By Robert Auers and John Auers
A couple of weeks ago, we discussed the potential of an impending “crunch” in pipeline takeaway capacity out of Western Canada. The outage of TransCanada’s Keystone pipeline after a spill in South Dakota shortly after that blog came out and the resulting impacts on Canadian crude prices certainly shined a light on that situation. But Western Canada is not the only place where a lack of takeaway capacity might rear its ugly head. Today we move our focus to the Permian Basin, an area where rapid increases in production continue to challenge logistics infrastructure, even after the completion of several new pipelines over the last few years. Appropriately, we’ve chosen a title song written by a great song writer from Texas – Guy Clark. Clark was actually born and spent much of his childhood in the heart of the Permian Basin during its original boom days in the 1940s and 50s in Monahans, Texas. “Desperados Waiting for a Train” was Clark’s first major success as a songwriter. It was originally recorded by Jerry Jeff Walker in 1973 and later, by The Highwaymen, in 1985. Just as the song describes how Clark and the old man felt like they were Desperados in the old west waiting on a train to rob, Permian crude may soon be “waiting on a train” to bring it to market if pipeline capacity fails to keep up with rapidly growing supply.
“He’s a … driller of oil wells”
The Permian has been the only major basin in the U.S. to continue growing production right through the oil price downturn. The chart below, taken from the EIA’s most recent Permian Drilling Productivity Report, illustrates this. It shows historical Permian production and forecast production through December 2017. Despite a brief slowdown in the production growth rate in late 2015 and early 2016, Permian production is now growing faster than it was prior to the price downturn and producers are seeing strong returns even in a sub-$50 WTI price environment. A growing inventory of Drilled but Uncompleted Wells (DUCs) also provides visibility for continued strong Permian production growth. As a result of these developments, we don’t expect any meaningful slowdown in Permian production growth over the next few years. 
Current Permian takeaway and local refining capacity of roughly 2.7 MMBPD is neck and neck with current production of just under 2.7 MMBPD. However, several new projects that are at or nearing completion promise to add nearly 700 MBPD of takeaway capacity by the middle of next year (with much of this capacity to be added over the next month). These projects include Energy Transfer’s Permian Express III, Enterprise’s Midland-Sealy Pipeline, Plains’ Cactus expansion, and the elimination of some bottlenecks surrounding Plains’ and Magellan’s recently completed BridgeTex expansion. All of these projects are slated for completion in Q4 2017 or 1Q 2018 and their capacities will ramp up at varying rates over the coming months as some of the final pumping stations are placed into service and bottlenecks are eliminated. Delays in these projects, however, could further strain Permian takeaway capacity in 2018 as Permian production continues to grow and perhaps even accelerate.
Additionally, as we look farther into the future, we see another possible bottleneck coming in 2019, as Permian production will likely grow to 3.3 MMBPD by YE 2018 and to over 4 MMBPD by YE 2019. There is definitely some uncertainty in these forecasts, but it seems a surprise to the upside is at least as likely as one going the other way, given continued technical improvements on the upstream side and clear focus on the Permian (reinforced by Q3 2017 conference calls) by upstream players. Still, there are more pipelines in the works as well to transport this production to the Gulf Coast. The most straightforward of these projects is the expansion of energy Transfer’s Permian Express III from 200 to 300 MBPD, which will likely be complete in early 2019. The next project to be completed will likely be TexStar’s EPIC pipeline to Corpus Christi, which will be able to transport 200 MBPD of crude. The completion of these projects will bring total Permian takeaway capacity to near 3.7 MMBPD, short of the projected 2019 production exit rate. However, both Plains and Buckeye have pipeline projects to Corpus that are currently in the early stages of planning that together could transport an additional 900 MBPD of Permian crude to the growing South Texas crude export hub. Both of these projects are slated for completion in late 2019, subject to sufficient shipper commitments and regulatory approval. As a result, the scope or timing of these projects could be significantly modified or they could be cancelled altogether. Pipelines that travel only within the state of Texas are, however, subject to much less regulatory scrutiny than interstate pipelines or pipeline projects in most other states. Moreover, Texas pipeline projects have not attracted the same level of activist attention as have some in other areas of the U.S. and Canada. As a result of these factors, regulatory issues are less likely to delay these projects than some of the ones (Keystone XL, TransMountain expansion, Line 3 replacement) that we discussed a couple weeks ago.
