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Tutorial on WTI & Brent

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  • 1. March 28, 2013NORTH AMERICA CRUDE OIL MORGAN STANLEY RESEARCHNorth America Crude Oil Global Morgan Stanley & Co. LLCWTI-Brent Teach-In Adam Longson, CFA, CPA Adam.Longson@morganstanley.com +1 212 761 4061 Chris Corda Chris.Corda@morganstanley.com +1 212 761 6005 Alan Lee Alan.H.Lee@morganstanley.com +1 212 761 3266For other important disclosures, refer to the Disclosure Section, located at the end of this report.
  • 2. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013North America Crude Oil Teach-In: Overview Background on the Problem How Key US Crudes Price and Why Implications for Commodities and Equities Appendix 2
  • 3. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Crude Oil Differentials: Cost of moving the marginal barrel typically sets relative crude pricingThe cost of transporting the marginal barrel tends to set the price differential between similar quality crudes. On the water, differentials aremostly the cost of a tanker between the source of the crude and its end market. On land, pipeline tariffs dictate prices.If pipeline capacity is insufficient, differentials are set by higher costs modes of transport like barge, truck and rail. That’s the situation todayin North America. If those higher cost modes don’t have enough capacity to clear the market, differentials widen to shut-in levels.4 Key Questions to understand when assessing crude oil differentials: 1) What is the marginal barrel for a given crude oil benchmark? 2) Where is that marginal, highest cost barrel headed (i.e. what is the end market customer)? 3) How is the marginal, high cost barrel getting to its end market (tanker, pipeline, rail, etc.)? 4) How much does that marginal barrel cost to transport relative to alternative sourcing options for that customer?Seaborne Crudes Tend to Trade Within A Historically, North American CrudesRange—Determined by Freight Cost Traded Off Pipeline Tariffs(Key light seaborne crude oil differentials vs. Brent) (Key North American crude oil differentials) 8 20 6 10 4 0 2 -10 0 -2 -20 -4 -30 -6 -40 -8 -50 2000 2002 2004 2006 2008 2010 2012 Jan-08 Oct-08 Jul-09 Apr-10 Jan-11 Oct-11 Jul-12 LLS Olmeca Saharan Blend WTI-LLS WTI Midland-Cushing WCS-Maya Syncrude-WTISource: Bloomberg, Morgan Stanley Commodity Research Source: Company Data, CAPP, Morgan Stanley Equity Research estimates 3
  • 4. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Infrastructure Not Configured for New Crude Flows, Particularly Out of the North• US pipeline infrastructure was designed to handle crude flows moving North from the Gulf. Historically, US refiners sourced crude from the southern US (the Mid-continent, West Texas and the US Gulf Coast) to feed refineries in Texas, Louisiana and the Midwest• Surging Canadian and Midwest production has reduced the need for Gulf Coast imports and transfers north from the South. Midwest refineries are increasingly becoming self sufficient, reducing the need to move crude north from West Texas and the Gulf.• Crude must now flow south from the Midwest, against the natural design of pipeline infrastructure. The old pipeline regime is being reversed, but this takes time. New pipelines are coming but are lagging demand. These infrastructure challenges are creating bottlenecks and forcing the use of temporary higher cost transportation alternatives to clear new crude volumes, which manifests in wider differentials to cover the higher cost of bringing the marginal barrel to market.Infrastructure Designed to Handle West …But Flows Shifting From South to NorthTexas and Gulf Coast Originations… With Rising Bakken/Canada Production(traditional USpipeline flows) (Left axis: kb/d; right axis: Gulf Coast imports, kb/d) 2,500 6,500 2,300 2,100 6,000 CHICAGO METRO 1,900 Refineries 1,700 5,500 2 1,500 PATOKA CUSHING 1,300 5,000 1,100 900 4,500 MIDLAND 700 500 4,000 ST. JAMES 2000 2002 2004 2006 2008 2010 2012 Refineries PADD2 Canada Imports + Midwest Production Refineries PADD 3 to 2 HOUSTON Gulf Coast Imports (RHS)Source: Purvin & Gertz, Source: DOE, Morgan Stanley Commodity ResearchMorgan Stanley Commodity Research 4
  • 5. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013North America Crude Oil Teach-In: Overview Background on the Problem How Key US Crudes Price and Why Implications for Commodities and Equities Appendix 5
