oil price differentials

7/31/2019 Oil Price Differentials

1/7

Published on Casey Research (http://www.caseyresearch.com)

Home > Oil Price Differentials: Caught Between the Sands and the Pipelines

Oil Price Differentials: Caught Betweenthe Sands and the Pipelines

Marin KatusaJune 20, 2012 1:45pm GMT

By Marin Katusa, Casey Research

One of oil's most important characteristics is its fungibility, which means that a barrel ofrefined oil from Texas is equivalent to one from Saudi Arabia or Nigeria or anywhere

else in the world. The global oil machine is built upon this premise tankers take oilwherever it is needed, and one country pays almost the same as the next for this

valuable commodity.

Well, that's true aside from two factors that can render this equivalency void. In fact,crude oil prices range a fair bit according to the quality of the crude and the challenge

of moving it from wellhead to refinery. Those factors are currently wreaking havoc onoil prices in North America: a range of oil qualities and a raft of infrastructure issues are

creating record price differentials. And with no solution in sight, we think thosedifferentials are here to stay.

The Parameters of Pricing

The first factor in oil pricing is quality. The best kind of crude is light and sweet: "light"means its hydrocarbon molecules average on the small side within the oil range; and"sweet" means it does not contain much sulfur. Light, sweet crudes are the easiest torefine into petroleum products, which makes them more desirable than heavy, sourcrudes.

No two reservoirs produce identical oil, though reservoirs in the same region oftenproduce similar crudes. For example, conventional oils from Texas are generally lighterand sweeter than the crudes that make up the European benchmark Brent blend; thisis why West Texas Intermediate crude oil carried a premium over Brent crude foryears. Similarly, Bonny Light oil from Nigeria is a bit heavier and sourer than Algeria's

Saharan Blend and therefore receives a slight price discount.

But wait, you say isn't Brent more expensive than WTI? Yes, today it is. This graphshows the two prices' movements over the last 25 years.

Page 1 of 7Oil Price Differentials: Caught Between the Sands and the Pipelines

2012/06/21http://www.caseyresearch.com/print/36435?ppref=CRX455ED0612A


2/7

(Click on image to enlarge)

For most of the graph the prices track very closely, with the green WTI line sitting justabove the black Brent line. Then, in the second half of 2010, the relationship starts toshift: WTI prices started to lose ground against Brent. The differential was only a dollarin November 2010, but by September 2011 Brent crude was worth US$27.31 or 32%more than WTI. The differential narrowed in December but has recently opened upagain, with the spot price of Brent closing US$13.88 above that of WTI yesterday.

The characteristics of WTI and Brent crude oils did not change during 2010, so thepricing reversal must have stemmed from the other factor that impacts crude-oil prices:infrastructure. More specifically, WTI prices started to slide because of a lack ofinfrastructure.

North America's Fantastically Flawed System

North America has a long history of oil production and processing. Decades ofproducing oil and consuming lots of petroleum products have left the continent with apretty good system of pipelines and refineries but pipelines are annoyingly stagnant

things that tend to stay where you build them. And it turns out that the pipelines ofyesterday are in the wrong places to serve the oil fields and refineries of today.

America's oil infrastructure was built around two inputs some domestic productionand large volumes of imports. You see, while the Middle East may be the biggestproducer of crude oil in the world, most of the refining occurs in the United States,Europe, and Asia. There are two reasons for this. The first is that it's easier to shipmassive volumes of one product (crude oil) than smaller volumes of multiple products(gasoline, diesel, jet fuel, and so on). The second reason is that refineries are generallybuilt within the regions they serve, so that each facility can be tailored to produce theright kinds and amounts of petroleum products for its customers.




3/7

During World War II, the US War Department (now the Department of Defense) divided

the United States into five regions to facilitate oil allocation. The regions were called"Petroleum Administration for Defense Districts," or PADDs.

The United States is split into five oil districts to help with regional administration of acrucial asset.

Thanks to the US EIA for the map.

Today, refineries in PADD I on the East Coast process oil shipped to the district'sAtlantic ports from all over the world. Its refineries produce enough petroleum products

to meet about one-third of regional demand; the rest comes from imports of refinedproducts, primarily from the Gulf Coast but also from Europe. PADD V, on the WestCoast, processes domestic oil from California and Alaska, as well as imported oil.

