Crude glut: A lesson in supply and demand : Running Out Of Storage

A LESSON IN SUPPLY AND DEMAND

Oil traders are growing increasingly nervous that a glut of crude will send prices into a tailspin.
5 ways surplus oil will affect us

Oil storage tanks in the United States have been filling rapidly as companies there contribute to produce more crude than refiners can process. As a result, the price differential between U.S. crude and international sources has widened considerably, once again providing a “North American” discount to the market.

North American motorists will like it

With rising inventories in key locations, refiners will be able to access cheaper crude and will pass at least some of those savings along to consumers. But refiners on the east and west coasts have limited access to cheaper North American crude and won’t feel the benefit as much as those who live in the mid-continent.

U.S. producers will fear it

With more crude in storage, oil companies are essentially competing with their own past production. And as space in the tanks become more scarce, producers will be forced to sell their current output at steep discounts, driving prices down further. Even as demand picks up in response to lower pump prices, the huge volume of inventories will moderate any rebound in crude prices.

American politicians will debate it

The boom in U.S. crude production has already prompted talk in Washington about lifting the 40-year-old ban on crude oil exports from the lower 48 states. As producers fill up available storage, the calls to end the prohibition (which does not include exports to Canada) will grow louder and more desperate.

Canadian producers will be sideswiped by it

Canadian crude prices are set in relation to the price of West Texas Intermediate, which is set in Cushing, OK., site of a major storage hub that is brimming with crude. Since U.S. crude is a “light” variety, Canadian oil sands producers are still seeing healthy demand for their “heavy” barrels. But their prices are being hammered down.

American environmentalists will seize on it

In the long-running debate over the Keystone XL pipeline, the Canadian government has sold the project as contributing to U.S. energy security. Opponents of the pipeline will point to the surplus production as another reason that the pipeline is unnecessary and should be turned down

Calgary’s Enbridge Inc. owns the largest oil storage facility at the continent’s most important location for such things, but it is a commercial secret as to how close its tanks are to full capacity.

In the past three years, as the U.S. oil boom took off, Enbridge expanded its tank farm in Cushing, Ok., by a third so that it can now store 20 million barrels of crude. Cushing is a strategic location: It is a hub for the web of pipelines that crosses the U.S. plains but is also the continent’s largest crude storage centre.

In recent weeks, oil traders have grown increasingly nervous that a growing glut of oil could overwhelm North America’s capacity to store it, and that we’ll soon run out of places to put it. If that occurred, prices would go into a tailspin and the industry would be forced to shut off their wells until growing demand caught up to shrinking supply.

The storage picture is opaque – clouded by companies’ commercial sensitivities and time lags in U.S. government data. Enbridge stores crude for its own account and on behalf of customers who profit by buying oil at today’s low prices and then re-selling it at a higher price on the futures market for delivery at some later date.

“Demand for commercial tank storage today is high since the future expected price of oil is higher than it is today so investors are looking to build up supplies in North America,” Enbridge spokesman Graham White said in an e-mailed statement. “Enbridge works with commercial storage clients to accommodate their requirements.”

Market fears were heightened late last week when the Paris-based International Energy Agency said that rising U.S. supply “may soon test storage capacity limits.” The warning prompted another selloff in oil markets, with North America’s key benchmark, West Texas Intermediate (WTI), falling to six-year lows Monday, down 2 per cent to $43.82 (U.S.) a barrel. That’s the lowest price for WTI since the depths of the great recession of 2008-09.

“The U.S. is a-flood with oil and other production points around the world are not letting up in their output. The question is how much more oil can we take before the storage tanks hit capacity?” said Gene McGillian, senior market analyst at Tradition Energy in Stamford, Ct.

For Canadians, the storage issue has broad ramifications.

Another round of price cuts would further cripple Alberta’s already-struggling oil industry, and blow an even larger hole in the province’s finances, as Premier Jim Prentice prepares to release his first budget since taking office in September. Federal Finance Minister Joe Oliver has delayed Ottawa’s budget until at least April in order to get a better sense of how falling oil prices will hit the Canadian economy.

