A Permian-Induced Oil Glut In The Works?

by: Robert Boslego
Summary

U.S. crude stocks highest in almost 2 years.

Despite seasonal rise in refinery demand and near record exports.

Mismatch between crude grades produced in Permian and refinery requirements.

SPR exchanges one possible solution.

Implication is a continued build in U.S. crude stocks.

U.S. crude oil stocks stand at 483.3 million barrels, as of May 31st, 46.7 million higher than a year ago and the highest since July 2017. Moreover, they have continued to build notwithstanding the seasonal rise in refinery operations and crude oil exports near record levels.

Over the past 4 weeks, crude oil supply has exceeded demand by 492,000 b/d, as measured by the trend in crude stock changes. In the prior three years, demand has exceeded supplies over the same weeks. Refinery inputs were 207,000 b/d lower than they were over the same weeks last year, and so they only explain part of the reason for the disparity.

U.S. refineries were largely designed to process heavy grades of oil that are imported from countries such as Canada, Venezuela, and Mexico. But much of the growth in shale oil production in the Permian Basin is a much lighter grade.

As shale production ramped-up, the mismatch between U.S. production grades and the grades refiners can process has grown. The lighter grades can be blended with the heavier grades for processing, but the unexpected loss of very heavy oil from Venezuela, due to the sanctions, has exasperated the problem.

Refinery Upgrades

The Permian light grades are a superior product to the heavy grades since they need less processing to produce light products, such as gasoline, distillates, and kerosene/jet fuel. But the refineries need to be upgraded and that requires investment capital and time.

For example, Exxon Mobil is planning a 250,000 b/d expansion to its Baytown refinery, which will be able to handle Permian-grade oils. But that project won’t be completed until 2022, according to a news report.

SPR Exchanges

One possible solution until refineries are upgraded is for refiners to borrow crude from the Strategic Petroleum Reserve. It has 645 million barrels of the crudes that U.S. refiners are designed to process.

And arrangements are in place for refiners to be able to obtain exchanges from the SPR wherein they would give the light crudes to the SPR, in exchange for the heavier grades they need.

According to the SPR website:

It is possible for exchange agreements to be completed within a few days of the receipt of a request from a company. Movement of the oil can occur when the contractor has made arrangements for the transportation of the oil -- usually within 24 hours of contract award. A sale and drawdown from the SPR is conducted online competitively. Deliveries of the crude oil can begin as early as 13 days after announcement of the sale, depending upon the scheduling and transportation arrangements made by the contractor for receipt of the oil.

Broad authority for exchange contracts is found in Section 159 of the Energy Policy and Conservation Act, P.L. 94-163. EPCA provides that the Secretary may acquire oil for the SPR by "purchase, exchange or otherwise." There also exists special authority for the Secretary to conduct a test sale or exchange.”

Congress has mandated a sale of SPR crude over 200 million barrels over the next 10 years. The SPR could re-sell the light grades when additional refinery capacity exists that can handle them. As one oil trading client used to say, "The oil industry always over-solves every problem."

Conclusions

According to EIA’s latest Short-Term Energy Outlook, crude stocks are projected to begin dropping in June. However, stocks would still end the year at a lofty 471 million barrels, 30 million higher than ending-2018.

But what is going to change to resolve the mismatch between light crude production and heavy crude demand? Absent SPR exchanges, the implication is that the light grades are destined for commercial storage until such time as upgraded refinery processing units come on-line. If so, crude stocks will continue to rise, which has a deflationary pressure on oil prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.