“The pipeline story has more twists than a 36-stage frac,” Paul Sankey, integrated-oil analyst for Deutsche Bank, said in mid-November upon the surprise announcement by President Obama that he would delay a decision on Keystone XL until 2013. Shortly after this, the proposed “Wrangler” Midcontinent-to-Gulf-Coast oil-pipeline project was canceled when ConocoPhillips sold its half-interest in the Seaway system to the Wrangler half-partner, Enbridge Inc.

Seaway has taken crude oil from the Gulf Coast to Cushing, Oklahoma, for years. Now Enbridge and former Wrangler partner Enterprise Products Partners LP, which already owned half of Seaway, plan to reverse the 670-mile pipe’s flow by mid-2012 and expand its capacity to 400,000 barrels a day.

At press time, however, Obama denied a permit for Keystone XL, saying more time is needed to evaluate environmental impacts.

Brad Olsen, a midstream analyst previously on the buyside with hedge fund Eagle Global Advisors, in Houston, and currently on the sell-side with Tudor, Pickering, Holt & Co. Securities Inc., says Keystone is political kryptonite for the Democratic president. Approving it would be a win for jobs. But, approving it would provoke the ire of environmentalists, who generally supported Obama’s election in 2008.

Pipelines and the tariff-based nature of their revenue stream don’t usually make headlines—in contrast with the upstream oil and gas industry, with its huge wildcat wells and new-play discoveries. But, for Olsen, the midstream is particularly exciting. “The midstream industry touches everything. You have to understand the upstream to know what’s filling the pipeline, and you have to understand the downstream to know the highest-value destination for a given hydrocarbon.”

Oil and Gas Investor visited with Olsen, Tudor Pickering’s vice president for midstream research, shortly after the Keystone XL amendment to the hot-potato payroll-tax-reduction bill cleared Congress, just before Christmas. Here are Olsen’s thoughts on that decision, the WTI/Brent spread, what’s driving the closure of U.S. Northeast refineries, and the new world order of U.S. hydrocarbon supply and demand.

The Keystone XL project is based on 20-year commitments, and it is not going away, says Brad Olsen, vice president of midstream research, TPH Securities.

Investor The Lugar-Hoeven-Vitter amendment to the payroll-tax-reduction bill put Keystone back on the table.

Olsen I’ve maintained throughout this political wrangling a disclaimer that when forecasting politics, there is really no such thing as an expert. It’s hard to predict the outcome of something as crazy as Washington. But I believe Keystone will eventually get built.

Investor Senator Lugar says Obama can only reject Keystone if he deems trade with Canada to be against U.S. interests. Is it this simple?

Olsen I read the amendment. There is really nothing in it that says this determines the future of U.S. trade relations. There is plenty of room for Obama to say, “I don’t like Keystone as it is proposed,” without endangering the whole Canadian-U.S. trade relationship. The U.S. is Canada’s largest trade partner and largest importer of Canadian crude. And, on our side, we wouldn’t somehow cancel the other 2 million barrels a day we receive from Canada just because we have some issue with this pipeline.

Investor Could there be yet another rabbit in the White House’s hat? We have been surprised before.

Olsen I don’t think so. Obviously, the dynamics are fluid, but the core issue here is that Keystone is a project based on 20-year commitments. It isn’t based on capitalizing on a WTI/Brent spread. It’s not a project that’s going away. Even if WTI trades at a premium to Brent in the future, for whatever reason, this is a project that reflects long-term demand by Canadian producers to access the Gulf Coast, which is the most liquid crude market in North America. The most dramatic event we’re going to see is the one we’ve already seen—when Obama announced he would delay a decision.

I was surprised too. But, I don’t think he has the stomach to reject it. He knows it will get built at some point, possibly with a different route; you can’t turn off the spigot from our largest single crude importer, which is Canada.

Investor Brad, speaking of the WTI/Brent spread, it’s evaporating.

Olsen Yes. From our perspective, the high level of WTI/Brent spreads we saw during the summer wasn’t justified by any fundamental factors. There is a speculative component. The reduction in the spread now (to about $8 in late December) has surprised some people, but, when you see it blow out like it did—in this or any of the commodity markets—there is always going to be a speculative component.

Also in play has been the fact that refineries manage their crude inventories to minimize the amount they hold in storage at the end of a year.