While the East- and West-Coast PADDs are not connected to the rest of the crude oilsystem, PADDs II, III, and IV have become very interdependent. PADD III, on the GulfCoast, has more refining capacity than anywhere in the world and accounts for 45% oftotal US capacity, with 45 refineries processing more than 8 million barrels of oil perday from countries like Mexico and Venezuela as well as domestic sources. Refineries

in the Midwest and California push the US's total refining capacity to 18 million barrelsof oil a day.

While domestic production has always helped meet the US's oil needs, imported oilhas long ruled the day. The US has relied on imported oil so heavily for so long that the

country's oil infrastructure is built primarily around refining imported oil and thenmoving refined products gasoline and diesel and the like north, from the Gulf Coastto the Midwest, or inland, from refineries on the coasts to customers in the interior.

It was not, it is important to note, designed to move oil from the interior of the country torefineries. But that is what is needed today.

Oil's a-Flowing, But with Nowhere to Go

North American oil production is on the rise in a serious way, and there are two primeculprits: the Bakken shale and the oil sands.

The Bakken shale formation underlying North Dakota gets most of the credit for theresurgence in US domestic output, though some of the shales in Texas are alsocontributing notably. Production in the Bakken is so booming that North Dakota's crude




4/7

output topped half a million barrels a day for the first time in November, up from just

300,000 bpd in 2010. The state is on track to surpass both California (539,000 bpd)and Alaska (555,000 bpd) this year to become the number-two oil-producing state in

the United States.

Oil from the Bakken is generally mid-weight and fairly sweet. Ideally it should stay inthe Midwest, because the refineries around Cushing are still designed to process light

sweet oil. However, the other area where North American oil production is boomingproduces just the opposite. In fact, oil from the Canadian oil sands is so heavy that it

has earned a distinct moniker: "bitumen." And there is a tsunami of bitumen on theway. The two million bpd being produced in the oil sands today is set to increase 50%in just the next three years.

However, Canada's oil sands are not the only place in the world producing heavy oil. Ingeneral, global production is gradually moving towards heavier, sourer crudes because

the easy deposits of light, sweet crude are being tapped out. And that has forcedrefineries to evolve.

A refinery designed to handle light, sweet WTI crude cannot switch to heavy, sour oil

sand bitumen without some serious upgrades. To that end, US refineries have investedbillions in upgrades over the last decade to enable them to process heavy oil. The

catch is, now the refinery army along the Gulf Coast needs heavy oil just as theycouldn't easily switch from light to heavy, they can't switch from heavy back to light.

The obvious source is the oil sands. It's a win-win: Oil-sands producers want to get

their oil to suitable refineries, and the heavy oil refiners on the Gulf Coast wantCanadian crude, because without access to bitumen they are being forced to pay apremium for to secure heavy oil supplies from Venezuela.

But that potential win-win is instead a losing predicament for all, because the pipelinesto move that oil simply don't exist.

Remember how the US's oil pipelines were designed primarily to move refinedproducts from the Gulf region and the coastal refineries to inland customers? Well,those pipelines of yesterday now run the wrong way. Today what North America's oil

machine needs are pipelines running from the oil sands to the Gulf Coast. At themoment there is just enough capacity to get bitumenpartwaythere it gets to

Cushing, the oil hub. And then it gets stuck.




5/7

This chart tells the story perfectly. The vast majority of Canada's bitumen is ending upin PADD II in Cushing where it simply sits in tanks because there is no heavy oilrefining capacity in the Midwest, and there is very limited pipeline capacity to move oilsouth.

Cushing is overwhelmed. The storage tanks at Cushing are at record levels, housingno less than 46.7 million barrels of oil. The recent reversal of the Seaway pipeline ishelping Seaway used to move refined products north from the Gulf Coast but hasnow been flipped to carry oil south. It is currently moving some 150,000 barrels of oil aday; volumes are expected to rise through the year to reach 400,000 bpd by early2013. The pipeline's owners would ideally like to twin the pipe, but regulatoryproceedings for that project are not yet under way.

The much-debated Keystone XL pipeline will also help. While routing and approval forthe northern section of the pipeline are still under debate, construction of the southernleg of the project, running from Cushing to the Gulf Coast, is set to begin this summer.It could be operational before the end of next year.

But even with Seaway reversed and Keystone XL's southern leg in place, the glut of oilat Cushing will continue to grow. Production from the oil sands and the Bakken issimply growing too quickly for infrastructure to keep up. And when oil becomeslandlocked, it loses that key characteristic fungibility that helps make it so valuable.

