No one really knows what will happen when—or if—storage reaches maximum capacity at Cushing.

There are so many variables: the rate of growth in U.S. production and when the trajectory may level out or potentially decline; the shape or term structure of the forward commodity curve; the effective capacity of storage not just at Cushing but also along the Gulf Coast and other key market centers given today’s greater “connectivity” of infrastructure; varying rates of refinery utilization; and crude import levels, to name a few.

In any case, such discussion may be overshadowed by even greater events: a possible lifting of sanctions and the reintegration of Iran into world crude markets; a strengthening or weakening dollar; and volatility in production by the likes of Iraq, Libya and Nigeria.

No matter the initial impact of rising crude inventories potentially “hitting tank tops,” however, some recent and possible developments make it more feasible that the commodity market could clear more efficiently than some expect.

Granted, some think oil inventories could linger at elevated levels through the fall refinery maintenance period. But other observers see signs of positive market mechanisms at work.

A research report by Morgan Stanley analyst Adam Longson, CFA, anticipates U.S. inventory levels continuing to rise through May, providing bearish headlines for U.S. crude, but says “a disaster scenario is unlikely” because there is plenty of storage.

“The system is more flexible than most realize,” he said. “U.S. crude oil inventories are rising sharply on turnarounds and higher production. While optically problematic, differentials should shift to move crude to balance markets. Full storage will never be realized because regional differentials move as congestion builds, allowing access to alternative storage, markets and clearing mechanisms.”

He thinks “a myopic focus on Cushing is too limited” in light of the elimination of bottlenecks and the ongoing infrastructure buildout in North America. “Crude can now move from Edmonton to the U.S. Gulf Coast with little trouble,” he said. “Interconnectivity is better than at any point in the past five years.”

As for fears of West Texas Intermediate (WTI) trading sharply lower as inventories build at Cushing, Longson thinks Cushing storage is more important for WTI structure (that is, the shape of the forward commodity curve). Weakness can be expected in the front month of the curve as inventories rise, he said, but global dynamics remain the more important factor in terms of absolute price. “As long as the U.S. is an importer, it can’t fully disconnect” from global markets, he said.

For 2015, a range of $8 to $13 per barrel for the WTI-Brent discount should be sufficient to clear markets, he said, noting several other “levers” that could help balance crude markets. These include increased exports to Canada via new pipelines and rail; the ability to re-export Canadian crude, provided it is segregated from U.S. crude; a rise in Jones Act deliveries to East Coast markets; and condensate splitters adding to refining capacity.

Meanwhile, FBR Capital Markets senior energy policy analyst Benjamin Salisbury notes that the Department of Commerce is currently reviewing a license application from Mexico’s state-owned oil producer, Pemex. The application is for a “swap” involving 100,000 bbl/d of U.S. light crude being shipped to Mexico in return for a similar amount of Mexican heavy crude in a transaction that would reportedly not be additive to current levels of imports from Mexico.

Potential approval would be under criteria put in place in the 1970s for an exemption to the U.S. oil export ban. These include a “compelling” reason why—in this case involving an oversupplied light sweet crude market—the exported crude cannot be marketed in the U.S. With declining light oil runs through its six refineries, Pemex may have the capacity to absorb additional light oil, possibly reaching 750,000 bbl/d over time, according to Salisbury.

Certainly, the U.S. crude market can expect to face headwinds. The crux of finding equilibrium is still impeded by the crude export ban and the ongoing mismatch between Gulf Coast refineries’ preferred slate of heavier sour grades and the current abundance of light sweet crude. But market mechanisms, backed up by a stronger, more integrated storage and infrastructure system, have the potential to clear the commodity overhang more efficiently than in the past.

As Longson noted, “Cushing is not an island.” Not anymore.

Comments