Analysis and prophecy really should not mix, but invariably the analyst feels compelled at some point to look into a crystal ball. Here at PAR, this seems like a good warning to heed about predictions:
Always in such situations, a few traders bet the other way, leading observers to declare them oracles. John Armitage, whose hedge fund made $1.5 billion last year betting on an oil bloodbath, hasn’t yet been crowned a sooth-sayer, though he could be at any time. On the other side, there are traders like Andrew John Hall, a long-time oil prophet who made a big bet starting in 2014 that oil prices were going back up, but they instead plunged; in 2015, he stayed with the bet, and by the end of the year, his hedge fund had reportedly lost more than a quarter of its value.
The analysts defend themselves by noting that they got this and that aspect of oil’s trajectory right, which is fair enough. But it seems all missed the big picture: First, they failed to see that from 2011 to 2014, a surge in shale oil production was going to become a big factor in global supplies; then, they did not anticipate that the same oil would create the mayhem before us now. In fact, in the case of the current turmoil, most forecast the precise opposite—economic nirvana. Interviews with the main institutions that made the bad calls reveal no crisis of confidence, and they are busy putting out analyses of the latest developments.
The track record of analysis in the oil markets should give one pause, but the glut of 2014-2??? is really not that hard to understand.
The Market is Completely Broken
A cursory glance at EIA data shows that refinery crude acquisition cost was lower for imported crude than domestic crude in the second half of 2015 while the spread favoring WTI over Brent (WTI at a discount to refiners) only closed in December. That’s correct–the markets made it more favorable for refiners to purchase imported crude despite Brent being more expensive than WTI for most of the year.
If that seems odd, notice that the average domestic crude acquisition cost/average WTI spot price from 1 July to 31 December 2015 was $54.15/$50.90 in July, $46.30/$42.87 in August, $46.68/$45.48 in September, $47.02/$46.22 in October, $43.37/$42.44 in November and $38.71/$37.21 in December. This could be the result of American oil refineries having a run of bad luck choosing the losing sides on crude oil futures trades, but the historical acquisition data shows refineries consistently are on the down side. Could not blame the refining sector if they feel the desire to bulldoze CME and NYMEX, as the mercantile exchanges seem dead set on destroying all refining capacity in the U.S.
So, how does this demented system work, and why haven’t oil imports skyrocketed? While American oil refineries would probably rather drink cyanide than voluntarily work within the commodities traders’ Rube Goldberg financial constructs, they have become very adept at playing the game. Refineries are classically low-margin affairs (not that they should be–bottleneck operations are high-margin and their suppliers low-margin in sane realities), essentially forced to sell at Brent prices demonstrated with the $10 Brent=25 cents per gallon gasoline rule of thumb. Except for December, American refiners could eke out a margin between domestic input costs and the Brent spot price and could go to town with cheap imported crude oil.
This naturally requires an explanation how refiners could buy imported oil off of an international crude index and sell petroleum products based on another international index.
The Enigma of PADD 4
Looking at this data shows the Rocky Mountain refining district consistently buys imported oil (and domestic for that matter) far cheaper than the other four districts. This is due in part to the fact PADD 4 is far smaller than its brethren and establishes conclusively that the financial apparatus behind oil markets is jaw-droppingly insane (economies of scale would dictate PADD 3 hold such an advantage). The other factor is Western Canadian Select (WCS).
When the Rocky Mountain refining district imports crude oil, other than once from Mexico in 1999 and once from Nigeria in 2003, it comes exclusively from Canada. As Montana has PADD 4’s largest refining capacity and is the only state in the Union that borders Alberta, this should not be surprising. Last year up to half of the oil PADD 4 refined each month was WCS, which presents a significant dividend:
West Texas Intermediate is the US produced benchmark crude and cannot be exported outside of North America; WTI therefore sells at a small discount to Brent, currently about $4 per barrel. All upgraded Canadian crude oil sells at prices close to West Texas Intermediate.
