An interesting aspect about energy is that there’s always something new to learn or relearn. And that’s likely also a reason why generalist investors tend to stay away, and that the S&P energy index weighting hovers around a lowly 6%.

Just recall a recent series of events: Investors warmed to E&Ps’ reinforced resolve to hold spending to within cash flow, or close to it, during first-quarter calls. Some market commentators began to talk about a rotation into energy. Production in Venezuela was on a downward spiral, and the U.S. had imposed new sanctions on Iran.

Amid concerns a price spike may weaken demand from key consuming countries, Saudi Arabia and Russia met to discuss easing barrels into the market. OPEC plus allies might bring back 300,000 to 400,000 barrels per day (bbl/d) under a Saudi plan, while a Russian proposal called for 800,000 bbl/d, said The Wall Street Journal.

All the while, smoldering under the surface, were the ingredients for a blowout of price differentials, resulting in widening spreads between the Midland hub in the Permian Basin and key markets centers in Cushing, Okla., the Gulf Coast and, globally, the Brent benchmark.

“Oil production out of the Permian is set to be materially higher than local refining and oil takeaway for the next 12 to 18 months,” said a Raymond James report. “U.S. production is growing faster than exports can efficiently ramp, and U.S. refiners are maxed out on their ability to process more light sweet barrels.”

In addition to declining supplies from Venezuela, the situation is compounded by Canadian heavy barrels that “are further outmuscling U.S. light sweets to flow to the Gulf refiners that are currently searching for alternatives to similar spec Venezuelan crude,” observed RBC Capital Markets.

The blowout in Permian “diffs”—as widespread as $20/bbl or more is forecast for Brent-Midland in 2019—is expected to “infect” the entire oil transportation chain, said Raymond James, noting growth in other inland basins was likely to “drive ratable increases in Cushing stocks over the coming quarters.”

Several research firms, including Raymond James, have forewarned that spreads were likely to widen as Permian growth marched higher--but not as soon or as violently as occurred in late May/early June. The firm was quick to revise its early June forecast of the Brent-WTI spread for 2019 to $15/bbl, up from $5/bbl earlier.

Not only is bottlenecked WTI being pushed $5/bbl lower, Brent is also moving $5 higher to form the $15 spread. “Any level of reduced production volume from the Permian is essentially removing additional barrels that are both expected and needed from an already tight market,” it observed.

And with the downward pressure on Permian prices, “the bottom line is that we now believe Permian activity will stagnate in the back half of 2018, dip slightly in early 2019 and then rebound steadily through the rest of 2019,” continued the Raymond James report.

Of course, the double whammy of all this impacts both volumes and pricing in myriad ways, depending on levels of firm transportation, marketing agreements, degrees of hedging, hedging structure, etc. “The actual prices received by various E&Ps will be all over the board,” noted the report.

The response of producers is most likely to be a mix of “some modest activity deferrals starting in late 2018,” said Raymond James, combined with some increased rail shipments—gradually moving from manifest to unit trains—and a much smaller amount from an already very tight trucking sector.

A case could be made for deferring completions, noted Credit Suisse analysts, as a pre-tax net present value per well improves roughly 10% if delayed into pricing at $3 vs. $20/bbl off the benchmark. However, E&P multiples of cash flow or EBITDA would be more expensive as cash flow/EBITDA falls.

But an initial selloff had already started. One large cap E&P seen as being less well-positioned was down 9% in three trading session through June 4. A similarly viewed smaller mid-cap was down 19%. Pioneer Natural Resources Co., positively prepared to enjoy premium Gulf Coast prices, was down less, but still 3%.

For long-term investors (if such still exist), the solution arrives in early 2020. By then, new projects are slated to bring online some 2.4 MM bbl/d of takeaway, expandable to 3.4 MM bbl/d. “The WTI-Brent spread should narrow even if a smaller set of incremental pipe reaches operational status,” said RBC.

By then there’s plenty of room for Permian players to ramp up production. But then, as one report noted, the Permian is “over-piped.”

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