North American Oil Differentials: Here to Stay

With so much supply landlocked, Canadian oil prices are taking a serious hit. Thebenchmark price for Canadian heavy oil is Western Canada Select (WCS), which iscurrently trading at just US$59.33 per barrel. By contrast, WTI is priced at US$82.70,which means the differential is a whopping US$23.37 per barrel, or 28% higher.




6/7

(Click on image to enlarge)

Even Canadian synthetic a partially upgraded bitumen product that has historicallycarried a premium to WTI is trading at a discount to its American peer: Canadiansynthetic is at US$79.13 per barrel.

It's a double-whammy differential: Canadian oil is heavy, which discounts its price; andthe system to move it to suitable refineries is clogged up, creating another discount.

Neither of those situations is going to change any time soon, and that means oil-sandsprojects may soon be on the chopping block.

The oil sands is one of the costliest oil regions in the world to develop; and with WCSprices so low, the economics behind many new oil-sands projects have become prettyweak. New oil-sands mines require a price of around US$80 per barrel to break even.If an upgrader is part of the plans, that break-even price rises to almost US$100. In-situprojects, which use wells and underground steam injection to extract oil from the sandsin place, usually carry a break-even price near US$60 per barrel.

But even with some projects postponed and others slowed, bitumen production is still

expected to climb rapidly. Estimates range, but most observers agree that it is likely theoil sands will be producing close to 2.7 million barrels a day by 2016, up from 1.6million bpd last year.

That kind of investment means that every time new pipeline and refining capacity isbuilt, supply will catch up and the system will remain chockablock. And that means thedifferential between Canadian and US oil prices is settling in for a long stay. There areways to benefit from this differential, but given the complexity of the situation, onlyinformed investors will be able to take advantage.

You can't afford not to be an informed investor, as a new cold war centered on

valuable but dwindling energy resources is heating up. Learn how to play it formaximum profit potential.




7/7

The Casey Research web site, Casey's Investment Alert, Casey's International Speculator, BIG GOLD,Casey's Energy Confidential, Casey's Energy Report, Casey's Energy Opportunities, The Casey Report,Casey's Extraordinary Technology, Conversations With Casey, Casey's Daily Dispatch and Ed Steer's

Gold & Silver Daily are published by Casey Research, LLC. Information contained in such publications isobtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The informationcontained in such publications is not intended to constitute individual investment advice and is not

designed to meet your personal financial situation. The opinions expressed in such publications arethose of the publisher and are subject to change without notice. The information in such publicationsmay become outdated and there is no obligation to update any such information.

Doug Casey, Casey Research, LLC, Casey Early Opportunity Resource Fund, LLC and other entities inwhich he has an interest, employees, officers, family, and associates may from time to time have

positions in the securities or commodities covered in these publications or web site. Corporate policiesare in effect that attempt to avoid potential conflicts of interest and resolve conflicts of interest that doarise in a timely fashion.

Any Casey publication or web site and its content and images, as well as all copyright, trademark andother rights therein, are owned by Casey Research, LLC. No portion of any Casey publication or web

site may be extracted or reproduced without permission of Casey Research, LLC. Nothing containedherein shall be construed as conferring any license or right under any copyright, trademark or other rightof Casey Research, LLC. Unauthorized use, reproduction or rebroadcast of any content of any Casey

publication or web site, including communicating investment recommendations in such publication orweb site to non-subscribers in any manner, is prohibited and shall be considered an infringement and/ormisappropriation of the proprietary rights of Casey Research, LLC.

Casey Research, LLC reserves the right to cancel any subscription at any time, and if it does so it willpromptly refund to the subscriber the amount of the subscription payment previously received relating to

the remaining subscription period. Cancellation of a subscription may result from any unauthorized useor reproduction or rebroadcast of any Casey publication or website, any infringement or misappropriationof Casey Research, LLC's proprietary rights, or any other reason determined in the sole discretion of

Casey Research, LLC.

Affiliate Notice: Casey Research has affiliate agreements in place that may include fee sharing. If you

have a website or newsletter and would like to be considered for inclusion in the Casey Researchaffiliate program, please contact us. Likewise, from time to time Casey Research may engage in affiliateprograms offered by other companies, though corporate policy firmly dictates that such agreements will

have no influence on any product or service recommendations, nor alter the pricing that would otherwisebe available in absence of such an agreement. As always, it is important that you do your own duediligence before transacting any business with any firm, for any product or service.

1998-2012 by Casey Research, LLC.

Source URL: http://www.caseyresearch.com/articles/oil-price-differentials-caught-between-sands-and-pipelines


oil price differentials

Documents