Energy Investing: Lessons from Cushing
One of the biggest stories in the energy patch last year was the deterioration of the longstanding price relationship between Brent crude oil and West Texas Intermediate (WTI) crude oil, the North American benchmark that underlies futures contracts traded on the New York Mercantile Exchange.
Of slightly higher quality that Brent crude oil, WTI historically has commanded a small premium to the European benchmark. But that relationship reversed in early 2011, when Brent crude oil began to trade at a substantial premium to WTI. Over the course of the year, the price gap widened to as much as $30 per barrel, though since late fall the difference has narrowed to roughly $10 per barrel.
Source: Bloomberg
In this week’s issue of The Energy Strategist, my colleague Elliott Gue laid out his 2012 forecast and called for Brent crude oil to trade at a roughly $10 premium to WTI for the foreseeable future. Although many commentators often attribute major shifts in oil prices to geopolitical risks–Iran’s recent rhetoric about closing the Strait of Hormuz is the latest example–the sudden reversal of the long-standing price relationship between WTI and Brent crude oil reflected domestic developments.
Local supply conditions in Cushing, Okla., the physical delivery point for WTI crude oil are the culprit. Pipelines transporting oil from the north into Cushing are running at full capacity, while the hub lacks sufficient infrastructure to transport this influx of oil to the refinery complex on the Gulf Coast. Much of the midstream infrastructure between the Gulf Coast and Cushing, Okla. flows northward.
Rapidly increasing oil production from unconventional plays such as the Bakken Shale of North Dakota and the Niobrara Shale in the Rockies have contributed to the glut of oil at Cushing. This upsurge in production from unconventional oil fields has been supported by the reversal of existing pipelines to transport crude oil south to Cushing. At the same time, the second phase of TransCanada’s (TSX: TRP, NYSE: TRP) controversial Keystone XL pipeline came onstream in February 2011, flooding Cushing with imported oil from Alberta, Canada.
This shift has not only glutted storage facilities at Cushing, but the reversed pipelines have limited flows out of the hub. When an influx of crude oil overwhelms refining capacity, stockpiles built up, and the price of WTI declined.
Refiners with substantial exposure to the Midcontinent region–Arkansas, Kansas, New Mexico and Texas–benefited immensely from the widening spread between WTI and most varietals of light, sweet crude oil. Able to purchase WTI at a substantial to discount and sell the refined products at full price, Midcontinent refiners such as CVR Energy (NYSE: CVI) and HollyFrontier Corp (NYSE: HFC) saw their gross margins shoot through the roof. CVR Energy’s first-quarter gross margins, for example, increased a whopping 996 percent from year-ago levels.
However, the outlook for Midcontinent refiners has dimmed somewhat in recent months, as the spread between WTI and Brent crude oil has narrowed. This declining price differential stems in part from a slight moderation in the price of Brent crude–a function of the resumption of Libyan oil exports, rising output from the North Sea and concerns that an EU recession will weigh on demand.
At the same time, oil inventories at the Cushing have also declined, as refineries have ramped up utilization rates and producers have engaged alternative means of transporting their oil to the Gulf Coast at considerable marginal expense. For example, oil shipped via railcar from the Bakken Shale to the Gulf Coast increased substantially in the back half of 2011, a trend that’s expected to continue into 2012. Meanwhile, some operators have engaged barges to ship oil stored at Cushing to the Gulf. This upsurge in business has been a boon to railroad and barge operators.
However, this logistical logjam can only be resolved by the construction of new pipelines to move crude oil from Cushing to the Gulf Coast, an area that’s home to about 30 percent of the nation’s refining capacity. WTI prices jumped in mid-November after Enbridge (TSX: ENB, NYSE: ENB) and Enterprise Products Partners LP (NYSE: EPD) announced that the two would invest about USD300 million to reverse the flow of the Seaway pipeline, which currently carries oil from the Gulf Coast to Cushing.
Work will begin once Enbridge’s acquisition of 50 percent stake in Seaway from ConocoPhillips (NYSE: COP) goes through. When Seaway comes onstream in the second quarter of 2012, the pipeline will be able to to transport 150,000 barrels of oil per day from the Midcontinent to the Gulf. A series of modifications to the pipeline would expand this capacity to 400,000 barrels of oil per day in 2013 and the partners recently announced an open season to gauge demand on a twin pipeline that would run alongside the Seaway, doubling its throughput capacity.
The developments in Cushing hold several important lessons for investors. First, the situation serves as a reminder that the dramatic increase in US oil and gas output from the nation’s shale fields necessitates a corresponding ramp up in midstream infrastructure, particularly in regions that traditionally haven’t produced hydrocarbons. Master limited partnerships (MLP), a tax advantaged structure that often pays above-average yields, will spearhead much of this investment.
We prefer established MLPs that already own extensive midstream assets, as these names can reduce construction costs by using existing infrastructure. Companies that provide compressors and other pipeline components also stand to benefit from the infrastructure boom.
At the same time, the capital-intensive nature of these construction projects and rising production from a host of emerging fields should lead to additional price imbalances that opportunistic investors can take advantage of via shorter-term trades.
Portfolio Roundup
In an encouraging sign for drilling activity in the Gulf of Mexico, Genesis Energy LP (NYSE: GEL) and Conservative Portfolio holding Enterprise Products Partners (NYSE: EPD) announced that their joint venture to build an oil-gathering pipeline that would support drilling in the Lucius development would proceed. The partners inked transportation agreements with a consortium of six producers. Genesis Energy and Enterprise Products Partners expect the pipeline to come onstream in mid-2014. Buy Enterprise Products Partners LP under 45.