  • 6. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Key US Crude Benchmarks: Quality Matters for Crude Oil Differentials • Regularly quoted light and heavy crude oil benchmarks are listed. • Light and heavy crudes have very different properties and customers and trade at different prices. The heavier a crude means the more viscous it is, which is typically associated with a higher sulfur content as well. • Light crudes cost less to process and therefore tend to be more valuable, but they also typically generate a higher gasoline yield. • Heavy crudes are more expensive to process and require special equipment. Heavy crude oil also requires more power to move through pipelines, which tends to result in lower pipeline capacity on heavy crude lines. • Crude quality matters when assessing differentials. In North America, you generally want to assess heavy crude benchmarks against other heavy crudes and light crude benchmarks against other light crude oils.Source: CAPP, Morgan Stanley Commodity Research 6
  • 7. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Bakken: Higher Cost East Coast Rail Is Now The Clearing Barrel• The Bakken is reliant on rail to clear production and will be for some time. Pipeline infrastructure out of the Bakken and surrounding regions has been insufficient to support the magnitude of production growth in the region for some time. Since early 2012, substantial investment in rail terminals has allowed the Bakken to avoid these bottlenecks and tap new markets first on the Gulf Coast, and now the East and West Coast. While new pipeline projects are scheduled for the coming years, they do not appear sufficient to fully clear Bakken production.• However, the clearing barrel for the Bakken has shifted to rail to the East Coast with material implications for pricing. As production has grown, the Bakken has shifted from pricing off pipeline economics to Gulf Coast rail economics to US East Coast rail economics today. The need to support high cost East Coast rail economics, with the marginal move involving rail and barge, implies a $20-30/bbl differential vs. the delivered cost of an imported East Coast barrel, which is typically not Brent.• Even if Cushing clears, it should have little impact on Bakken pricing. As long as Bakken producers need to support East Coast rail economics, prices cannot rally above the cost of an imported barrel less transport economics.Bakken to Rely on Rail to Keep Marginal Clearing Barrel to East CoastProduction Debottlenecked Costs $20-30/bbl from the Wellhead(kb/d) $4-8/bbl 2000 gathering+ trucking/ $13-16/bbl transloading Marginal rail + + leasing transload 1600 Clearbrook 1200 Bakken Albany $3-5/bbl barge + NORTH 800 transloading SEA Philadelphia Chicago $-1 to 400 +4/bbl x USGC differential $12-15/bbl Marginal rail 0 $1-2/bbl WEST Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Tanker AFRICA rates Pipeline Takeaway Rail Takeaway Bakken Production Source: Bloomberg, Genscape, Morgan Stanley Commodity Research Source: Company Data, Morgan Stanley Commodity Research estimates 7
  • 8. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013WTI: Marginal Barrels Come from the North And Dictate Pricing• WTI is currently pricing off the marginal barrel flowing into Cushing from the North, which is dictated by exit capacity from Cushing. Spare capacity into Cushing exists via both pipeline and rail, but is not being maximized given congestion. WTI is pricing off whether to either incentivize greater inflows into Cushing on these various routes from the North.• With additional takeaway capacity, WTI is now pricing to support greater pipeline inflows. At $20/bbl, WTI-Brent was pricing to slow pipeline inflows into Cushing. However, with Seaway now offering greater outflow capabilities, Cushing can now accept greater inflows. Sending barrels into Cushing via pipeline from the North costs a few dollars, which implies WTI-Brent should be in the mid-teens to cover this incremental cost.• The next marginal barrel would be rail into Cushing = Low-teens WTI-Brent. Rail volumes into Cushing used to run as high as 60 kb/d, but are now gone as economics ($8-9/bbl) are no longer supported. If new pipelines drain enough volume from Cushing, rail could be required again, which would push WTI-Brent to the low-teens. We see this as a possible 3Q13 event.• The XL Gulf pipeline will finally clear Cushing in 4Q13 = $6-10/bbl. At that point, WTI will price off the Gulf Coast with WTI-LLS at $6/bbl based on pipeline economics. WTI-Brent will simply be $6 + the amount of any discount in LLS-Brent due to the glut of light crude in the Gulf.Transport Economics and Differentials Opening Pipeline Arbs Should JustifyTend to Dictate Cushing Flows WTI-Brent In the Mid-teens into 3Q13(marginal capacity into Cushing by cost and impact on WTI-Brent) $2+/bbl pipeline + congestion Cum. Implied Clearbrook Capacity Inflow WTI-Brent $20-25/bblCost Marginal Barrel (kb/d) (kb/d) ($/bbl) Bakken Marginal rail + truck/barge to theLOW Limited Inflows 0 160 ~$20+ East Coast Spearhead 190 Keystone - Cushing 160 350 ~$15 EAST COAST Rail - Hawthorne 90 440 ~$12 CHICAGO METROHIGH Barge Unwind 60 500 $7-9 2 Cushing Clear $6+ $1-2/bbl CUSHING Tanker ~$3/bbl rates Pipeline into NORTH SEA Cushing Note: $20-25/bbl is from the rail terminal. Source: Bloomberg, Genscape, Morgan Stanley Commodity Research 8 Source: Company Data, Morgan Stanley Commodity Research estimates