Investor The Seaway deal came about shortly after Obama’s November announcement. There was the idea of reversing Seaway, and ConocoPhillips wasn’t onboard with this. Enterprise and Enbridge came up with Wrangler. Then, Obama pushed a decision on Keystone. Suddenly, ConocoPhillips had a deal to sell its half of Seaway to Enbridge. How did this ménage a trois work?

Olsen The Seaway reversal is the only game in town as an existing asset positioned to get a large amount of onshore oil production to the Gulf Coast. If Wrangler were canceled and Keystone were delayed, Seaway’s value would suddenly be much higher. Seaway is about a 400,000-barrel-per-day pipeline from the Gulf Coast to Cushing. Keystone and Wrangler were about 1.5 million barrels a day together. If these were built, Seaway’s value would be considerably impaired. From Conoco’s perspective, if it held onto Seaway to the point where the 1.5 million capacity is approved and being constructed, it would then be difficult to sell Seaway for an attractive price.

The Keystone delay made Seaway more valuable. It’s already in the ground and requires few approvals to reverse the direction. That’s what we saw: Conoco finalized the sale shortly after the Keystone announcement.

Investor It also had two highly incented bidders—Enterprise that wanted to reverse it, and Enbridge that wanted in on an oil-to-the-Gulf-Coast pipeline?

Olsen Yes. Wrangler was a project by En-bridge and Enterprise. If Enterprise bought the second 50% of Seaway and canceled Wrangler, then Enbridge would basically be out of the game, sitting on the sidelines.

Investor With Keystone and Seaway, that’s more than 1 million additional barrels a day. Is there that much more Gulf Coast oil demand?

Olsen On the Gulf Coast, there is the option to ship refined products—gasoline, diesel, other fuels—abroad. It is the most liquid crude market in the U.S. and where we have a disproportionate amount of our refining capacity as a country. Canadian crude has traditionally gone to Chicago, but Chicago is not going to be able to take another 1.3 million barrels a day of crude oil coming out of the oil sands all of a sudden. And, it doesn’t make sense to expand refineries in Chicago, because you can’t export the products from there to another country; Chicago is essentially landlocked. The only real solution is to get it down to Texas or Louisiana where excess crude is made into gasoline or diesel and you can ship that to another country.

Everyone is just trying to get oil to the Gulf Coast. There, you always have the opportunity to send it to another country if you overwhelm domestic demand.

“The Seaway reversal is the only game in town as an existing asset positioned to get a large amount of onshore oil production to the Gulf Coast,” says midstream analyst Brad Olsen of Tudor, Pickering, Holt & Co. Securities Inc. Meanwhile, the Keystone XL project has been rejected for now.

Investor Could WTI resume having a premium to Brent?

Olsen I don’t think we will see WTI at a premium for the foreseeable future. Much has changed in the U.S. and global market in the past few years. WTI has historically commanded a premium as North America had been seen as a region where production was in decline everywhere except for the Canadian oil sands, while U.S. petroleum consumption was believed to be on a permanent uptrend. It was thought that the continent would only get more and more supply constrained and the only growing source would be from OPEC. Thus, a looser supply/demand dynamic for Brent than for WTI, and WTI at a premium to imported crudes.

Investor And that’s no longer true?

Olsen Yes, you’ve seen a reversal of this thought. You’ve seen OPEC members in the Middle East having issues with maintaining production, especially in light of some of the political unrest of the past year. The Middle East is now thought of as a supply-challenged region, while the only place with high-visibility growth in crude supply is North America—between the oil sands, the Bakken, the Eagle Ford and various other plays. Now, the historical relationship of Brent being a looser supply/demand scenario and WTI being a tighter supply/demand situation is reversed.

Today, North America is the only place where crude supply is seen to be increasing over the next few years, while it is much more uncertain in global markets.

Investor How has this affected the Northeast U.S. refining scene?

Olsen That’s a longer-dated issue. We have roughly one half of total Northeast capacity shutting down in the next two years—40% to 50% of Northeast capacity. It’s really dramatic. It’s because of how the U.S. pipeline system is set up and some outdated assumptions about where crude oil comes from. There haven’t been any really meaningful pipelines delivering North American crude oil to the East Coast. They have always received their crude from overseas—mainly light, sweet crude from West Africa and the Middle East. In the 1990s, Gulf Coast refiners debated whether future supply growth would be in the form of heavy, sour crudes from Canada and South America, which are difficult to refine, or the light, sweet crude from the Middle East and elsewhere.