Of slightly higher quality that Brent crude oil, WTI historically has commanded a small premium to the European benchmark. But that relationship reversed in early 2011, when Brent crude oil began to trade at a substantial premium to WTI. Over the course of the year, the price gap widened to as much as $30 per barrel, though since late fall the difference has narrowed to roughly $10 per barrel.
Source: Bloomberg
In this week’s issue of The Energy Strategist, my colleague Elliott Gue laid out his 2012 forecast and called for Brent crude oil to trade at a roughly $10 premium to WTI for the foreseeable future. Although many commentators often attribute major shifts in oil prices to geopolitical risks–Iran’s recent rhetoric about closing the Strait of Hormuz is the latest example–the sudden reversal of the long-standing price relationship between WTI and Brent crude oil reflected domestic developments.
Local supply conditions in Cushing, Okla., the physical delivery point for WTI crude oil are the culprit. Pipelines transporting oil from the north into Cushing are running at full capacity, while the hub lacks sufficient infrastructure to transport this influx of oil to the refinery complex on the Gulf Coast. Much of the midstream infrastructure between the Gulf Coast and Cushing, Okla. flows northward.
Rapidly increasing oil production from unconventional plays such as the Bakken Shale of North Dakota and the Niobrara Shale in the Rockies have contributed to the glut of oil at Cushing. This upsurge in production from unconventional oil fields has been supported by the reversal of existing pipelines to transport crude oil south to Cushing. At the same time, the second phase of TransCanada’s (TSX: TRP, NYSE: TRP) controversial Keystone XL pipeline came onstream in February 2011, flooding Cushing with imported oil from Alberta, Canada.
This shift has not only glutted storage facilities at Cushing, but the reversed pipelines have limited flows out of the hub. When an influx of crude oil overwhelms refining capacity, stockpiles built up, and the price of WTI declined.
Refiners with substantial exposure to the Midcontinent region–Arkansas, Kansas, New Mexico and Texas–benefited immensely from the widening spread between WTI and most varietals of light, sweet crude oil. Able to purchase WTI at a substantial to discount and sell the refined products at full price, Midcontinent refiners such as CVR Energy (NYSE: CVI) and HollyFrontier Corp (NYSE: HFC) saw their gross margins shoot through the roof. CVR Energy’s first-quarter gross margins, for example, increased a whopping 996 percent from year-ago levels.
However, the outlook for Midcontinent refiners has dimmed somewhat in recent months, as the spread between WTI and Brent crude oil has narrowed. This declining price differential stems in part from a slight moderation in the price of Brent crude–a function of the resumption of Libyan oil exports, rising output from the North Sea and concerns that an EU recession will weigh on demand.
At the same time, oil inventories at the Cushing have also declined, as refineries have ramped up utilization rates and producers have engaged alternative means of transporting their oil to the Gulf Coast at considerable marginal expense. For example, oil shipped via railcar from the Bakken Shale to the Gulf Coast increased substantially in the back half of 2011, a trend that’s expected to continue into 2012. Meanwhile, some operators have engaged barges to ship oil stored at Cushing to the Gulf. This upsurge in business has been a boon to railroad and barge operators.
However, this logistical logjam can only be resolved by the construction of new pipelines to move crude oil from Cushing to the Gulf Coast, an area that’s home to about 30 percent of the nation’s refining capacity. WTI prices jumped in mid-November after Enbridge (TSX: ENB, NYSE: ENB) and Enterprise Products Partners LP (NYSE: EPD) announced that the two would invest about USD300 million to reverse the flow of the Seaway pipeline, which currently carries oil from the Gulf Coast to Cushing.
Work will begin once Enbridge’s acquisition of 50 percent stake in Seaway from ConocoPhillips (NYSE: COP) goes through. When Seaway comes onstream in the second quarter of 2012, the pipeline will be able to to transport 150,000 barrels of oil per day from the Midcontinent to the Gulf. A series of modifications to the pipeline would expand this capacity to 400,000 barrels of oil per day in 2013 and the partners recently announced an open season to gauge demand on a twin pipeline that would run alongside the Seaway, doubling its throughput capacity.
The developments in Cushing hold several important lessons for investors. First, the situation serves as a reminder that the dramatic increase in US oil and gas output from the nation’s shale fields necessitates a corresponding ramp up in midstream infrastructure, particularly in regions that traditionally haven’t produced hydrocarbons. Master limited partnerships (MLP), a tax advantaged structure that often pays above-average yields, will spearhead much of this investment.
We prefer established MLPs that already own extensive midstream assets, as these names can reduce construction costs by using existing infrastructure. Companies that provide compressors and other pipeline components also stand to benefit from the infrastructure boom.
At the same time, the capital-intensive nature of these construction projects and rising production from a host of emerging fields should lead to additional price imbalances that opportunistic investors can take advantage of via shorter-term trades.
Portfolio Roundup
In an encouraging sign for drilling activity in the Gulf of Mexico, Genesis Energy LP (NYSE: GEL) and Conservative Portfolio holding Enterprise Products Partners (NYSE: EPD) announced that their joint venture to build an oil-gathering pipeline that would support drilling in the Lucius development would proceed. The partners inked transportation agreements with a consortium of six producers. Genesis Energy and Enterprise Products Partners expect the pipeline to come onstream in mid-2014. Buy Enterprise Products Partners LP under 45.
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