A Distinction With a Difference

In this week’s issue of The Energy Letter, I discussed the cyclical nature of the oil industry, which goes like this:

1. When oil prices are low, oil companies don’t earn as much money, and capital investments into new projects decline.

2. Oil production growth flattens due to underinvestment.

3. Global demand growth marches on, and this erodes the spare production capacity.

4. Oil prices rise and oil company profits climb.

5. Higher profits result in a number of new projects.

6. After a few years, the new projects deliver new capacity at a rate faster than demand growth, and prices once more fall. The cycle repeats — at least as long as capacity can continue to grow.

We see a similar cycle in the natural gas industry, with the major difference being that the gas industry is more of a local market. There are not normally huge disparities in oil prices around the world because oil can reach the global market in a much easier fashion than can natural gas. Thus, we might see natural gas priced at $3 per thousand cubic feet in the US, but four or five times that level in Europe or Japan.

But local supply/demand imbalances do still occur in the oil market, just to a lesser extent than in the natural gas market. Consider the historical pricing of West Texas Intermediate (WTI) and Brent crude.

Source: Energy Information Administration

WTI is a benchmark for crude oil prices in the US. Brent crude, of slightly lower quality than WTI, is the benchmark for most of the global oil trade. Historically, the price difference between WTI and Brent has been small. Prior to 2010, WTI was typically slightly more expensive than Brent. One reason for that is that production in the US had been on a long decline since 1970, while US demand had been on a pretty steady rise.

During the first part of the last decade, the oil industry was in the “underinvestment” stage of the oil cycle (Phase 2 of the cycle). Oil prices were low, and capital budgets were tight. But after 2002, the combination of underinvestment and rapid demand growth in developing countries quickly pushed the industry into the “capacity erosion” stage. The loss of spare capacity led to much higher oil prices, record profits for oil companies, and tremendous amounts of money allocated to new projects.

High oil prices had two impacts in the US. Oil production that was previously uneconomical was suddenly profitable, and oil booms developed in North Dakota and Texas. The decline in US oil production began to slow, and in 2009 it reversed direction and has been climbing ever since.

At the same time, US demand fell in response to high prices and economic slowdown. US demand started to fall in 2006, and by 2009 it had fallen 9 percent from 2005 levels. The US was soon producing more refined products than we needed, so refined products like gasoline and diesel began to be exported.

Source: Energy Information Administration

A major bottleneck developed in the nation’s most important oil hub in Cushing, Okla. Oil flowed into Cushing at a faster pace than it flowed out, and the result was a mini-glut of oil in the middle part of the US. Crude oil inventories in Cushing grew from under 20 million barrels in 2008 to nearly 50 million barrels by the end of 2012.

Because of insufficient pipeline capacity to get mid-continent oil to the Gulf Coast where it could benefit from global markets, the price of WTI became depressed relative to Brent. After years of having traded at a $1 to $3 discount to WTI, Brent suddenly began to trade at a premium to WTI. In 2011 this differential increased to above $25/bbl.

Source: Energy Information Administration

The substantial increase in the Brent-WTI differential created profitable opportunities for certain refiners. While some refineries on the East Coast had to pay Brent prices and were closing due to lack of profitability, other refiners could access the disadvantaged mid-continent crude and sell the finished products to coastal markets at prices that were more reflective of Brent crude. Refiners like Valero (NYSE: VLO) and Tesoro Corp. (NYSE: TSO) — both Buys in our Energy Watch list — saw profits increase substantially, and their share prices increased in 2012 by 62 percent and 89 percent respectively.

Yet the high Brent-WTI differential will not last — it will return to historical norms; only the timing is uncertain. And this will create plenty of opportunities, and some threats, for investors.

Why do I believe the differential will disappear? Because there are a number of projects in the pipeline that will relieve the bottleneck in Cushing. In May 2012, Seaway Crude Pipeline Company — a 50/50 joint venture between Enterprise Products Partners LP (NYSE:EPD) and Enbridge (NYSE: ENB) — reversed the flow direction of the Seaway Pipeline. This allowed the transport of 150,000 bpd of crude oil from Cushing to Gulf Coast refineries near Houston. While this helped stem the growth of inventories in Cushing, it represented a small fraction of the increased US oil production that flowed into Cushing over the past four years.

That will change this year. This month the capacity of the Seaway pipeline will be increased by 250,000 barrels a day. Later this year the southern leg of the Keystone pipeline — which President Obama endorsed from the campaign trail in 2012 and which should not be confused with the proposed Keystone XL expansion that would cross the US/Canadian border — should come onstream. This Keystone-Cushing extension will have an initial capacity to transport 700,000 barrels of oil per day from Cushing to Gulf Coast refineries. These three projects have a total capacity of 1.1 million barrels per day — which amounts to most of the increase in US oil production capacity over the past four years.

The clearest investment opportunity is for commodity traders to take advantage of a return to historical norms by implementing various spread strategies. But most readers are more comfortable investing in individual stocks. The primary beneficiaries of these pipeline expansions are the pipeline companies themselves, who will receive increased revenues as more oil flows through their networks, and crude oil producers with the newfound ability to get their crude to the global market.

Among pipeline companies, we recommend NuStar Energy LP (NYSE: NS), which we updated in the last issue. Our favorite producers are those with strong exposure to the sources of unconventional oil where logistical transportation bottlenecks are holding back production. Right now, our favorite in this space is Growth Portfolio holding EOG Resources (NYSE: EOG), one of the pioneer producers in the Eagle Ford, the Bakken Shale, the Barnett Combo, and the Wolfcamp and Leonard Shale plays in the Permian Basin. Buy EOG Resources below 125.

For investors with a tolerance for risk in exchange for higher upside potential — Oasis Petroleum (NYSE: OAS), in our Aggressive Portfolio, is nearly a pure play on high-quality WTI oil from the Bakken Shale in North Dakota and Montana. Oasis drills in the West Williston and East Nesson areas of Bakken and has enormous capacity to increase production in the years to come. Buy Oasis Petroleum below 38.

The potential losers as pipeline capacity expands are the refineries that currently benefit from the Brent-WTI differential, and railway companies that have benefited from moving crude oil out of areas like North Dakota’s Bakken Formation but may see their revenues hurt as pipelines take over.

Last year the Energy Information Administration (EIA) reported that year over year delivery of petroleum by rail had increased by 38 percent. The largest mover of that crude oil was BNSF Railway Co., which Warren Buffett’s Berkshire Hathaway Inc. acquired in 2010. Canadian Pacific Railway (NYSE:CP) also transports Bakken crude and benefits from the current pipeline bottleneck.

The railways and refineries will not suffer immediately from the pipeline expansions. In fact, it is possible that they won’t suffer much if US oil production continues to grow strongly over the next few years, and if Canadian oil flow into the US continues to grow. But the 1.1 million bpd increase of crude oil transport by pipeline from Cushing that will have been implemented by year end — and the inevitable narrowing of the Brent-WTI differential — will cut into their profits unless oil production capacity catches back up. Thus, it would be prudent to keep close tabs on companies in these categories — especially as the Keystone-Cushing extension approaches completion.


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