Investor They bet on heavy, sour crude.

Olsen Yes, Valero (Energy Corp.) threw its chips in and said, “We believe it is going to be harder and harder to find conventional crude in the future. Light, sweet crude prices are going to spiral upwards as heavy, sour crude prices go downward. We’re going to have to refine this heavy, sour crude.”

Investor Northeast refineries didn’t switch?

Olsen They would have had to re-engineer their facilities too and they don’t even have access to heavy Canadian crude. Sunoco (Inc.) and most of the East Coast refiners decided to throw their hat in with light, sweet crude.

The way this worked out, obviously, is not to their advantage. The fact is that Valero was right. With exploration in Brazil, Venezuela, Colombia and elsewhere in South America, all have found increasing amounts of heavy, sour crude. Canadian crude has also been increasingly heavy and sour as a result of oil-sands development.

Investor Was the WTI/Brent blowout the tipping point?

Olsen Sunoco and the others found themselves competing to sell gasoline made from $120-abarrel, Brent-priced crude while gasoline from the Gulf Coast was coming from discounted, heavy, sour imported oil and from less expensive WTI-priced oil. Also, East Coast supply has been occasionally interrupted by terrorist attacks and other issues in Nigeria.

Investor What’s driving renewed interest in North American pipelines?

Olsen We had a system of plumbing that, as a result of shale and other horizontal discoveries, no longer reflects where hydrocarbons are coming from. You have a massive amount of oil coming out of South Texas that had historically been just a dry-gas-production area. You have a reinvigoration of oil production in the Permian, and new oil supply coming out of Oklahoma. North Dakota’s Williston Basin went from being a marginal producer to one of the largest fields in North America. You have all of these new gas plays. And now, a resurrection of Ohio and Pennsylvania hydrocarbon production.

We have these completely unpredicted, unforeseen, unforecasted resources. To connect them to demand areas, you need substantial amounts of new pipeline infrastructure. This is really a once-in-a-lifetime transformation.

Investor Has the midstream space ever been so heated?

Olsen No, not at all. This is as hot as it’s been in generations. Prior to the past 20 or 25 years, the overwhelming majority of midstream assets were within larger energy companies and part of a larger, integrated business model. In 1986, the new tax code allowed for the creation of MLPs (master limited partnerships) that have been a great capital-aggregation vehicle for the midstream industry and seen great demand from investors seeking stable, high-cash-flow assets, which are exactly what the midstream provides. With the advent of the MLPs, larger energy companies have had a market in the past few decades to sell their midstream assets into and at high prices.

That’s why you see an independent midstream sector today. This is the first time midstream has been able to participate in this kind of growth as a sort of standalone industry.

Investor When will the transformation be complete?

Olsen There’s little doubt that the pace of new unconventional-resource discoveries in North America has decelerated. With the Marcellus, the Fayetteville, Haynesville, Eagle Ford, Granite Wash, it sounded like there was a new play coming out every week or two. Now it looks as though the pace has slowed.

But the growth in the midstream industry will continue for the next two or three years because, as the resource is proven in a region, there is a lag effect. Even as we see the pace of discoveries slow down, we will still see very meaningful amounts of midstream investment.

Investor What else should oil and gas investors know about the North American business today?

Olsen WTI/Brent spreads will be substantially diminished by 2014. WTI should remain at a discount as close to 2 million barrels per day comes in from Keystone, Seaway and new Permian pipeline capacity.

Investor You’ve said that onshore U.S. dynamics have affected the global market. How so?

Olsen The last economic recession has turned the U.S. into a flat-demand-type market. In the past, the U.S. as a hydrocarbon consumer has always had a reputation that we’ll eat anything; give us more and we’ll wolf it down. Today, you can’t just shift your oil to the U.S.

We’re in a situation, for the first time in a long time, in which onshore producers are trying to get their hydrocarbons to the Gulf Coast because they are no longer confident that North America will just absorb all the excess supply.

This is the core principle that is driving a lot of this pipeline construction.

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