Without a doubt, the dynamics of U.S. oil markets have changed in the past few years. Unprecedented spikes in domestic oil production from North Dakota and Texas have resulted in pricing differentials that are surprising to even the most-seasoned industry veterans. But have asset valuations kept up with commodity prices in their respective basins? By examining the spread between West Texas Intermediate (WTI) and Louisiana Light Sweet (LLS), data suggests that the market has not taken into account a sustained price premium in the Gulf Coast.

WTI oil is stored at Cushing, Oklahoma, considered to be the primary U.S. oil hub. Cushing has been oversupplied with excess product, particularly from Canada and North Dakota, with infra - structure bottlenecks constraining the oil storage to some 50 million barrels and counting. Historically trading at a slight premium to the lower-quality Brent crude from Europe, WTI is now trading at a discount to Brent of as much as $23 per barrel (as of February 2013).

LLS oil is stored at St. James, Louisiana, near F the refineries that process oil imports, and it has typically traded in line with international markets. And with the divergence of WTI, Gulf Coast LLS has continued to sell at Brent parity. Until the cheaper WTI crude finds its way to the Gulf Coast, the LLS pricing premium will continue.

Clearly this shortage of take-away capacity at Cushing is causing quite a stir, so won’t a bunch of massive pipelines resolve the situation? Indeed, the Seaway Pipeline reversal and Keystone XL project are expected to add a significant 1.5 million barrels per day of transport capacity from Cushing to the Gulf Coast by second-quarter 2014. But with at least 3.5 million barrels per day of oil production growth expected from 2011 to 2016, will these pipelines be enough to materially eliminate the price differential?

Even if the bottleneck at Cushing is resolved, the Gulf Coast refineries may be the Lower 48’s next challenge. There is approximately 7.7 million barrels per day of refining capacity along the Gulf Coast, while U.S. oil production plus imports is expected to reach a combined 16 million barrels daily by 2016. Covering this shortfall will require will require significant time, money and regulatory battles to construct the required refineries.

graph- pricing history and transaction metrics

With all the intended infrastructure build-outs, will domestic supply continue to exceed consumption? How will these developments impact commodity pricing? These are exactly the kinds of questions that face the oil industry when considering acquisitions and divestitures today.

If the status quo is maintained, Gulf Coast producers should be receiving a significant premium for their assets due to LLS pricing. But limited history of LLS strength is not enough for a paradigm shift in the way most companies value reserves. Third-party reserve audits are generally based on historical realized pricing held flat, regardless of any impact that differentials may have in the near future. And while A&D valuations generally do factor in price-deck sensitivities, the question is whether the market believes in a sustained LLS premium.

After examining Gulf Coast oil-weighted producing asset transactions over time, there is no clear evidence of a premium paid per barrel in the new LLS pricing environment. By separating transactions into 2007-2010 and 2011-2012 buckets, we would have expected to see a significant spike in valuation metrics.

But despite the 38% increase in Gulf Coast LLS oil prices, average transaction multiples increased only 9%. This suggests two of many possibilities: most companies in our sample set have hedged substantially against oil prices, or the market is ignoring the existing LLS premium for realized price forecasts.

Clearly, the supply and demand factors of price differentials are complex and difficult to predict. But some analysts speculate that LLS premium is here to stay, with the long-run LLS differential expected to converge to the Cushingto-St. James transportation costs of $5 to $7 per barrel.

In that case, barring any erosion in global oil prices, those producing assets near the Gulf Coast (including the Eagle Ford) should be expected to sell at production metrics directionally higher than the market is seeing today.