U.S. Oil Exports Become Victim Of Their Own Success

U.S. oil exports surged to record levels earlier this year as more oil flows to the Gulf Coast, but the recent narrowing of WTI to Brent could slow shipments, unless and until the discount widens again.

WTI has often traded at a discount to Brent in recent years, owing to surging shale production and a limited ability to move product. As exports increased, it acted as a pressure relief valve, moving more oil out of the U.S. and pushing the two benchmarks together.

More recently, the startup of the Cactus II pipeline, which will ramp up to a capacity of 670,000 bpd, has connected more Permian oil to the Gulf Coast. In the third quarter, a total of three pipelines are expected to commence operations, including Cactus II. In addition, the 900,000-bpd Gray Oak pipeline is expected to come online in the fourth quarter. The industry is at risk of overbuilding, as the sudden onset of multiple new pipelines adds more midstream capacity than is justified by the increase in Permian production.

Nevertheless, the new pipeline additions have pushed up Midland prices to the point where oil in Midland has actually traded at a premium to WTI in Cushing. “Now, the entire Midland-Cushing forward curve is in positive, due to expectations of excess pipeline capacity and a slowdown in E&P development activity in the basin,” Bank of America Merrill Lynch wrote in a note.

More oil escaping the continent has pushed WTI and Brent closer together as differences in the U.S. market and the international market become smoothed out. But a narrow differential, in turn, challenges the economics of exporting oil from the U.S., putting a kind of cap on shipments. “In order to ensure USGC barrels continue to clear in the export market, we think Brent-MEH spreads will likely need to widen from here. Europe has recently imported upwards of 700k b/d of US crude oil exports,” Bank of America said. MEH refers to the price of WTI at the Magellan East Houston terminal – or more simply, the price of oil in Houston. In other words, Bank of America is arguing that the price that oil fetches along the U.S. Gulf Coast may have to fall relative to Brent in order for exports to increase.

U.S. oil exports have declined a bit in recent weeks as WTI has moved closer to Brent.

On the other hand, a smaller differential is another way of saying that Permian oil producers are fetching a higher price for their oil. The health of shale drillers in West Texas is now the subject of intense scrutiny. Shale E&Ps are decidedly out of favor with Wall Street, and financial stress is apparent at a large number of companies. Drilling has slowed, the rig count is down, and spending cuts are proliferating.

However, Bank of America was more upbeat regarding the productivity of shale. Among the myriad issues with shale drilling, one of the more recent subjects of debate was the fact that E&Ps were suffering from operational problems. For instance, Concho Resources revealed that its densely-packed 23-well project performed much worse than expected, raising questions about shale drilling reaching its limits.

Bank of America is not convinced this spells the end of productivity gains. “Recent E&P performance results and commentary from industry experts have caused concern over the end of productivity gains in the US shale basins,” the investment bank wrote in its report. “We are of the opposite view and think that service efficiency and well level productivity continue to improve.” BofA said that drilling efficiencies wrote 14 percent so far this year, with frac efficiencies up 11 percent.

Even with those gains, however, drilling is slowing down. “As drilling activity has slowed, so too has growth in completion activity. The slowdown in completion activity in 4Q18 and 1Q19 has led to meaningfully slower growth in the shale basins,” Bank of America said. “At an aggregate level, US crude oil production has flat-lined in recent months, however we forecast faster growth in the shale basins in 2H19 versus 1H, helping to re-establish the upward trajectory of US supply.”

Slower production growth acts to push WTI closer to Brent, but the economic limits of exports when the two benchmarks are close together works in the other direction.

One other wrinkle to consider is the U.S.-China trade war, which could put U.S. oil exports under pressure. Some analysts think that China may directly target U.S. oil for tariffs, although the damage from that move could be mitigated by shipping oil elsewhere. “All things considered, the U.S. crude-export machine may struggle to maintain its record-breaking run,” Stephen Brennock, oil analyst at PVM Oil Associates, told CNBC.

In the long run, exports are likely to continue to rise. Billions of dollars of capital continue to flow into the Gulf Coast, and the number of export projects continues to grow as developers race to bring their terminals online before their competitors. But because of the complicated dynamics between exports, price differentials, pipelines and upstream shale stress, the precise levels of exports will continue to be choppy.

By Nick Cunningham of Oilprice.com