The storage of crude oil has recently garnered a heightened level of attention, even outside the energy realm. Volumes in storage have been rising quickly and some fear that if builds continue maximum storage capacity could be reached by mid-year 2015 or sooner. The situation has prompted several questions: Why has storage been filling? What are the ramifications? What does this mean for the midstream MLPs in which OFI SteelPath invests?
Why Has the Volume of Crude Oil in Storage Been Increasing?
The increase in the volume of crude oil in storage can be attributed to numerous factors including production trends, refinery utilizations, and the relative pricing of crude oil futures contracts.
Crude oil production in the United States continues to grow, reaching almost 9.4 million barrels per day in the four weeks ending March 20, 20151, a rate that is 14.9{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} higher than the same period in 2014. While producers have dramatically decreased their drilling activity in reaction to lower crude oil prices, the impact has yet to impact production levels. Previously drilled wells continue to be brought into production and the remaining rigs, focused on the most productive, or economic, areas means per rig productivity measures are moving higher.
Adding to the situation has been refinery activity levels. Refiners are the primary consumers of crude oil, processing it into refined products such as gasoline, diesel, jet fuel, and heating oil. Traditionally, refiners undergo maintenance (“turnarounds”) in the late winter and early fall and, therefore, crude oil storage typically builds during these periods. While some refiners were able to defer maintenance this turnaround season, Morgan Stanley recently noted that turnarounds among U.S. refiners still peaked at 1.1 million barrels per day of offline capacity during March. Further, a recent labor strike at certain refineries and an explosion at ExxonMobil’s Torrance, California refinery in February also curtailed refining operations. Taken together, refinery utilization, which reached a high of 95.4{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} in December, declined to a low of 86.6{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} in late February2.
Finally, the upward sloping shape of the crude oil futures curve has incentivized placing crude oil into storage. This shape, known as contango, occurs when futures prices are higher for longer-dated periods relative to near-term prices. When futures prices are higher than current prices, crude oil traders can purchase crude barrels today, place their crude into storage and lock in the sale of those barrels at the higher futures price as long as the cost to store those barrels is less than the pricing differential. Recently the difference in futures prices between the front month and the one-year out period has generally ranged between $8 to $12 per barrel as compared to a monthly storage cost that generally runs $0.20 to $0.70 per barrel per month3, or $2.40 to $8.40 per barrel per year.
Will Storage Reach Capacity and What Happens If It Does?
Typically, the refining maintenance period comes to an end in May. Therefore, in the coming weeks, increasing refinery utilizations should help moderate storage increases. Further, though storage at Cushing, Oklahoma, the largest and most closely watched storage hub, has been posting records, substantial storage capacity remains overall. In fact, due to large capacity additions in recent years, capacity utilization at Cushing actually remains below prior highs. Cushing represents a preferred storage location due to its connectivity (midstream access) and as it presents the least basis risk for those seeking to de-risk storage builds through the use of futures contracts. However, as Cushing nears maximum capacity, regional pricing differentials should shift, encouraging storage to move to other locations. Nonetheless, certain producing regions could experience more exaggerated spot price weakness should regional storage hit capacity and if midstream access to an exit is limited. Therefore, producers with exposure to such constrained locations could be impacted.
How Does The Rising Storage Situation Impact Midstream MLPs?
Midstream MLPs are the owners of a significant amount of the crude oil storage infrastructure in the United States. Most of the capacity owned by the publicly-traded midstream entities, of which the majority are structured as MLPs, is contracted capacity; meaning a counterparty has previously contracted to pay the owner of the capacity a fixed fee to reserve the space whether it is used or not. This contract structure results in a steadier margin compared to the vagaries of spot storage rates. However, this also means that though certain operators will be able to capture some healthy short-term margin, the overall impact from the current crude oil storage environment is likely to be fairly modest across the sector as a whole.
Nonetheless, the market’s recent focus on crude oil storage does highlight the importance of energy infrastructure. Further, producers with sufficient crude oil storage or adequate pipeline access to liquid markets are likely grateful for these previous investments. Producers or other market participants lacking sufficient access to infrastructure may certainly seek to make such investment in the future.
Read more insights from OFI SteelPath and from Portfolio Manager Brian Watson.
- U.S. Energy Information Administration, This Week in Petroleum, March 25, 2015
- U.S. Energy Information Administration, Weekly U.S. Percent Utilization of Refinery Operable Capacity
- Wells Fargo Securities, MLP Weekender: It Takes Too (Much Crude) To (Con)Tango, March 27, 2015
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Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. Diversification does not guarantee profit or protect against loss.
The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in an Oppenheimer SteelPath MLP Fund does not offer the same tax benefits of a direct investment in an MLP. The Funds are organized as Subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6}) as well as state and local income taxes. The potential tax benefit of investing in MLPs depends on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution which could result in a reduction of the fund’s value. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund’s after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked.
These views represent the opinions of OppenheimerFunds and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the open on April 2, 2015 and are subject to change based on subsequent developments.
SOURCE: OppenheimerFunds Blog – Read entire story here.