  • 9. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013LLS: Gulf Coast to Be Oversupplied, But LLS More ProtectedThe Gulf Coast is at risk of being oversupplied with light crude oil. As US shale production grows, the US is quickly displacing all its light crudeimports in the Gulf. The US also restricts US crude oil exports, which means the US could end up with too much light crude oil and the Gulf relative tothe natural level of demand. That should cause prices to discount to turn off imports, discourage flows, or incentivize demand.Greater light flows will pressure the Gulf Coast light crude oil prices, especially around Houston. XL Gulf will be forced to move primarily lightcrude barrels given a lack of heavy capacity into Cushing before mid-2014, which should easily than displace all light crude imports. Given the size ofXL Gulf, the impact could be magnified early on as elevated inventories at Cushing are drained into the Gulf Coast. But there are offsets come 2014.The market is too bearish LLS, which is becoming a poor benchmark for the Gulf. As a light crude importer, most regions of the Gulf Coast usedto price similarly to support imports. As imports are displaced and flows move South, that is no longer the case. St. James is a difficult market toreach, limiting the potential impact on prices, and there are numerous potential mitigating measures that would prevent a significant discount fromdeveloping.Growing US Production Displacing Light …But LLS Is Relatively Insulated fromCrude Oil Imports in the Gulf… Oversupply in Houston(Gulf Coast light crude oil imports by state, kb/d) PATOKA1,4001,2001,000 CUSHING 800 600 400 200 - ST. JAMES HOUSTON Jan-10 Jul-10 Oct-10 Jan-11 Jul-11 Oct-11 Jan-12 Jul-12 Oct-12 Apr-10 Apr-11 Apr-12 GoM Imports TX LA Other Gulf Coast Light Source: EIA, Morgan Stanley Commodity Research Source: Company Data, Morgan Stanley Commodity Research estimates 9
  • 10. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013WTI-Brent and LLS-Brent Are Not Purely A Bet on US Fundamentals The US does not import Brent. Investors have focused on light crude differentials vs. Brent (LLS, WTI, Bakken, etc.) as indicative of evolving North American fundamentals and where US crudes must price to displace imports. However, the US has not imported a barrel of light crude oil from Europe since June 2012. The only North Sea crude imported into the US today is some condensate from Norway to the East Coast. Imported crudes represent the barrel that needs to be displaced that differentials must match. In reality, many North American crudes must price against the true imported barrel, not Brent. East Coast light crude imports are from West Africa, Latin America, Canada and the FSU. Similarly, Gulf Coast light crude imports are from Mexico, Venezuela and West Africa. As a result, rail arbs for Bakken are not directly linked to Brent pricing. Similarly, LLS-Brent can see substantial volatility without impacting Gulf Coast imports. Import prices are only loosely associated with Brent through global differentials and arb opportunities. If Brent trades well above or below these crudes (as it does now), it can result in a significant disconnect between US crude pricing and Brent. These disparities can have a material impact on key differentials such as WTI-Brent, LLS-Brent and Bakken-Brent.An Improper Benchmark: The US No Light Crude Differentials vs. Brent CanLonger Imports Brent Be Volatile(US European light crude imports, kb/d) (Key light crude oil differentials vs. Brent)300 $6 $4250 $2200 $0150 -$2 -$4100 -$6 50 -$8- -$10 Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- Jan- Jan-10 Jul-10 Oct-10 Jan-11 Jul-11 Oct-11 Jan-12 Jul-12 Oct-12 Apr-10 Apr-11 Apr-12 11 11 11 11 12 12 12 12 13 US: LLS NG: Qua Iboe ALG: Saharan Blend Light SA: Arab Extra Light MX: Olmeca Note: 35-40 API crudes; Source: EIA, Morgan Stanley Commodity Research Source: Bloomberg, Morgan Stanley Commodity Research 10
