New oil pipelines, price bottlenecks and how Cushing, Okla., impacts Canada’s economy

Why has North America suddenly gone crazy over pipelines? The little town of Cushing, Okla. holds the answer.

 

Enbridge’s Cushing Terminal in Cushing, Okla. (Photo: Shane Bevel/Bloomberg/Getty Images)

It isn’t exactly the sort of place you’d expect to find a traffic jam. Cushing, Okla., a sleepy town of 8,300—which sits well off the interstate between Oklahoma City and Tulsa in a scrubby flatland—is best known for the vast farms of oil storage tanks that ring its southern flank. You see, Cushing, a name well known to global crude oil traders, is the self-described “pipeline crossroads of the world,” and at the moment those massive containers are nearly full to the brim with North American crude that’s all pumped up with no place to go.

According to Brent Thompson, who heads Cushing’s chamber of commerce, oil was discovered in the area in the 1930s, and those wells were responsible for supplying much of the U.S. military’s needs during the Second World War. But production exceeded demand, so the oil companies began building storage facilities. Then came the pipelines, bringing in West Texas Intermediate (WTI), a light, sweet crude, to be distributed to refineries in the Midwest and the East Coast. Eventually, Cushing became the “pricing point” for futures traders in distant New York and Chicago. “I guess we just happened to be in the right place at the right time,” shrugs Thompson.

In the past two years, however, Cushing has turned into a giant, vexing bottleneck in the middle of a North American pipeline system that is no longer in sync with the way crude is produced, pumped and refined. Indeed, the hub’s shortcomings—too many lines coming in, as Thompson remarks, and not enough flowing out—explain why pipelines, normally out of sight and out of mind, have suddenly become front-page news. Enbridge, TransCanada and Kinder Morgan Energy Partners LP want to spend billions to sort out the logjam. The problem is, the new pipelines required to circumvent that Cushing bottleneck have turned into a fearsome political knot, one that doesn’t look as if it will be untangled any time soon.


 

Much of North America’s pipeline network was built at a time when oil companies were moving domestic crude and refined imports from the Gulf Coast to interior hubs. But with Western Canada’s oilsands and the newly productive Bakken shale deposits in North Dakota and Montana, energy giants want that new-found crude to flow south, and possibly west, to hungry markets in Asia. Thus the rationale behind North America’s most contentious pipeline schemes: TransCanada’s Keystone XL and Enbridge’s $6-billion Northern Gateway, which aims to pump Alberta oil over the Rockies to a port in Kitimat, B.C.

Indeed, the confluence of crude in Cushing helps explain why the pipeline puzzle has dominated the headlines in the past few months. Keystone—its approval stalled due to strenuous objections from both conservative Nebraskans and environmental groups—has become a debating point in the U.S. presidential campaign. Alberta premier Alison Redford is at war with B.C.’s Christie Clark, who is threatening to block the Northern Gateway scheme unless her province gets a piece of the action.

Ottawa, its critics claim, wants to green-light the plan even before its own scientists have assessed the environmental impact on hundreds of streams and rivers along the proposed route. All the while, regulators in both countries are coming down hard on the pipeline companies in the wake of a scathing assessment by the National Transportation Safety Board, released in Washington in July, of the causes behind a disastrous Enbridge spill in Kalamazoo, Mich., two years ago.

But the swirling regulatory controversy has overshadowed a larger and more pressing issue, at least as far as Canada’s energy sector is concerned. For the past two years, West Texas Intermediate has been selling at a substantial discount relative to world prices, the so-called Brent benchmark. Why? Because so much North American crude is now stockpiled in Cushing, and the resulting glut has driven down prices.

“With so much supply landlocked, Canadian oil prices are taking a serious hit,” Casey Research energy analyst Marin Katusa wrote in a late June investment note that estimated that Western Canadian Select, a heavy crude, was trading for a whopping US$23 less than WTI; a gap 30% larger than the average differential between 2006 and 2010. The depressed prices mean lower prices for refiners and less pump pain for North American drivers, but it’s hardly good news for Canada’s oil industry, which spent billions on oilsands projects after world crude prices had risen high enough to justify the investment.