Cushing and Midland Bottleneck Redux
We’ve all seen the LLS-WTI (Cushing) differential, which serves as a proxy for light sweet crude at the Gulf Coast compared to light sweet crude at Cushing, widen from about $2.50 earlier in the year to around $6.00 more recently. Initially, this widening was blamed on hurricane activity, but due to the persistence of the wide differential even after GC refineries have come back on-line, it has become increasingly clear that this was not the only driver of the expanding discount. In fact we believe a major underlying cause of the widening differential is the increased volumes of crude oil coming into Cushing and a lack of pipeline takeaway capacity leaving the Cushing complex. While production growth in the Permian has remained relatively strong throughout the industry downturn, Oklahoma volumes, primarily from the STACK and SCOOP plays of the Anadarko basin and Colorado volumes from the Denver-Julesburg (DJ) basin declined in late 2015 and through most of 2016. In 2017, however, production from these basins began increasing again and new pipelines have been completed to transport this production to Cushing. Meanwhile, no meaningful amount of new takeaway capacity has been built from Cushing since the completion of the Keystone and Seaway expansions. All in all, we estimate total pipeline capacity into Cushing exceeds takeaway capacity by about 600 MBPD.
Still, two major projects that will likely be starting up over the next month may reverse this dynamic, at least for a time. The first is the 200 MBPD Diamond pipeline, which will replace the Capline pipeline as the primary source of crude for Valero’s 195 MBPD Memphis refinery. The second is the expansion of the Ozark pipeline to Wood River, IL, from 230 to 345 MBPD. The futures market appears to agree with us, as the differential narrows to under $4 for the May 2017 contract. However, production growth in the Permian, Anadarko and DJ basins could put this differential under pressure once again if sufficient takeaway capacity out of Cushing is not built to match production growth.
Another equally, if not more, interesting trend regarding locational differentials has been the inversion of the WTI Midland – WTI Cushing differential. Historically, WTI (Midland) has been priced at a discount to WTI (Cushing) to account for transportation. Furthermore, we saw this differential widen substantially in 2012 and again in 2014 to account for the lack pipeline takeaway capacity in the Permian. Recently, however, the differential has reversed with WTI (Midland) priced slightly above WTI (Cushing). The primary reason for this oxymoronic relationship is the quality of the two crudes. WTI (Midland) is typically a true light sweet West Texas barrel. Cushing, however, is not just a pipeline and storage hub, but also a blending hub. Because of the presence of a number of different crude grades at Cushing, blenders are able to blend a variety of crudes (including, at times, Canadian heavy) and condensates to make a pseudo-WTI barrel that meets the API and sulfur specs indicated in the NYMEX WTI specifications. Many of these blends are subject to dumbelling and often contain relatively high amounts of metals and high TAN. Both of these values should be very low in a true WTI barrel. Accordingly, many refiners with direct pipeline access to both the Permian and to Cushing have chosen to pay a premium for the Midland barrels due to their superior refining value. While we do expect WTI at Cushing to return to a premium over the Midland barrels in the next few months, differences in quality will likely put continued pressure on this relationship, prevent the differential from widening too far and cause potential reversals similar to the current one and other similar reversals seen over the past 2-3 years. The chart below shows the LLS-WTI and WTI (Cushing-Midland) differentials dating back to the beginning of 2015.
Due to the time and space limitations of a weekly blog, we have included only a high-level discussion today on the very wide-ranging and critical developments taking place regarding Permian and Cushing takeaway capacity and the corresponding impacts on crude supply/demand dynamics. TM&C does this analysis at a deeper, quantitative level in our Crude and Refined Products Outlook, where we talk much more in-depth about how the future developments in this area will affect refiners not only in the U.S., but in the rest of the world as well. Our 2018 Crude and Refined Products Outlook, which is scheduled to be issued in late January/early February 2018, will discuss these issues and provides a comprehensive and detailed forecast of supply, demand, and prices for all crudes and products on a regional and global basis through 2030. Market, policy, demographic and technology developments are all considered in our analysis and forecasts. For more details about this or other TM&C publications, please visit our website or give us a call at 214-754-0898.