  • 11. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013North America Crude Oil Teach-In: Overview Background on the Problem How Key US Crudes Price and Why Implications for Commodities and Equities Appendix 11
  • 12. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013The Commodity View: Some Takeaways for North America Crude Oil in 2013Differentials will not return to historical levels WTI-Brent Should Fall To $6-10/bbl in 4Q • The structural realignment of crude flows in the US has (WTI-Brent quarter average price forecast,$/bbl) permanently altered pricing and differentials WTI-Brent • We see WTI-Brent settling at $6/bbl long term with LLS-Brent at Base 2013 1Q -$19.00 2Q -$15.00 3Q -$13.50 4Q Full Year -$11.50 -$14.50 parity, which is still advantageous for US refiners 2014 -$9.50 -$9.50 -$8.00 -$7.00 -$8.50Light crude differentials are set to narrow in 2013, Bull 2013 -$21.50 -$21.50 -$18.50 -$14.50 -$19.00particularly WTI-Brent 2014 -$12.50 -$12.50 -$11.00 -$10.50 -$11.50 • Narrower diffs are bullish for Permian and Midcon producers. • That said, WTI-Brent may be getting ahead of itself and won’t Bear reconnect until 4Q13 when XL Gulf comes online 2013 -$17.50 -$10.00 -$7.00 -$4.50 -$10.00 • Our base case assumes a small disconnect in LLS-Brent by year- 2014 -$5.50 -$5.50 -$5.50 -$5.50 -$5.50 end, but that is conservative and should be resolved by mid-2014. Source: Bloomberg, Morgan Stanley Commodity Research estimatesBakken will still price off East Coast rail The Market Is Too Bearish LLS-Brent • East and West Coast refiners will increasingly gain access to (LLS-Brent, $/bbl) advantaged crude and could see the greatest EPS positive $0.00 revisions. -$0.50 -$1.00Canada will be the story for 2014 • The US will see a notable rise in light crude exports to Canada in -$1.50 2014, both via pipeline and exports out of the Gulf. -$2.00 • WTI may end up pricing off of Eastern Canada, and exports should -$2.50 alleviate oversupply problems in the Gulf. -$3.00 • WCS differentials should see significant relief in mid-2014 with the Flanagan South pipeline, which is bullish for oil sands producers. -$3.50 -$4.00 Key Commodity Trades: -$4.50 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 • LLS-Brent could be at parity by mid-2014 vs. a forward market of -$4/bbl in mid-2014. LLS-Brent Forw ard Curve MS Base Source: Bloomberg, Morgan Stanley Commodity Research estimates 12
  • 13. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Evolving North America Differential Story: An Alpha PlaygroundPlenty of alpha opportunities within the differential story: Equities offer more opportunities to play the evolving North American crude oil storythan commodities. There are a number of ways to play the differential story on a thematic basis, but also on a company specific basis.North American differential story here to stay, but will continue to evolve. The resurgence in North American oil and gas production is one of thegreat themes in the market today, and it will take several years to play out. The story and differentials will continue to change over time with newpipelines, plays and production growth that will recast the landscape of winners and losers. Understanding and forecasting how the story evolvesshould create significant investment opportunities.Thematic Framework and Potential Ways to Play Differentials1. Industry Exposure to Wider Differentials2. Geographic or Crude Exposure (i.e. by basin) by Company • Thematically, northern geographies typically face wider differentials • Changes in differentials for various plays lead to earnings revisions3. Individual Consumers Crude Appetite and Cost of SourcingIndustry Exposure to Wider Crude Oil Key Crude Oil Basins: RelativeDifferentials Pricing Revision in 2013Industry Impact Comment Product prices set by Brent. Refiners can process cheap North PositiveRefiners ▲ Revision 1. Permian American crudes and capture the margin benefit. Wider differentials indicate grow ing production and a need forMidstream ▲ 2. Midcon: MS Lime, Granite Wash, etc. greater pipeline capacity or investment. Wider differentials and grow ing production support alternativeTransports ▲ 3. Syncrude modes of transportation, like crude-by-rail. Typically sell closer to the marginal price. Wider diffs w eigh onE&P ▼ FCF and returns. Infrastructure constraints associated w ith 4. WCS w ider diffs also limit production grow th. Truly integrated models are hedged. Cheaper crudes w eigh on 5. BakkenIntegrated ▬ E&P realizations, but result in better refining realizations. 6. LLS Wider differentials mean low er prices and less FCF for E&POil Services ▼/▬ capex. Associated infrastructure constraints also slow drilling. Negative 7. Eagle Ford RevisionSource: Morgan Stanley Commodity Research 13
