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The price of oil has dropped significantly in a very short time. This has been painful for companies like SandRidge Energy, Inc. (NYSE:SD) which is selling crude at West Texas Intermediate (WTI) pricing. It has been even worse for Bakken names like Kodiak Oil & Gas Corp (NYSE:KOG), as differentials have widened with respect to WTI.

Companies operating in North Dakota have had to get creative to improve the price at which they collect for crude. EOG Resources (NYSE:EOG) announced on April 15th its St. James crude-by-rail facility had accepted its first Bakken crude, capturing the $15 Louisiana Light Sweet or LLS price lift. Continental announced half of its Bakken crude will be transported by rail. The majority of this oil ends up in the Gulf Coast, where it is processed relative to LLS.

WTI is the standard for United States oil pricing. It is light and sweet and better quality than Brent. Bakken Light is better than WTI. Given this, dynamic pricing seems to be reversed, but this has more to do with refining and transportation than quality. The price of WTI has historically moved in step with Brent, but this has changed. Oil production in the United States has been quite small when compared the amount of Brent it has imported. Now that domestic oil production has increased, we are seeing a change in this dynamic.

The United States is broken into five regions known as PADDs (Petroleum Administration for Defense Districts). PADD I is the east coast, while PADD V is the west coast. These two areas rely on oil imports, while PADD V also uses crude from Alaska and California as a feedstock. PADD I refineries have suffered the most as its costs are significantly higher than that of the mid-continent. The mid-continent is composed of PADDs II, III and IV. PADD III may be the most important region with respect to oil differentials as it is the home of the majority of U.S. refining capacity. Due to this, infrastructure had been built on imported oil being refined at the Gulf Coast into products that were transported by pipeline to the north.

Crude production in the U.S. has increased significantly over the past few years. The Bakken, Niobrara, Anadarko, Eagle Ford and Wolfcamp have contributed to this growth. Much of this oil is light and sweet, and is a good fit with Midwest refineries. Midwestern refineries have a lower Nelson Complexity Index when compared to the Gulf Coast. The mid-continent isn't the only area increasing production, as the Canadian Oil Sands are doing the same. This oil is very heavy and requires high complexity refineries like those on the Gulf Coast. U.S. companies have spent billions of dollars over the past few years to convert refineries to heavy oil. The trick is how to get this heavy oil to the Gulf Coast for refining.

Since the United State's pipeline and refining system had been built on an import driven system, some changes need to be made. Imported oil was refined in the Gulf Coast and refined products were transported north to its customers. Heavy oil is now entering from the north and has to be transported south, where it gets stuck in Cushing. This occurs because Midwestern refineries cannot refine heavy oil.

The Enbridge Energy Partners (NYSE:EEP) Seaway pipeline reversal will allow for heavy Canadian crude to be transported from Cushing to Texas City and Port Arthur. By early 2013, this will transport 400000 bpd, and the Seaway pipeline twin will add another 450000 bpd by mid-2014. TransCanada's (NYSE:TRP) Keystone XL is on hold for now, but its Gulf Coast project has been approved. This will add 550000 bpd initially and increase to 830,000 bpd from Cushing to Houston and Port Arthur. These projects will open up the glut at Cushing, and should allow Canadian crude to flow to the Gulf.

Western Canada Select or WCS is not the only crude to benefit from pipeline changes and additions. During the second quarter of this year, Colt rail added 27000 bpd of capacity and Savage rail added 90000 in North Dakota. In the third quarter, Lario will add 100000 bpd of rail take away. In the fourth quarter of this year, Plains will add 50000 bpd and Enbridge will add 145000 bpd of pipeline capacity. Next year, the Bridger/Bell Fourche will add 100,000 bpd and Quintana will add 90,000 bpd in the first quarter. Tesoro (NYSE:TSO) also finished its Mandan, North Dakota refinery expansion where it spent $35 million. It is also sending Bakken crude by rail to its Anacortes refinery at Bakken crude price plus $8.50/Bbl. By the end of 2012, it plans to purchase 100,000 bpd.

In summary, Bakken and Canadian crude differentials should continue to improve. Even with production increasing at a very fast rate, infrastructure will catch up at some point. There are still headwinds, such as a strong dollar and the possibility the Saudis are continuing to produce 10 million barrels/day, to push down the price of oil for the purpose of slowing down unconventional production in Canada and the United States. In the short term, I do not believe we will see any large moves, but should see differentials much lower by the year's end.

Source: Bakken And Western Canadian Select Differentials Will Improve

Additional disclosure: This is not a buy recommendation.