Influence of U.S. Pipeline Developments on WTI Hedging Behavior

  • 6 Nov 2018
  • By Chad Britnell and John Coleman
  • Topics: Energy

Crude oil pipeline infrastructure is undergoing a dramatic transformation to service record levels of shale volume produced daily in the United States. Current oil production in the Permian Basin has neared 3.5 Mb/d, accounting for a large portion of aggregate U.S. supply, and surpassed the current 3.4 Mb/d of pipeline capacity used to transport crude from the region. Permian operators are currently unable to move excess supply to the Gulf Coast for export and are utilizing all available pipeline evacuation routes, including North into Cushing. Wood Mackenzie estimates that supply growth will grow 2.4 million b/d by 2023 and will require substantial infrastructure buildout to support growth in the basin. Midstream companies are working to address the pipeline bottleneck and the basin will see three new long-haul pipeline projects come online by the end of 2019 or early 2020 to deliver Permian crude directly to the USGC market, providing access to export markets and international pricing. However, hedging behavior in 2019 and 2020 WTI futures contracts suggests that producers may be anticipating delayed completion dates for key pipeline projects.

This paper examines the ongoing developments in U.S. crude oil infrastructure and the specific impacts of pipeline projects in the Permian Basin on producer hedging behavior.

Chart 1: New Pipeline Capacity 2019-2020

Pipeline Origin Destination Capacity (000s b/d) Start-up date (est.)
Cactus II McCamey TX Corpus Christi, TX 670 Sep-19
EPIC Pipeline Midland, TX Corpus Christi, TX 600 Jan-20
Gray Oak Pipeline Crane, TX Houston, Freeport, Corpus Christi 800 Jan-20

Source: Wood Mackenzie North American Crude Markets Service

Pipeline Project Timelines Under Question?

Given the initial start-up dates provided by pipeline operators, approximately 2.1 Mb/d of capacity will be available via Cactus II, EPIC and Gray Oak likely by the end of the first quarter of 2020. The pipeline developments are expected to relieve bottlenecks and increase takeaway capacity from the area. Although, according to analysis provided by Wood Mackenzie, in June 2018 market participants began to express concerns regarding the target completion dates for the three major Permian pipelines. Issues surrounding labor supply, construction delays, and material procurement are among some of the project complications leading to the possibility of later start-up dates.

Wood Mackenzie projections show that delays in pipeline completion dates have the potential to add 565,000 b/d to the original Permian-to-Cushing pipeline flow estimates. Cushing is viewed as a sub-optimal destination for Permian-produced crude given the light sweet crude saturation in the US midcontinent market. The US Gulf Coast market is viewed as a more optimal destination for Permian barrels to access international export markets and waterborne pricing. Nonetheless, transport on a pipeline into a sub-optimal market rather than an expensive trucking haul into the optimal market remains the better economic alternative for producers. From this, significantly more crude volumes are flowing north out of the Permian basin into Cushing storage tanks than normally would under free-flowing pipeline conditions.

This creates a scenario where greenfield pipeline delays continue pushing volumes north to Cushing into 2020, in conjunction with rapidly increasing production north of Cushing also flowing into the hub. This has the potential to put substantial pressure on major traditional exit routes out of Cushing and significantly impact the WTI Cushing price relative to international benchmarks such as Brent. The charts below highlight Wood Mackenzie forecasts for crude flows by source into Cushing, Oklahoma under a base case with Permian pipes delivered on schedule and a 3-month Permian pipeline construction delay case.

Chart 2: Base Case Oil Flow Projections into Cushing, OK (kb/d)

Chart 3: Permian Pipeline Delay Case Flow Projections into Cushing, OK (kb/d)

The State of Midland and WTI Oil Prices

The lack of pipeline capacity in the Permian Basin has caused WTI Midland oil prices to trade at a significant discount to WTI Cushing throughout 2018. With that said, the differential between the two market prices began tightening at the beginning of September on news of an early start up of the Basin pipeline expansion by Plains All American into Cushing, relieving pressure to transport crude on a tight long-haul trucking market. However, the improvement in Midland prices relative to Cushing may be affected, with continued Permian basin production growth forecast in coming quarters and alleviation of constraints from greenfield projects still more than12 months away.