  • 14. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Company Specific Opportunities Are Prevalent:Transportation Costs Vary And Can Lead to A Competitive Advantage Product prices trade off of Brent assuring relatively similar revenue for refined products in a given region. However, the cost of crude and processing varies dramatically between regions and refiners. The cost of transportation varies across customers creating opportunities for alpha capture. The cost to move the marginal barrel sets the differential, but differentials do not represent the average cost to access a given crude. Many customers can access crude for cheaper prices through other means. Even in markets where pipeline capacity is limited, some customers can avoid bottlenecks with contracts for committed pipeline capacity, which provides a competitive advantage. Uncovering these advantages can lead to significant alpha capture. Example: The impact of an LLS disconnect is overstated. Many Gulf Coast refiners are already receiving advantaged crude, which diminishes the importance of LLS for Gulf Coast realizations. For example, Bakken is now pricing to support higher cost East Coast rail economics, but Gulf Coast rail is still ongoing, creating an arbitrage opportunity for refineries in Louisiana relative to East Coast rail and LLS.Wide Range of Bakken Rail Prices, with Transportation Advantages Can CreatePBF Leading East Coast Rail Economics Meaningful Value(Bakken crude by rail cost, $/bbl) ( US Gulf Coast estimated average delivered price at St. James by month, $/bbl) Marginal $120 20 Arb opportunities Cost 18 $115 16 14 12 $110 Pipeline 10 8 $105 6 4 2 $100 0 PSX Bayway Mustang/XOM Albany Philadelphia Anacortes Spearhead/ Del City S. California N. California USGC Rail Enbridge/ PBFs Seaway Enbridge/ $95 TSO TSO TSO Oct-12 Nov-12 Dec-12 Jan-13 Bakken - Gulf Bakken - East Coast LLS WAFSource: Company Data, Morgan Stanley Commodity Research Source: Bloomberg, Company Data, Morgan Stanley Commodity Research 14
  • 15. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013North America Crude Oil Teach-In: Overview Background on the Problem How Key US Crudes Price and Why Implications for Commodities and Equities Appendix 15
  • 16. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Key Debates Related to Crude Differentials for both Commodities and Equities• Timing of new infrastructure (pipeline and rail) and the impact of various differentials • How will the marginal cost of transportation change for various crude oil basins?• When will WTI pricing reconnect with the Gulf Coast? • Will the BP Whiting refinery return early and run crudes out of Cushing? • Will new West Texas pipelines in 2Q and 3Q be sufficient to drain inflows and clear Cushing?• Will an oversupply of light crude oil in the Gulf result in significantly wider differentials? • How far below Brent will Gulf Coast light crude oil prices (esp. LLS) trade?• What is the outlook for Canadian crude oil differentials, particularly challenged heavy crude oil (WCS)? • What is the next catalyst and where do WCS differentials trade? • Will enough pipeline capacity be built to allow Canada to reach its long term production goals?• What is the opportunity for crude by rail and how long can it last?• How much will US production grow and what does that mean for pricing? • Is there an ability to absorb all of this light crude oil? • Will US production growth result in much lower global prices? • What does all this production mean for crude oil differentials long term? 16
  • 17. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013US and Canada Pipeline MapSource: Canadian Association of Petroleum Producers 17
  • 18. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013US Oil and Gas Shale PlaysSource: EIA 18
  • 19. MORGAN STANLEY RESEARCH North America Crude Oil March 28, 2013Disclosure SectionThe information and opinions in Morgan Stanley Research were prepared or are disseminated by Morgan Stanley & Co. LLC and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan StanleyMexico, Casa de Bolsa, S.A. de C.V. and/or Morgan Stanley & Co. International plc and/or RMB Morgan Stanley (Proprietary) Limited and/or Morgan Stanley MUFG Securities Co., Ltd.and/or Morgan Stanley Capital Group Japan Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. 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