However, a good portion of bitumen from the Canadian oil sands is not upgraded and sold to market as Western Canadian Select (WCS), which is a blend of bitumen, diluted with light condensate. Western Canadian Select trades a discount to WTI, this difference is referred to as the Heavy Oil Discount, currently at $17.40 per barrel.
From a December 2014 perspective, Oil Sands Magazine identified the mechanism that would throw the glut into overdrive:
The drop in crude prices this year has been far less dramatic than 2008, although it is very likely we have not yet reached the lows in this decline. While West Texas Intermediate is down 45% from the highs of mid-2013, Western Canadian Select has fallen more sharply, so far down 55% from the peak of over $90 per barrel reached in the summer of 2013. Today’s closing price for WCS is $40.40 per barrel, the lowest since the spring of 2009.
Traditionally, when the price of crude oil is low, the heavy oil discount is relatively narrow. However, the price differential to WTI has been widening going into the winter months. The heavy oil discount so far for the month of December has averaged $18 per barrel, representing a 32% discount to WTI. This reflects the oversupply in the North American market and more importantly, the lack of port access for Canadian crude oil.
In the face of much lower crude prices compared to 14 months ago, the heavy oil discount has grown even larger…
34.06 ▼ 0.40 (1.2%)
BRENT USD/bbl30.89 ▼ 0.83 (2.6%)
WTI USD/bbl16.69 ▼ 0.78 (4.5%)
WCS USD/bbl23.16 ▼ 0.82 (3.4%)
WCS CAD/bbl
…which is having a disproportionate impact in the Midwest.
PADDing WCS
Today in February 2016 four out of the five PADDs are running at 83% capacity utilization. However the Midwest refining district (PADD 2) is running at 97.4%. With more than six times the capacity as PADD 4 (second only to PADD 3), PADD 2 likewise prefers to eschew importing oil from anywhere other than Canada. There is a compelling reason for this:
WCS is pouring into Illinois, whose four refineries represent over a quarter of the district’s capacity. PADD 2 was the exclusive beneficiary from Keystone starting with the June 2010 opening of Phase I followed by added pipeline access to the WTI hub when Phase II went online in February 2011. Used to playing off WCS vs. WTI, PADD 2 refineries increasingly turned to Alberta over Oklahoma. Last week, almost 65% of the crude processed in PADD 2 was Canadian.
PADDs 1 and 5 do not have the same phenomenal access PADDs 2-4 have to WCS, but nevertheless Canada is becoming the import-of-choice on the coasts. PADD 1 imports are a third Canadian, and while the Pacific still is a large OPEC customer PADD 5 imports roughly the same nominal Canadian quantities as the Atlantic. One huge customer remains largely untapped.
PADD 3 still imports six times as much from OPEC as the Canadians, chiefly from its choice to prioritize WTI transport over WCS in Phase IIIa. But Texas is warming to Alberta while slowly souring on OPEC, which is sure to intensify the Saudi Arabian response. But this is definitely not a war the Persian Gulf is likely to prevail in against the Gulf of Mexico, nor do they have any hope against the U.S.’s largest oil partner.
Pipelines vs Tankers
Even assuming OPEC can drive the Brent/WTI spread negative long enough to wipe out American shale oil drillers (a circumstance that hasn’t prevailed much since Keystone went online), bridging the gap with WCS is an almost impossible task.
Canadian crude is consistently the lowest cost available to refineries, a trend that has been ongoing for years. This has made Canadian oil two to three times more favorable than Saudi Arabian imports, a ratio that would only widen if American domestic crude becomes scarce. Moreover WCS is in fact the cheapest crude index worldwide, and the Canadians can hold out against an onslaught for much longer than the Persian Gulf as their economy is far more diversified than those in OPEC.
For the coming year(s), so long as there is a significant Brent-WCS spread in the Canadians’ favor, low oil prices will be the norm. It really is that simple, unless the commodities markets are sorted out and end this epic, decades-long failure.
The Petroleum and Economic Analysis Report 