Once substantial pipeline relief arrives, the Permian basin will likely be in a temporarily over-piped scenario, which could lead to premium prices in Midland over Cushing prices in 2020. Producers potentially hedging Midland prices at a discount to WTI in 2020 may be indicative of risk mitigation that the greenfield pipes, along with regional price relief are delayed later into 2020.

Chart 4: WTI Midland and WTI Cushing Prices

Source: CME Group

Are producers changing their long-term hedging strategies?

CME Group’s WTI Crude Oil futures are experiencing a spike in open interest for far dated contracts during the second half of 2018. Market expectations of increasing oil flows stemming from the Permian Basin and heading for Cushing may be causing producers to ramp up their WTI hedging activity in far dated contracts, particularly in December 2019 (CLZ9) and December 2020 (CLZ0) where most of commercial hedging takes place. Despite slow aggregate open interest growth in the summer months of 2018, open interest levels in the DEC19 and DEC20 crude oil futures contracts have grown 116% and 81% YTD respectively, adding the equivalent 162 million barrels of oil since January 2018. December 2019 and 2020 dated contracts now account for 14% or 314 million barrels of total CL open interest, up 20% against comparative contracts in 2017. The recent increase in hedging activity in DEC19 and DEC20 WTI contracts suggests that Permian producers foresee sustained pipeline flows to Cushing in both 2019 and 2020 indicating that there is uncertainty surrounding pipeline development timelines.

Chart 5: Open Interest – Far Dated Contracts

Source: CME Group

Chart 6: Open Interest – Far Dated Contracts YoY Growth

Source: CME Group

The shift of attention to 2020 production can be seen specifically in the abnormal increase of two-year hedging activity taking place in the latter half of 2018 and may also provide some legitimacy to the rumors surrounding pipeline project delays. The back end of the WTI curve has weakened during the same time which could be an indication that producers are aggressively selling production forward in anticipation of Permian oil flowing to Cushing further into 2020 than initially projected. This can be observed specifically in the DEC19/DEC20 spread, which began widening in late June following market whispers of project delays.

Chart 7: Developments In 2-Year Hedging Strategies

Source: CME Group

Chart 8: WTI Futures Far Dated Spread

Source: CME Group

Key Takeaways

In today’s price environment, record U.S. oil production is testing pipeline infrastructure developments and driving the hedging strategies of market participants. Pipeline and crude flow analysis from Wood Mackenzie's North American Crude Market service layered over CME Group open interest data yields a potential narrative of producers moving to mitigate perceived risks in 2020 at a greater rate than historical norms. More specifically, uncertainty surrounding key project timelines is increasing regional risk management appetite amongst producers in the Permian Basin. Constraints on transportation to the Gulf Coast, reflected in the WTI Midland – WTI Cushing price differential, has forced sellers in the Permian Basin to source alternative paths for their product. The Cushing route to the Gulf Coast remains the economic choice for Permian operators and will continue to be utilized while the market awaits further takeaway capacity. As a result, it is possible that producers may be using WTI futures to hedge their 2020 production on expectations that pipeline completion delays will result in excess flows to Cushing well into 2020.

About the Author

John Coleman is a senior analyst leading Wood Mackenzie’s North American Crude Markets research where he is responsible for short and long term North American crude market outlooks, crude differential forecasts, and midstream logistics analysis. John holds dual B.S. degrees in economics and finance from Southern Methodist University, a M.S. in Accountancy from Texas A&M University, and a M.S. in Finance from the Indiana University Kelley School of Business. John is a Certified Public Accountant and is currently a CFA Level III Candidate.

About the Author

Chad Britnell is a research analyst covering the energy and metals markets at CME Group where he is responsible for providing economic and statistical analysis in support of new and existing commodity derivatives products. Chad holds a B.S. degree in finance and political science from Providence College and is currently a CFA Level II Candidate.