Is Cushing Signaling Bullish Market Structure at Crossroads?

By Brian L. Milne, Editor, Product Manager with DTN

Billing itself as the “Pipeline Crossroads of the World,” the Cushing crude oil supply hub in Oklahoma is the underlying delivery location for the West Texas Intermediate futures contract traded on the New York Mercantile Exchange. In March, crude oil supply at Cushing was drawn down for the first time in three months, with the draw coinciding with a flip in market structure from backwardation to contango by WTI futures first and second month delivery contracts. This market signal raises the question, is the US crude market at the Crossroads from bullish to bearish?

Tank storage capacity at Cushing accounts for about 13% of total crude storage capacity in the United States, which compares with the Gulf Coast which has more than 55% of domestic storage capacity for crude oil. Yet supply changes at Cushing are closely watched due to its delivery location status for WTI futures, with trading volume averaging 1.23 million contracts per day in 2017, up 12% from 2016, according to the Chicago Mercantile Exchange which owns and operates NYMEX.

The spike in active trading in WTI futures has two driving factors—the surge in US crude oil production, and increasing US crude oil exports. Supply changes at Cushing reflect the domestic supply-demand disposition for crude oil, with the futures contract’s value also compared with Brent crude oil values—the international price marker, to signal arbitrage opportunities for US crude exports.

These are relatively new features for Cushing and WTI futures. In the early days of the US energy renaissance as tight oil drilling using hydraulic fracturing techniques was creating bottled up supply in North Dakota, WTI futures frequently traded at a steep discount to Brent crude oil futures on the Intercontinental Exchange of more than $20 bbl from 2011 to early 2013.

There was an outcry that the importance of WTI futures and supply changes at the Cushing hub were “sinking down,” no longer serving as an effective price marker. “Nobody seemed to know me, everybody passed me by.”

In hindsight, this was a period of transition, as a massive infrastructure buildout in support of the new oil discoveries was in its early days. Indeed, shell storage capacity at Cushing expanded by 33.8 million bbl or 59% from 2011 through 2017 to 91.6 million bbl to support climbing US production as well as increased imports from Canada.

The transition at Cushing was more profound than in just adding more tanks at the storage farm. Pipelines were redirected and expanded, with Cushing initially positioned as a supply hub to not only take in barrels from Canada, but also imports received along the Gulf Coast and production from offshore drilling in the Gulf of Mexico. Cushing has pipeline connections with several refineries in the Midwest that were also expanding capacity on the heavy end of the crude slate to process increasing supply from Canada.

CME notes in-bound pipeline capacity at Cushing of 3.0 million bpd, which includes heavies and WTI specified crude oil. WTI inbound flow capacity is about 1.0 million bpd. Cushing outbound pipeline capacity totals about 2.7 million bpd, with Cushing now having a direct conduit to Gulf Coast refineries and the ability to move supply south for waterborne exports.

Cushing supply peaked in April 2017 at 69.4 million bbl, with storage averaging about 62 million bbl in 2017, down slightly from the 2016 average of 64 million bbl. Cushing supply began a gradual draw down late in the fourth quarter, and for 12 consecutive weeks beginning in mid-December, declined continually until it reached better than a three-year low at 28.2 million bbl or 30.8% of shell capacity.

There was more than one factor sparking the draining of the Cushing hub, with a pipeline outage falling under the “usual suspect” category. On November 16, the Keystone Pipeline was shut following the discovery of a leak in Marshall County, South Dakota. The pipeline was returned to service on November 29, but at a reduced flow rate, and continues to operate at less than capacity.

TransCanada operates the 590,000 bpd Keystone Pipeline, which sources heavy crude from Canada’s tar sands operation, with the line’s origin point in Hardisty, Alberta. The pipeline runs south to Steele City, Nebraska, where it splits. The eastbound line runs to Wood River and Patoka, Illinois, with the southbound line running to Cushing, and continuing to Port Arthur and Houston, Texas. Keystone’s inbound flow at Cushing is about 250,000 bpd.

As Keystone was operating at a reduced pipeline flow, the 200,000 bpd Diamond Pipeline began operations in December, with the 20-inch diameter pipeline running 440 miles east to Memphis, Tennessee, connecting Cushing with Valero’s 190,000 bpd Memphis refinery.

Reduced inbound flow and increased outbound flow were key to the steady three-month drain of Cushing supply, but another feature also had a hand in the mix—backwardation.

Backwardation refers to a market structure in which a futures contract nearest to delivery trades at a premium to deferred delivery, the opposite of a carry or contango market. Under this market structure, there’s a disincentive to store crude oil, considering its forward price depreciates, not to mention the costs for storage and lost opportunity.

NYMEX WTI futures moved into backwardation in the fourth quarter, and has mostly maintained the bullish market structure until mid-March. In comparison, Brent’s forward curve moved into backwardation in early September and remains firmly backwardated.

The two price benchmarks have varying fundamental features that underpin their value. In considering Brent crude, which is sourced from the North Sea, production cuts of 1.8 million bpd by the Organization of the Petroleum Exporting Countries and 10 non-OPEC oil producing countries led by Russia have lent upside support for Brent futures. The production cuts began on January 1, 2017, and run through the end of 2018.

The production cuts come alongside strong global oil demand that benefits both crude grades, as does the production cuts. Yet, the OPEC-led production agreement was in response to climbing crude oil production in the United States which has reached record rates in the first quarter, with growth in US oil output projected to accelerate.

The Energy Information Administration reports US crude production topped 10.3 million bpd in March, and forecasts domestic output to average 10.7 million bpd this year and 11.3 million bpd in 2019, overtaking Russia as the world’s top oil producer.

Are WTI futures again “going down” to cheap “barrelhouse” values amid building supply?

Not this time, as the oil infrastructure buildout is bringing oil from one-time stranded fields to paying markets. A key distinction in this latest surge in US crude production is, however, the end of restrictions on US crude oil exports which occurred in December 2015.

Overseas customers can compare the spread between WTI and Brent, with a WTI discount providing an incentive for foreign buyers to source US crude oil. The greater the discount by WTI to Brent, the wider the arbitrage window. US crude exports have averaged 1.45 million bpd so far this year, which compares with a little more than 975,000 bpd in 2017 and 485,000 bpd in 2016.

In the late 1960s, Eric Clapton with Cream popularized “Crossroads,” a blues song written by Robert Johnson in 1936 and initially named “Cross Road Blues.” Clapton’s interpretation of the blues song inspired numerous cover versions, and the Rock and Roll Hall of Fame included the song in its “500 Songs That Shaped Rock and Roll.” Rolling Stone magazine placed the song at number three in its list of “Greatest Guitar Songs of All Time.”

About the Author:

Brian L. Milne is the energy editor with DTN, an independent, trusted source of actionable insights for 600,000 customers focused on feeding, protecting, and fueling the world. Customer-centric and employee-driven, DTN focuses on empowering agriculture, oil and gas, trading, and weather-sensitive industries through continuous, leading-edge innovation. DTN is based in Minneapolis, with offices globally.

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