 of each other, although not this year. Not everyone shares that view. “I would strongly advise not making too big a deal out of the Seaway pipeline,” says Tim Evans, an energy analyst at Citi Futures Perspective in New York, a Citigroup (C) unit. “The conclusion that the world has just changed because Seaway opened tends to be an oversimplification of what’s going on in the real world.”
As Seaway pushes more WTI-priced crude out of Cushing and to the Gulf Coast, refineries there should be able to reduce the amount of imported oil they buy, which in turn should free more international barrels of crude to flow to Europe and Asia, where inventories are much tighter than in the U.S. According to Tom Kloza, chief analyst at research firm Oil Price Information Service, giving Gulf Coast refiners more access to WTI could eventually lead to lower gasoline prices in the U.S. as more expensive types of crude that are priced along the Gulf have to compete with cheap WTI. Don’t look for that relief to hit anytime soon, though.
After a huge runup from October through mid-March, oil prices have tanked over the last month, with Brent prices falling by 10 percent and WTI by nearly 15 percent. Crude oil for June delivery traded around $94 per barrel Tuesday after settling on May 14 below $95, the first time since mid-December.
This decline has been accompanied—or perhaps partly driven—by an all-out rush for the door among oil speculators. Since mid-March, money managers have liquidated more than half their combined long position in oil futures contracts. As of May 11, speculators held a net long position of 250,364 contracts, or the equivalent of about 250 million barrels per day. “Managed money is heading for the hills,” says John Kilduff, a partner at Again Capital, a New York-based hedge fund that focuses on energy. “People are not wanting to be exposed to traditional safe havens like gold or oil; they want to be in cash.”
The general idea is that Seaway will put a floor under WTI prices and eventually raise them closer to Brent by making the crude more valuable. “As those barrels currently stuck at Cushing get liberated, they’re worth more,” Kilduff says. “Moving them from a bad neighborhood into a good neighborhood, where the market can actually use them, puts the WTI price more in line with the global market.”
As of May 15, futures contracts for WTI and Brent appeared headed in opposite directions, with the price of Brent falling by about $3 from June to November, and the price of WTI rising by more than a $1 during that same period. The result will be a smaller spread of about $13 by November 2012.
Still, as much as the Seaway pipeline might impact the situation, the fact is that oil markets are influenced more by what happens in places like Iran and Greece than along a 500-mile path from Oklahoma to the Texas Gulf Coast. Much of the oil market, says Evans, is “just a big wrestling match in the futures market.”
