By John Auers and Elizabeth Hilbourn
Pink Floyd’s song, “Empty Spaces,” contains a heavily-buried engineered reversed vocal in the beginning minute or so, that is described as a ‘secret message’: Congratulations. You’ve just discovered the secret message. Please send your answer to old pink, care of the funny farm. For years, nonmetal people have been accusing various metal bands of influencing their flock with hidden messages that could only be heard by playing the vinyl backwards. But we’re not here to rehash those arguments, but instead to focus on another kind of “reversal,” that of the crude oil flows that are taking place in North America. Driven by the reversal of U.S. crude production growth due to the “shale boom” and helped along by the reversal of U.S. crude oil export restrictions and the reversal of Enbridge’s Line 9 in Canada, North American crude oil flows are and will continue to see significant changes. It is these changes that we will be discussing today. Fortunately, we won’t have to resort to the tactics used by the hippies of the 60’s and 70’s who, while doing acid, would reverse the drive on their turntables and listen to records backwards to hear their “secret messages.”
Let’s begin by revisiting some history. Since U.S. crude production peaked in 1970, the U.S. more or less steadily increased its dependence on imported oil. Even though legislation to restrict U.S. crude exports was passed during the Arab oil embargo scares of the late 1970’s, this legislation was only symbolic in nature as there was no incentive to export crude from a market short of crude. This began to change with the “shale boom,” as growing production began to exceed the capabilities of domestic refiners to efficiently process the extra light crude oil. Since the export restrictions did allow the export of crude oil to Canada, this became the first “safety valve,” and crude exports to Canadian refineries in the Atlantic Provinces grew rapidly from under 100 MBPD prior to 2013, to reach an average of over 400 MBPD by 2015.
But this limited outlet wasn’t enough to keep large “domestic discounts” from appearing, as U.S. crude became “stranded.” Producers started lobbying hard to rescind or modify the crude oil restrictions to gain relief from this stranded situation. They achieved very limited success in mid-2014 when the U.S. Department of Commerce Bureau of Industry and Security (DOC/BIS) responded to classification requests and ruled that lease condensate, processed through a distillation tower, is a refined petroleum product rather than crude oil and is, therefore, not subject to the licensing regime applicable to crude oil exports. This propelled several Gulf Coast condensate splitters and opened an outlet for some of the light crude oil. The EIA included this category under unfinished oils-kerosene and light gas oils, though it was difficult to accurately account since the exporter sometimes reports it to the Census Bureau under crude and other times as finished product. The volumes were relatively small with the largest month at 130 MBPD.
Producers finally won their major legislative success just over a year ago, when congressional leaders compromised with the Obama Administration on legislation to lift the four-decade law restricting crude oil exports; however, with the drop in overall crude prices which began in mid-2014, crude production growth slowed and eventually began to decline. This, combined with the ability to export lease condensate and send crude to Canada, removed the pressure to find external homes for U.S. crude. Thus, by the time the export restrictions were actually rescinded, the domestic discount had already disappeared and there was relatively minimal immediate impact on the market.
Although economic factors were no longer driving the need to export U.S. crude, the removal of the restrictions did result in some additional exports. Many of these first exports in 2016 were “test” cargoes by foreign refiners to see how U.S. crude worked in their refineries. Other cargoes were incentivized by quality factors. Overall, 25 different countries, located in every continent except Oceania, received crude from the U.S. in 2016, and total crude exports reached a record of 520 MBPD (vs. 465 MBPD in 2015).
Another major development impacting U.S. export flows also took place in late 2015, the reversal of Enbridge’s Line 9B. This allowed up to 300 MBPD of crude from Alberta’s oil sands regions to reach Eastern Canadian refineries. This new option, combined with the decreased U.S. domestic crude discount, resulted in a decline in U.S. crude exports to Canada by over 100 MBPD in 2016 (from 427 MBPD to about 300 MBPD), and exports to other countries, actually exceeded exports to Canada in several months of the year. Figure 1 shows the changing landscape of U.S. crude oil exports over the last several years.