For consumers, the further decline in crude prices offers more relief at the pump with prices again dropping below $1 per litre in major Ontario markets, while at the same time, undercutting the value of the Canadian dollar.

But some analysts argue the fears are overblown.

“Yes, the U.S. has seen unprecedented growth in crude stocks this year,” said Afolabe Ogunnaike, a Houston-based analyst with Wood Mackenzie, an international consulting group. “But we still think there is significant amount of storage capacity available.”

He said U.S. inventories have gown by 66.5-million barrels since the beginning of the year, but estimates there is still room to store another 200-million barrels. Meanwhile, the pace of the stock build-up should slow as refineries, which were down for seasonal maintenance, resume operations to prepare for the summer driving season. And as the industry reacts to lower prices by cutting drilling and other spending, it will soon begin to show up in lower production.

The U.S. energy department reported in February that crude storage capacity is 60 per cent full, and the figure has climbed a few percentage points since then. But the situation varies widely across the country and within Canada. The largest tank farms are close to production facilities, as in Cushing, or Hardisty, Alta. Or on the U.S. Gulf Coast, which is close to Texas producers and Gulf of Mexico producers and serves the world’s largest refining centre.

The U.S. separates the country into districts known as “PADDS – for Petroleum Administration Defence Districts, which were created during the Second World War for logistical purposes. PADD 1, for instance, is the East Coast, which has a large refining sector that relies heavily on imported crude and has little storage capacity beyond the refineries themselves. The East Coast market for petroleum products heavily influences the pump prices paid by consumers in Eastern Canada.

The key regions for storage are PADD 3, which includes the U.S. Gulf Coast, and PADD 2, which contains Cushing and the Midwest, where the vast majority of Canada’s record exports to the U.S. are headed. As of March 6, the U.S. Energy Information Administration (EIA) calculated that PADD 2 storage was 73-per-cent full, while PADD 3 was at 59 per cent. For technical reasons, many storage facilities can’t go above 80-per-cent capacity.

Oil storage tanks in Linden, N.J. are shown in this aerial file photo of Aug. 29, 2007. (The Associated Press)

The PADD 2 market is particularly important for Canadian producers, who have growing — but still limited ability — to reach the Gulf Coast. The International Energy Agency warned that should storage capacity in the Midwest reach its limits, Canadian exports would suffer.

However, refiners have invested heavily in equipment required to process the heavy-diluted bitumen that is produced in the oil sands and are keen to maintain those imports, said Greg Stringham, vice-president of the Canadian Association of Petroleum Producers.

Analysts note that Washington is working with out-dated numbers for storage capacity. The energy administration last updated its capacity estimates in September, and will do so again in March.

“Crude oil stocks are rising everywhere in North America,” said Hillary Stevenson, manager of supply chain network for Genscape, an energy-market consulting firm. “But there’s been considerable growth in capacity, especially on U.S. Gulf Coast since September . . . so things maybe aren’t as full as people are thinking, especially on the Gulf Coast. We do have some time to absorb this growing supply glut that we’re having.”

But there is still an incentive for investors to store crude, though companies such as Enbridge are raising prices at their tank farms. The speculators are taking advantage of a condition in the futures market called contango, when prices for immediate delivery or next month are considerably below those for later months.

On the market yesterday, one could buy a barrel of crude for April delivery for $43.79 (U.S.) a barrel, and then resell it for delivery a year from now for $55.55. So if storage for the year costs less than $12 a barrel, you stand to make a profit.

Earlier this winter, traders were anticipating the same type of transaction using supertankers. In 2009, an armada of supertankers are leased, filled with crude and left at anchored for delivery at higher prices later. But this year, international crude prices have not seen the same steep differential in the futures markets, so the sea-borne market never developed.

But there is another source of “storage” that is not as accessible as the oil in tanks but still represents a future challenge for producers. In the prolific shale oil fields of Texas and North Dakota, many companies are drilling wells but not doing the final work need to bring them into production.

As above-ground storage begins to reach its limits, more firms will decide not to complete the wells they are now drilling. The glut will be buried, but not dead.

 

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