Investigating the Discrepancy Between Midwest and East Coast Oil Refineries: The Brent-WTI Spread
Midwest refineries are minting money while their East Coast counterparts are bleeding cash. Here's what's behind the immense disparity.
Ever see a cash cow? Yeah, me neither. But if there ever were one that came close, it would be an oil refinery in the Midwest.
Since the downfall of West Texas Intermediate (or WTI) as the world crude benchmark (and simultaneous tracking of Brent as the new benchmark), it's been an absolute "Tale of Two Cities." Midwest refineries are minting money while their East Coast counterparts are bleeding cash. And the bloodbath is so profuse that ConocoPhillips (COP) plans to shut down its Trainer, Pennsylvania, unit if it cannot find a buyer. Similarly, Sunoco (SUN) is arranging to do the same with its Marcus Hook and Philadelphia refineries. A total of almost 700,000 barrels-per-day of capacity will be lost if buyers for these assets are not found. As PBF Energy recently purchased several Valero Energy (VLO) refineries, it remains one of very few companies left in the R&M business in the mid-Atlantic.
Why exactly is there an immense discrepancy between the two regions? Since Brent is the new benchmark, crude distillates and products including gasoline (RBOB) and heating oil (HO) track its prices rather than WTI's. Midwest refineries can purchase WTI crude as their input because they are located close to Cushing, Oklahoma (WTI's pricing point). East Coast refineries can't buy WTI because of the high cost of transportation from Cushing, so they purchase Brent crude instead. Refineries make money on the "Crack Spread," the difference in prices of a barrel of product and a barrel of crude oil. The WTI Cracks are enormous (Midwest refineries' gross margins), but the Brent Cracks are peanuts (East Coast refineries' gross margins). In effect, the WTI-Brent spread is to blame -- currently trending around the $26 level (front-month contracts for WTI settled on Friday at $86.80 and Brent at $112.23).
The weekly EIA numbers showed the first storage build in Cushing in 11 weeks. Yet despite the 10 previous weeks of draws from the WTI pricing point, the spread continued to widen over the summer. Confirming the trend of lower East Coast refinery runs, US Atlantic Coast refinery utilizations were down to 69.7% in comparison with the Midwest at 89.6%. This is the first week of sub-90% utilization in the Midwest since the second week of July. Despite several weeks of 90%+ refinery utilization in the Midwest, stocks continued to build in PADD 2 (a region that includes Cushing). With upcoming maintenance scheduled for refineries in the area lowering utilization numbers, a continuation of building stocks seems inevitable.
So, the question that everyone seems to be asking is: When will the spread close in? Before we go there, let's talk more about reasons why there's a spread in the first place:
1. Glut of supply in Cushing -- plenty of pipelines moving crude into Oklahoma, but not enough moving the oil out of OK. This is also due to more and more oil flowing from the North in recent years -- from both North Dakota as well as TransCanada's (TRP) Keystone XL pipeline from the Canadian Tar Sands. Bearish WTI.
2. North Sea E&P production issues as well as significantly lower Libyan oil production, which happens to be of the light sweet variety as well, create a depressed supply picture for the Brent market. This is well represented by the extraordinarily low European inventory numbers and the backwardated Brent forward curve with demand upfront. Bullish Brent.
3. Expensive to transport oil from Cushing to the Gulf Coast for export purposes (and thus arbitrage) supports the oversupply in OK. Bearish WTI.
WTI being slightly higher quality than Brent, it's historically been priced approximately $2 more per barrel. But with the differential now $25 in the other direction, it will certainly be a long stretch before tightening up. Taking a look at the WTI forward curve, it is contago-ed until relative flattening occurs in mid-2013. Assuming my reasoning above is correct, this is the point at which the market expects enough outward-facing pipelines from Cushing to have been built to reduce the oversupply. Must we wait two years until the Brent-WTI spread reduces? And what happens in the mean time -- will it reduce slowly or can it widen even more? Or will there be increased interest in alternative forms of oil shipment out of Cushing, such as rail transport and river barges? Will it ever be the same again? You decide.
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