On November 16, Enbridge Inc. (ENB) and Enterprise Products Partners (EPD) announced plans to reverse the direction of crude oil movement on their co-owned Seaway pipeline. Beginning in mid-2012, oil will flow southward from storage at Cushing, Oklahoma, to refineries in Freeport, Texas. The pipeline currently transports oil northward.

The immediate-day market reaction to this news was dramatic. Front-month West Texas Intermediate (WTI) oil prices rallied 3.24%, gaining slightly more than the 12-month strip, which increased 3.03%. The rationale was that with oil able to move out of storage and into a vast refinery complex, crude supply will fall, boosting prices. Yet the backwardation in the futures curve steepened as contracts for 2013 and 2014 inched higher by progressively smaller percentages—1.63% and 0.63%, respectively.

The outperformance of near-term months relative to deferred months occurred even though Seaway will not be operational for at least another seven months, and at that time will be able to move only a modest 150,000 barrels per day out of storage.

With new pump stations, Seaway’s take-away capacity could be expanded to 400,000 barrels daily, but that would not happen until 2013. In other words, the market gave Seaway more immediate credit for its potential impact in reducing Cushing supply than is perhaps warranted.

Shares of the independent refiners, as measured by the S&P 500 Refiners Index, sank 10%, significantly underperforming all other oil and gas subsectors, which lost less than 2%. Clearly, the market worried that the higher WTI prices would squeeze refiners’ margins.

In subsequent days, refiners continued to lag other energy subsectors as research analysts reinforced concerns about the impact of higher WTI prices by lowering their 2012-2013 earnings-per-share (EPS) estimates for the group by more than 20%, while upping earnings expectations for oil-weighted upstream producers.

Analysts also projected that the WTI-Brent spread would continue to narrow, converging at $4 in second-quarter 2012 from record levels exceeding $25 per barrel at the end of this past summer, due to expectations for ongoing strength in WTI and stability in Brent.

This $4 figure reflects the estimated tariff producers would pay to transport oil on Seaway to the Gulf Coast. In other words, the investment community believes that WTI will reach a new equilibrium with waterborne crudes based on the cost of transport. This is a significant development, as WTI has been trading at a major discount to Brent for most of 2011, which in itself was a departure from WTI’s historical premium to Brent.

Canadian price gains

Another interesting facet of market reaction to the Seaway reversal announcement was the price performance in the Canadian oil-sands producers. Amid losses among all sectors, these stocks closed almost uniformly higher, supported by strong volume.

The gains came even as the prospects for Seaway’s biggest competitor, Trans - Canada’s 500,000-barrel-per-day Keystone XL pipeline, looked increasingly bleak. Just a few days prior, the U.S. State Department said it would examine alternative routes for Keystone XL, which prompted analysts to remove the pipeline entirely from their models for TransCanada’s annual earnings estimates through 2015, suggesting that Wall Street has serious doubts about the pipeline’s future.

Canadian oil companies gained on the Seaway announcement on the theory that oil-sands production could ramp up aggressively with the availability of new pipeline capacity to transport the region’s heavy, sour Canadian crude oil to refiners on the Gulf Coast, which are among the most advanced in their ability to process these higher complex oil grades. In fact, the operators of the Gulf-based refiners prefer to process Western Canadian Select (WCS) oil over light, sweet crude in order to maximize coking economics.

Due to its more complex density, WCS traded at an approximate $22-perbarrel discount to WTI in first-quarter 2011. Even as analysts removed Keystone XL from their calculus for oil prices, they projected WTI/WCS differentials as narrow as $5 for 2013-2014 on the assumptions that Seaway alone would bolster WCS demand.

There is some support for this thesis. Seaway’s new co-owner, ENB, is a Canadian logistics company with stated goals of moving its home country’s crudes to the U.S. With its recent acquisition of the 50% ownership stake in Seaway, ENB now has pipeline connection all the way from Alberta, Canada, to Texas on either company-owned or affiliated assets. While EPD indicated that Seaway’s initial capacity will be primarily for WTI crudes, some investors read the joint venture’s plans to build a pipeline extension from Houston to the higher-complex refiners at Port Arthur, Texas, as a sign that Seaway is ultimately allocated for Canadian rather than U.S. crude. And, oil-sands producers may be willing to pay far more robust tariffs for access to the Gulf Coast.

Soon after the Seaway reversal was announced, ENB and EEP dropped their prior plans for the Wrangler pipeline, a Greenfield project to move oil from Cushing to the Gulf Coast, leaving Seaway as the main contender in the race to profit from regional spreads in oil prices. But Seaway alone could hardly be sufficient to fundamentally alter the dynamics of both U.S. inland and Canadian oil sands pricing as much of the market is suggesting.

Cushing inventories have been declining steadily since this past spring on growing rail capacity to evacuate landlocked crude and on higher Midcontinent refinery utilization. However, if Midcontinent production continues its rapid growth and no other credible pipeline projects are proposed, Cushing would yet again experience inventory buildups as take-away capacity is outpaced. In this case, WTI time spreads will revert back into contango and WTI-Brent differentials could widen even from the historic levels earlier this year.

At the least, time spreads and oil grade differentials are likely to be more volatile pending greater clarity on the take-away capacity of Seaway (whether it is expanded), the long-term shipper contracts (U.S. land producers or Canadian producers) and the ultimate verdict on Keystone XL.

On the Brent side of the equation, North Sea production has recovered from a heavy period of summer maintenance and Libyan output is coming back faster than originally anticipated, all of which could pressure Brent prices relative to WTI.

—Tamar Essner, associate director,

Thomson Reuters Energy
Advisory Services,
Tamar.Essner@thomsonreuters.com