Our models predict a small premium to Cushing, but only if bottlenecks don’t emerge.
After a shake-up this spring, Midland’s price differential to Cushing (Mid-Cush) is back to its pre-March levels. The chart below shows historical and futures spreads along the three legs of the Midland-Cushing-Houston “Triangle.” The Midland-Cushing leg shows Midland prices are at a small premium to WTI at Cushing.
We expect Midland to trade near parity with Cushing for a while, without pipeline interruptions and if overall oil prices hold near today’s levels.
Our main reason for expecting low Mid-Cush volatility is the amount of excess pipeline capacity out of the Permian basin. Bottlenecks in-basin are not very likely. The chart below shows historical Permian oil production against total pipeline capacity. Without a sudden, large increase in production growth, the Permian basin is likely to have several years of abundant takeaway capacity.
With such excess capacity, holders of pipeline contracts will be looking to sell capacity into the secondary market at very low prices. We expect that “floor” to be around $1/Bbl. Therefore, Midland will tend to trade near a one- or two-dollar discount to Houston. And, because Houston is typically a better price than Cushing, this tight Midland-Houston spread would drag Midland prices higher, to parity, or a small premium, to those at Cushing.
Our main risks in this analysis are (1) potential storage constraints along the Texas Gulf Coast, and (2) potential strength at Cushing.
First, PADD 3 (the U.S. Gulf Coast) storage has been rising. Total PADD 3 storage capacity is quite high, but the storage facilities tied to the pipeline supply chain could fill with little warning. This would cause some barrels to be sold into Midland instead. It would be bearish for Mid-Cush.
Second, if refinery demand for oil increases in the Midwest, there could be some shortage of light-sweet crude oil. Refiners would increase their bid for the nearest sources of supply, and that is likely Cushing or pipeline deliveries from the Bakken. It’s the latter that concerns us the most, because Dakota Access Pipeline (DAPL), which delivers Bakken crude to Illinois, is under legal threat and could be forced to shut down (see our previous commentary here). Difficulty in delivering Bakken oil to Midwest refineries could increase the value of Cushing WTI, therefore causing a dip in the Mid-Cush differential.
We recommend most clients with Mid-Cush exposure to hedge it at its current small positive value. The risk of lower Mid-Cush is greater than a risk of a more premium Mid-Cush differential.