“If we want to grow the oil industry in Western Canada, we have to find a way to build those pipelines,” says Scotiabank commodities expert Patricia Mohr, who describes them as “absolute national priorities” that eclipse drivers’ gripes about gas prices. “As you alleviate the pipeline constraints, it should move gas prices up to international levels.” Yes, consumers will complain bitterly about the higher prices, but the benefits will more than offset the damage. A TD study last spring found that a 10% bump in crude prices was enough to nudge the country’s entire GDP up by more than $5 billion. Mohr’s bottom line: Canada’s oil producers can only continue to create shareholder value, employment growth and tax revenues if the pipeline companies and regulators sort out the logjams and get prices back up.

The price gap between North American crude and world prices is a new and unfamiliar dynamic in international oil markets, and represents a “double whammy discount” for Western Canadian producers, as Casey puts it. According to a June 2012 Scotiabank commodities index report, Brent and WTI prices tracked almost identically for years, building steadily through the early 2000s. Prices finally soared to the US$140-barrel range in mid-2008 before plunging just as dramatically in the recessionary aftermath of the 2008 credit crisis. After bottoming out at US$40, international oil prices gradually climbed back up, finally surmounting the US$80 mark in late 2010.

And then a funny thing happened on the way to Cushing. Even as prices continued to rise throughout 2011, a gap opened up between Brent and WTI, and grew larger throughout this year. Mohr’s latest commodities report, released in late August, pegged the WTI-Brent differential at $15.79 for 2012, year to date. The average gap between 2006 and 2010 was 6¢.

Part of the reason for the growing disparity, say energy watchers, is the remarkable productivity of the newly developed Bakken shale oilfields in Montana and North Dakota, which flow into Cushing and other mid-western hubs. So much for all the talk about peak oil. “Bakken has grown faster than anybody anticipated,” says Casey’s senior research analyst Joe Hung. “This has caused WTI to plunge.”

A year ago, he notes, Bakken was selling for US$4 more than a barrel of WTI; today, because of the stockpiles at Cushing, it trades for US$6 under. Those kinds of fluctuations, Hung says, “are very dramatic. It essentially doesn’t happen.” Traders, he adds, haven’t been able to take advantage of “a huge arbitrage” because of a long-standing U.S. law that prohibits the export of U.S. crude. All this robust production—Western Canadian conventional crude has also jumped unexpectedly in the past year—has taken place at a time when consumption has dropped due to the faltering U.S. economy and aggressive Saudi Arabian overproduction in anticipation of a conflict involving Iran. As a result, both world prices and WTI dipped sharply this year, with Brent down $25 since March.

What happens next depends directly on the expensive and complicated business of reworking a North American pipeline and refining infrastructure that was built to serve the needs of an era defined by huge imports of light, sweet crude.

While TransCanada’s 1,897 km Keystone XL has received the lion’s share of public attention, the company is also pushing ahead with its Gulf Coast Pipeline, which will bring 700,000 barrels per day to Gulf Coast refineries that have been re-engineered to process heavy crude. The project is waiting for a green light from U.S. regulators and is expected to be in service by late 2013. Paul Miller, TransCanada’s senior vice-president of oil pipelines, predicts it “will go a long way toward alleviating the bottleneck.”

Besides the high-stakes fight over the Northern Gateway scheme, Enbridge has also begun its own efforts to drain that Oklahoma backlog, including the recent reversal of the 800-km Seaway pipeline between Houston and Cushing. In May, it began pumping Cushing crude down to the Gulf Coast at a rate of 150,000 barrels per day. Enbridge officials expect to twin that line by 2014. Seaway, in fact, is just one element in Enbridge’s broader North American game plan, which includes rejigging to its pipeline network in Ontario, Quebec, Ohio and Michigan to bring Western Canadian crude to refineries in Sarnia and Montreal. Including Gateway, Enbridge’s North American oil pipeline program “is probably the biggest capital expansion in the history of the company,” says Vern Yu, vice-president for business and market development.

In fact, the new infrastructure should add $2 to $3 to the cost of a barrel of Western Canadian crude, say Enbridge documents submitted with the National Energy Board. “Increasing the number of transportation options and markets for Canada’s oil supply will lead to higher netbacks for all Canadian producers.”

