From the Midland Reporter-Telegram
With the Permian Basin approaching a century of producing oil and natural gas, the region continues to experience historic cycles of imbalances between production rates and takeaway capacity.
The Permian has increased production nearly 30 percent since the beginning of the year and has nearly doubled production since the beginning of 2016. This surge in production has exceeded takeaway capacity, sending the differential between West Texas Intermediate Cushing and West Texas Intermediate Midland climbing to between $10 and $15 a barrel.
With the Permian expected to continue producing vast quantities of crude and natural gas, midstream companies have the incentive to invest in additional capacity. But this leaves operators seeking ways to navigate that imbalance while mitigating the financial risks of lower realized prices.
Opportune LLP, an energy consulting company, analyzed how Permian producers are navigating this challenge. They found some larger companies, such as Chevron and Occidental, have been faring well by purchasing additional pipeline capacity or selling excess capacity to other producers. Other companies have executed hedges to lock in fixed-price differentials between WTI Midland and WTI Cushing.
Chris Hedge, a director in Opportune’s Process & Technology Group, discussed the company’s analysis by email with the Reporter-Telegram. His colleague, Ryan Dusek, director with Opportune’s Derivative Valuation group, discussed the new WTI Permian futures contract established by the Intercontinental Exchange.
MRT: If larger companies like Chevron and Occidental had the foresight and/or the ability to utilize their own midstream infrastructure, how are smaller companies that are still major Permian produces – Apache, Noble, Concho, Pioneer, Parsley, Diamondback – faring? Have they dedicated acreage to pipelines and are they hedging?
Hedge: Most of the major integrated oil companies sold out of their midstream assets in the 1990s/early 2000s. The infrastructure is owned/operated by midstream companies and the capacity on the pipeline is allocated on a contracted/tariff basis. These pipelines are regulated common carrier pipelines and there are rules set forth in the tariffs as to how the capacity is allocated or contracted. I believe that Oxy recently cashed out (for an estimated $5 billion) of their midstream infrastructure by selling the Centurion pipeline and associated assets to Lotus Midstream and the Ingleside complex to Moda Midstream. Most players in the basin have “going forward” production plans and should have, or be in the process of, terming up takeaway capacity to meet those plans. It is my experience that the integrated oil companies like Chevron keep their actual crude hedging to a minimum as they have a natural hedge by virtue of being an integrated oil company. The “upstream only” producers are much more likely to have hedging programs in place that should minimize their exposure to the differential, at least for a short while.
MRT: It’s obvious why producers have priced in expectations the new pipelines will erase the constraints, but why does Opportune say some producers are now wary of these projects?
Hedge: Not sure that producers are “wary” of the projects. Rule number one for the commercial groups is to never shut in production because of takeaway constraints. If they are worried, it’s because they don’t know if the projects will be executed fast enough and/or they are being asked to sign up for potentially onerous terms. There is always a maverick or two who will term up a minimum (to get the project funded) and bet on the industry’s propensity to overbuild capacity.
MRT: What impact do you see, if any, on Permian Basin activity due to these wide differentials? And are they at record highs?
Hedge: It could slow down completions until the capacity can be firmed up and in place. From a marketing/trading perspective, the wider the differential the more creative the solutions. Any trepidation on implementing these creative solutions is that the investment required must be recovered before the arb closes.
MRT: Is Opportune following the new ICE Permian/CME WTI Futures contract?
Dusek: I believe the two exchanges (ICE and CME) will compete with one another, just as they currently do for contracts based in Cushing, OK. However, given the continued boom of the Permian, I expect both exchanges to be successful in their efforts. In addition, having wo separate real-time pricing mechanisms will only increase transparency in the market. Also, the relative price of the new contract vs. WTI Cushing should help alleviate some of the existing pricing inefficiencies in the market. The WTI Cushing market may decrease in liquidity over time, but it is extremely unlikely that it will ever go away. Many existing long-term deals and hedges are based on this pricing location. Furthermore, it has been the U.S. benchmark for decades and may take just as long for that to change. The ultimate popularity of the contract will determine any potential capacity issues, relative pricing of Cushing and the new Houston WTI contract will help to keep physical constraints in check. If the immediate demand for the Houston WTI contract is overwhelming, I would expect an infrastructure buildout to occur soon after.
