As production in the Permian Basin continues to ramp up, the future of the WTI Midland market remains risky with potential for the downside.

Additional pipeline capacity is lacking in the area despite an active trading center of light, sweet crude oil that remains a major hub for storage and pipelines connecting directly to the Cushing and Gulf Coast markets.

Although there are currently four pipelines which contain WTI crude oil from Midland to Cushing and Houston, more capacity is greatly needed with the rapid rise in crude oil production in the Permian Basin. The two major pipelines that carry crude oil from Midland to Cushing are the Basin Pipeline and the Centurion Pipeline, which have a total capacity of 650,000 barrels per day (bbl/d). There are also two pipelines operated by Magellan, which provide access to the Gulf Coast market in Houston with a capacity of 600,000 bbl/d.

Despite plans to create new pipeline capacity to transport oil outbound from the Midland trading hub, the crude oil at the Midland hub has been discounted.

West Texas is producing a superlight crude oil and not an intermediate blend, which is refined mostly in the Midwest and Gulf Coast regions, said Patrick Morris, CEO of New York-based HAGIN Investment Management.

The issue is the shortage of middle distillates in the crude that is being produced in the Permian, he said.

Refiners in the U.S. are built to process 30-35 API crude. The superlight crude oil can be blended with super-heavy/heavy crude oil, but the shortage of heavy crude is causing some real issues in the U.S. due to refinery utilization rates, Morris said.

Outside the U.S., demand for ultralight is tepid. While exports are picking up the slack, the price differential is widening as the demand is driven by the discount.

“Increased production will only reinforce this trend, and I would think that the WTI/Brent spread will continue to widen, perhaps to more than $10 barrel and perhaps as high as $15 a barrel,” he said.

Rising U.S. crude exports, surging domestic production and new pipeline infrastructure has transformed the WTI Midland from an “opaque and regional market into a vibrant and international marketplace with active participation from Europe and Asia,” said Owain Johnson, managing director of energy research and product development at CME Group, a Chicago-based derivatives exchange group.

“The liquidity of the WTI Cushing benchmark has spurred rapid growth in the spread trading of these domestic crude oil grades and helps to ensure better price discovery in setting the basis differential for the grades market,” he said.

The CME Group reports increased trading volume and open interest in their WTI Midland futures contracts, as well as their other regional crude oil futures contracts anchored to WTI Cushing. So far during 2018, the main WTI Midland futures contract has traded 2,600 contracts per day on average and has reached record levels of open interest at 181,000 contracts. Together with other WTI Midland futures contracts, there is a combined 250,000 contracts of open interest. This is up from a combined open interest of 80,000 contracts one year ago.

“These spread markets further strengthen and rely on our WTI benchmark at Cushing, which provides a flat-price reference for the crude oil grades,” Johnson said. “During 2018 year-to-date, average daily volume in our WTI light sweet crude oil futures have grown 17% to 1.3 million contracts. Open interest set a new record, reaching 2,713,986 contracts on May 16.”

In the past, industry experts were more concerned about the Midland—Cushing differential, said Bruce Bullock, director of the Maguire Energy Institute at Southern Methodist University's Cox School of Business. Now producers are seeking to get their barrels to the Gulf Coast as quickly as possible since there is greater value in that area since the refiners and other customers are located there as well.

“The Midland Houston differential has become the more closely watched differential, in addition to Brent/WTI,” he said.

Midstream companies are struggling to meet the capacity requirements to move the crude oil even though there have been a litany of announcements on pipeline projects from the Permian to the Gulf Coast—mainly to Houston and to a lesser extent Corpus Christi, Bullock said.

“Producers are seeking other methods such as trucking to other pipelines or rail,” he said.

Since infrastructure has historically trailed production, this means that prices will remain depressed until it catches up.

The Permian Basin has ramped up rapidly because it is “arguably the most attractive play in the world” and major oil companies such as Chevron are increasing their rig counts and reserving pipeline space in anticipation of production, Bullock said.

Another key factor that is adding to the region’s production is that private equity companies are no longer just buying, selling and swapping acreage. They are monetizing their assets by proving the reserves up by drilling and producing them, he said.

“Even at these discounts, Permian production remains very economic and breakeven points are likely in the $30 to $40 per barrel range and the oil will continue to get produced,” Bullock said.

Investors are trying to quantify the risks associated with the Permian Basin’s supply growth compared to takeaway capacity for both oil and natural gas, said Ryan Smith, director of research for East Daley Capital in Centennial, Colo.

“With price differentials severely discounted, the market is focused on how bad it could get and when it will it improve,” he said.

Since both pipelines and refinery utilization in the basin are full, which is indicated by the current WTI-Midland differential, transportation has moved to more expensive options— rail and truck.

“We estimate between 50,000 bbl/d to 75,000 bbl/d of rail loading capacity in the Permian Basin and the rest will be forced to move by truck until new pipelines come online,” Smith said.

The cost to move crude by truck from Midland to the Gulf Coast is between $10/bbl to $12/bbl depending on distance.

“Fortunately for Permian operators, there is some excess capacity on Eagle Ford pipelines which will help some truckers cut off some distance to Gulf Coast markets,” he said. “Truck capacity is elastic and will respond incrementally to wider spreads, but the Permian supply has the ability to grow rapidly depending on completions activity.”

If rapid growth occurs, it could backfire and cause a temporary strain on trucking capacity, which could cause the WTI-Midland basis to widen to the point that operators slow production in response to weak prices.

“This is really a short-term event because Enterprise Products Partner’s (EPD) Midland-to-Sealy Pipeline is expanding by 35,000 bbl/d in the third quarter of this year and Permian Express III is expanding by 50,000 bbl/d in the fourth quarter of 2018,” Smith said.

These expansions will be followed by a wave of pipeline additions adding more than 1.2 MMbbl/d between the first quarter of 2019 and the middle of 2019.

“The differential will narrow by third quarter in 2019 as indicated in the forward curve, but we see some short-term risk that spreads could continue to widen depending on how fast production grows by the end of the year,” he said.

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