Surging U.S. Domestic Crude Grades Market

The four key futures contracts for the U.S. domestic crude oil grades are financially settled based on crude oil price assessments published by Argus Media.  These cleared futures contracts provide the hedging tools for managing arbitrage risk between the U.S. and global markets.   Table 1 shows the current liquidity information for the crude oil grade spread futures contracts trading at CME Group.

Average daily volume is for the 6-month period Jan 2018 through June 2018; Open Interest is as of 07/11/2018.

To help understand the growing significance of the U.S. domestic grades market and its impact on the international market, an overview of each of the four major crude oil grade benchmarks is provided below.

There is an active physical crude oil trading center based in Houston, Texas, which is a major hub for storage and pipelines with direct connectivity to the Cushing, Midland, and U.S. Gulf Coast markets.  There is active trading in light sweet WTI type crude oil (also referred to as domestic sweet).  The WTI crude oil stream in Houston is a fungible blend of domestic light sweet streams with quality parameters of 44 degrees API gravity maximum and 0.45% sulfur maximum, which are slightly lighter than the WTI specifications in Cushing.

The Houston physical delivery mechanism is comprised of a network of nearly a dozen pipelines and 10 storage terminals.  There are substantial pipeline inflows of WTI-type crude oil to Houston from four major hubs:   1) from Cushing via the Seaway and the Transcanada MarketLink Pipelines; 2) from Midland, Texas via the BridgeTex Pipeline and the Longhorn Pipeline; 3) from the Eagle Ford area in Texas via the Enterprise Pipeline and the Kinder Morgan Pipeline; and 4) from the Bakken production region in North Dakota via the Dakota Access Pipeline (DAPL).

The Argus assessment for WTI Houston crude oil is based on delivery at the Magellan terminal in East Houston, which is a key hub for delivery of WTI-type crude oil.  The cash market liquidity is vibrant, and market participation is deep, with 20 to 30 market participants.

Based on feedback from industry sources, the recent pipeline flows of WTI-type crude oil inbound to Houston is in the range of 3.0 million barrels per day (b/d).   The capacity of each pipeline is presented in Table 3 below.

TOTAL In-Bound Pipeline Capacity: 3.3 Million Barrels/Day

There is an active physical crude oil trading center based in Midland, Texas, which is a major hub for storage and pipelines with direct connectivity to the Cushing and U.S. Gulf Coast markets.  There is active trading in light sweet WTI-type crude oil at Midland.  Further, there are substantial pipeline flows of WTI-type crude oil from Midland, Texas to Cushing and Houston.  Two major pipelines carry crude oil from Midland to Cushing:  the Basin Pipeline and the Centurion Pipeline, with total capacity of 650,00 b/d.  In addition, there are two pipelines operated by Magellan that provide access to the Gulf Coast market in Houston with takeaway capacity of 600,000 b/d.  Figure 2 shows the pipeline systems between Midland, Cushing and Houston.

The major challenge for the Midland trading hub has been providing additional takeaway pipeline capacity to keep pace with the rapid rise in crude oil production in the Permian Basin.  There are plans for new pipeline capacity to transport oil outbound from the Midland trading hub, but in the short-term, the infrastructure has lagged behind the ramping production, and consequently, the crude oil at the Midland hub has been discounted.  As the export market continues to expand, the oil industry has responded with logistical solutions to ensure the crude oil producers in the Permian Basin will have access to the Gulf Coast market.

The LLS grade is traded at its hub in St. James, Louisiana, which consists of storage facilities and major pipelines for distribution from the Gulf Coast to refineries in Louisiana. There are significant new developments in Louisiana that will impact logistics around the LLS market. First, Marathon Pipe Line LLC has begun work on the reversal of the Capline system, and the pipeline system has terminated northbound shipments from St. James. As a result, the Capline is no longer available as an outlet for the LLS crude oil flow to refineries in the Midwest.

When the Capline is finally reversed in 2022, the line will provide access to Bakken and Canadian crude oil to flow southbound from Patoka to the Gulf Coast in direct competition with LLS. The shutdown of Capline has significantly altered the logistics in the LLS market, as market participants seek out additional outlets for LLS in Louisiana and in the export market.

Second, the LOOP facility has completed work to load export vessels from its deep-water port that will allow for loading of LLS onto VLCC vessels with capacity of 2 to 4 million barrels. This will provide access for LLS to be exported to the global marketplace, and provide new arbitrage opportunities for the LLS benchmark.

Light sweet crude oil production from Louisiana and Texas accounts for a significant portion of the LLS-quality crude that is blended and traded in St James, LA.   Light sweet crude produced in the Eagle Ford and Permian regions in Texas is frequently shipped via pipeline and barge to the hub in St. James, and blended into the LLS stream.  There is direct pipeline connectivity from Houston to St. James via the Shell Zydeco Pipeline (also called the Ho-Ho Pipeline) with capacity of 375,000 barrels per day as shown in 4 below.  In addition, light sweet crude oil is delivered by barge from Houston and Corpus Christi to the terminals in St. James for blending into the LLS stream.

The Mars market represents spot trade of Mars Blend crude oil which is deliverable at the LOOP facilities in Clovelly, Louisiana.  As mentioned above, there are significant developments in Louisiana that will impact the Mars market.  First, the LOOP facility has begun loading export vessels from its deep-water port that will allow for loading of Mars onto VLCC vessels with capacity of 2 to 4 million barrels.  This will provide direct access for Mars to be exported to the global marketplace, and provide new arbitrage opportunities for the Mars benchmark.