Crude imports have also been impacted by developments in the domestic production and export landscapes. As U.S. crude production grew, and with limited outlets for exports, U.S. crude oil imports reached a two-decade low of about 7 million BPD at the time the export ban was lifted. With production sliding, exports growing, and refinery runs remaining strong, imports have grown again, reaching 8 million BPD during the second half of 2016 and averaging about 7.85 million BPD for the year (vs. less than 7.4 million BPD in 2015). Figure 2 shows the history of U.S. crude oil imports. Though off the scale of the graph, imports peaked at just over 10 MMBPD in the 2004-2008 timeframe, and had not been consistently below 8 MMBPD levels since early 1996.
The changing crude supply/demand balance in the U.S. has resulted in major changes in domestic vs. international crude prices, as shown in Figure 3. Prior to 2011, LLS (St. James) generally carried a premium of between $2 and $4 per barrel vs. Dated Brent, a value necessary to incentivize the imports required to meet U.S. refiners crude needs. This differential began to decline in 2011 as U.S. crude production increased and moved to an ever larger “domestic discount” in the 2013/2014 timeframe, as an export restricted domestic crude glut developed. With domestic production declining, export restrictions removed and a growing need for imports returning, the LLS premium returned in 2016. More recently, as domestic production has shown some renewed strength, LLS has again moved to a discount vs. Brent, although there has been significant day-to-day volatility.
Ultimately, a key determinant of what happens to U.S. crude trade flows will be the direction of U.S. crude production. Increases in production efficiencies have lowered costs and led to significant increases in drilling activity, with rig counts up by almost 75% over the last several months. The recent strength in crude prices (as a result of the OPEC agreement to cut production) has also boosted upstream efforts. Together, this has led to a reversal in volume declines. After bottoming out in July, total domestic production has been slowly increasing and recent estimates show that these increases could be as much as 400 MBPD above the lows.
Certainly other factors will also impact U.S. crude balances, including refinery runs, new pipelines, overall regional and world demand and regulatory developments. Actions by U.S. refiners can have an impact as well. In the last 25 years, they have invested to reconfigure their plants so that they can efficiently process heavier crude oil slates, because this oil has traditionally sold at a discount and has been increasingly available to U.S. refineries. Much of this heavy oil originates in Canada, Mexico, and Venezuela. In contrast, over the last few years, many refiners have invested to handle more of the lighter crude that is produced in the U.S. In addition, many new crude oil pipelines have been built. A significant amount of crude oil has been shipped by rail the last several years. U.S. refinery appetite and transportation infrastructure will impact how much of the U.S. production will be utilized by refinery assets. Increases in U.S. crude oil exports will likely depend on increases in U.S. crude oil production and significantly wider price differences between domestic and international crude oils.
One regulatory issue in particular has become prominent in recent weeks- the consideration of a Border Adjustment Tax (BAT), which is part of an effort by Congress to push an ambitious tax reform package. Though the final version of the tax reform legislation is still under development, it includes a BAT provision. It has the general intent of penalizing importers and rewarding exporters. Imported crude oil would not be deducted for tax purposes. Exported crude oil would avoid taxation, effectively receiving a tax rebate. A BAT is different than a tariff in that it affects imports and exports, while a tariff only affects imports. A tariff raises consumer prices. The major assumption of a BAT is that prices in America effectively would not go up because the dollar’s rising value would offset the increased cost of imports. The BAT would affect all imports and exports; however, oil is a product group which comprised 8.7% and 7.1% of the dollar value of all imports and exports, respectively, in 2015.
Turner, Mason & Company is continually monitoring developments in the global petroleum markets and assessing how they will impact the industry. We utilize this analysis to assist both individual clients and also to develop reports and studies, which we provide on a multi-client basis. Crude oil balances will be discussed and analyzed in greater detail in the upcoming release of our Crude and Refined Products Outlook. This biannual publication evaluates the latest trends and drivers in the petroleum industry, and it will be published in early February. For more information on this and other TM&C products, call Shanda Thomas at 214-754-0898 or visit our website at turnermason.com.