That’s because the new pipelines will connect Alberta’s oil to international markets, where they can command higher prices than in North America. While offshore oil in Eastern Canada competes with crude from Africa and the North Sea, Western Canadian bitumen to date has flowed only toward landlocked and bottlenecked U.S. markets. “We’ve got a global product, and we’re selling it to one customer,” observes University of Alberta business professor Richard Dixon, executive director the Centre for Applied Business Research on Energy and the Environment. “We got lazy.”

Yet Nathan Lemphers, an oilsands analyst with the Pembina Institute, an environmental watchdog group, warns that the goal of selling Alberta oil to Asian buyers via the Northern Gateway is hardly a slam dunk. New pipelines in Siberia and Central Asia, as well as the discovery of shale oil in China, mean that Asian refineries will have access to closer sources of crude, he says.

For the time being, though, safety concerns have eclipsed all other factors in the ongoing debate over how to sort out North America’s pipeline puzzle. The Keystone XL route remains a political hot potato, even though the company agreed to make 57 changes to the project in response to regulatory concerns, according to Paul Miller. The company expects an answer next year, once a new U.S. administration is in place.

Enbridge’s problems seem graver, given its history of spills, including a small one earlier this summer. The company won’t comment on whether the National Transportation Safety Board ruling on the Michigan leak—which calls for stepped up operational scrutiny and increased oversight—will delay the approval process for its various projects. “That’s speculative right now,” says spokesperson Graham White.

Yet Greg Stringham, vice-president of the Canadian Association of Petroleum Producers, admits the NTSB recommendations will likely have some kind of impact, particularly in the way the pipeline giants manage their operations. Pembina’s Lemphers goes further, predicting that Enbridge and TransCanada “will have a lot of trouble putting in additional pipelines” until the NTSB’s recommendations, or their equivalents, are implemented on both sides of the 49th parallel. TransCanada’s Paul Miller agrees: “The public scrutiny will remain high and intensive.”

He also points out that it is almost impossible to time infrastructure development to coincide with increased production and demand. “Development is choppy and sloppy and comes in blocks.” Yet he anticipates that over the next few years, the pieces of a new North American pipeline system will begin to fall into place, with the result that Western Canadian heavy crude may have a better shot at achieving fair value.

TD Bank economist Leslie Preston says the bank is forecasting the WTI-Brent gap to close by 2014 or 2015, with WTI trading for about $100/barrel by 2013. “It’s what the market is expecting.” Scotiabank’s Patricia Mohr agrees that projects like Seaway and Gulf Coast will help chip away at the discount, allowing Western Canadian crude prices to float up to world levels. The pricing, she adds, is not just determined by the Cushing bottleneck, noting that geopolitics and the global economy remain the principal drivers. “The price is determined by perceptions that may or may not be accurate. It’s always been volatile.”

Some analysts, however, remain skeptical. “The real effect of [Seaway and Gulf Coast] won’t be seen until late 2013, and the effect won’t be as big as people are expecting,” predicts Casey Research’s Joe Hung. Loosening the bottleneck, he continues, “won’t be enough. There’s still going to be a giant glut at Cushing.” Hung is also pessimistic on the subject of the regulatory showdown over Keystone and the Northern Gateway projects. “If it doesn’t make sense politically, it won’t happen,” he predicts. “We give the oilsands companies a less generous outlook based on these factors.”

Back in sleepy Cushing, all the pipeline politics and the prognosticating about crude futures seems both impossibly remote but also intensely immediate. Its overflowing storage farms, which can keep the U.S. going for almost five days, fan out across the Oklahoma flatlands like a gigantic checkerboard, and represent the tiny community’s reason for being.

That’s probably why Brent Thompson, in spite of everything that’s happened in recent months, prefers to take the long view. After all, many of the 14 major companies with storage or distribution operations in Cushing are members of his chamber, and so his information comes right out of the tap, as it were. “These things are being worked on,” he says in an even mid-western drawl. “They’re not where the oil companies want them to be, but you’ve got to start somewhere.”

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