In addition, as discussed above, Marathon Pipe Line LLC has begun work on the reversal of the Capline system. Previously, Mars flowed northbound to Midwest refineries via Capline, but the pipeline flows have been terminated. After the reversal is complete, the Capline will provide southbound access to Bakken and heavy Canadian crude oil to flow to the Gulf Coast in direct competition with Mars. This pipeline reversal has significantly altered the logistics in the Mars market, and as a result Mars has become a key export grade from the LOOP terminal.

The Mars Pipeline System^1,2 originates approximately 130 miles offshore in the Deepwater Mississippi Canyon and terminates in salt dome caverns in Clovelly, Louisiana as shown in Figure 6.  The System transports offshore crude oil from the Mississippi Canyon area, including the Olympus platform as well as the Medusa and Ursa pipelines, and from the Green Canyon and Walker Ridge areas via the Amberjack pipeline connection³. It has a capacity of up to 600,000 barrels per day.

The Mars System Pipeline:

Gathers from producers in: Mississippi Canyon

Gathers from pipelines: Ursa, Medusa, and Amberjack

Delivers to terminals: Chevron’s Fourchon Terminal and LOOP Clovelly Terminal

Delivers to pipelines: Clovelly to Houma, Clovelly to Norco, LOCAP, and Chevron’s Fourchon to Empire pipeline

In conjunction with the Mars Pipeline System, the Mars infrastructure network consists of a storage cavern with capacity of eight million barrels at the LOOP Clovelly Terminal.  This cavern and its interconnection to other LOOP facilities provide a flexible market link to the Gulf Coast pipeline network.

According to Argus, the Mars oil stream is a light sour crude oil with quality parameters of 28 degrees API gravity maximum and 1.93% sulfur maximum.  Market participants in the Gulf Coast sour crude oil cash market include 30 to 40 companies.

U.S. Gulf Coast (PADD 3) region is the major tight/shale oil production area, accounting for 40% of overall U.S. production in 2018.   Driven by reduced drilling costs and higher efficiency, shale plays have increased production significantly since 2010.   The Eagle Ford shale formation is located in South Texas from the US-Mexico border north of Laredo in a narrow band extending northeast for several hundred miles to north of Houston.  Permian Basin shale spans west Texas and southwest part of New Mexico.  Both shale plays are among the most prolific oil production areas.  Figure 6 shows the two shale regions in PADD 3.

U.S. crude oil production has nearly doubled from 5.1 million barrels per day (b/d) in January 2009 to 10.9 million b/d in June 2018.   In its latest short-term energy outlook, the U.S. Energy Information Administration (EIA) predicts oil production to hit a new record high in 2019 of 11.8 million b/d. According to the EIA, most of the growth in U.S. crude oil production is WTI type crude oil with API gravity between 40 and 45 degrees.  This is significant for the WTI benchmark, as it underscores the similarity in quality between the new oil production and the WTI pricing reference.

U.S. crude oil exports more than tripled in June 2018 compared to one year ago,  to average 2.4 million b/d. The growth in exports has been transformative for the U.S. crude oil market.  Houston has become a major export hub, and new infrastructure has been constructed to process the growing export volumes.  These infrastructure changes have transformed the U.S. into the marginal supplier of oil to the world.

The growth in U.S. crude oil exports has been balanced and diverse, with strong participation from Asian countries.  As figure 8 shows, China has been the second largest buyer after Canada of U.S. crude oil exports. The broad participation indicates a well-developed export market that spans both Europe and Asia.  As U.S. oil exports gain deeper penetration in the global oil markets, the U.S. crude oil grades will continue to expand their importance as key price references in the international marketplace.

The U.S. domestic crude oil grades market has been transformed into a vibrant and international marketplace with active participation from Europe and Asia.  This transformation has been driven by rising U.S. crude exports, surging domestic production, and new pipeline infrastructure.  With rising exports, the Gulf Coast grades are accessing the global marketplace, and competing directly with Atlantic Basin and West African crude oil grades.

Further, the liquidity of the WTI Cushing benchmark has driven impressive growth in the spread trading activity for the U.S. crude oil grades, and this ensures better price discovery in setting the basis differential for the grades market.  The WTI benchmark at Cushing provides a reliable anchor as the flat price reference for the crude oil grades, and allows for more reliability in the price mechanism based on active spread trading.

Currently, oil market participants are pricing U.S. oil exports based primarily on the assessment of WTI at Houston, which is quoted as a differential to the WTI benchmark price at Cushing.  This WTI pricing differential is highly liquid, and reflects the location basis between Cushing and the export hub in Houston.  The WTI benchmark at Cushing provides the flat price reference for the WTI priced at Houston.  In addition, the liquidity of the WTI benchmark at Cushing helps to enhance the accuracy and the transparency of the basis differential for WTI at Houston where exports are priced.

The oil industry faces infrastructure challenges to keep pace with the surging U.S. shale oil production.  In the short-term, the crude oil at the Midland trading hub has been discounted, but the industry is responding with logistical solutions to provide access to the U.S. Gulf Coast market.  In addition, there are significant changes coming in Louisiana that will impact the LLS and Mars markets.  The ability to export from the LOOP facility is a game-changer that will provide direct access to the global marketplace, and provide new arbitrage opportunities for the LLS and Mars benchmarks.  In addition, the planned reversal of the Capline system in 2022 will allow crude oil to flow southbound to the Gulf Coast in direct competition with LLS and Mars.  This pipeline reversal will significantly alter the logistics in the LLS and Mars markets, and will impact the pricing of these benchmarks.

In summary, the U.S. domestic crude oil grades are competing in the global marketplace, and have become important price references in the international market.  The cleared CME crude oil grade futures contracts provide the hedging tools for managing arbitrage risk between the U.S. and global markets.