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Oil and gas producers in the Permian Basin in West Texas suffer when the price of Midland crude decreases relative to the domestic benchmark crude of West Texas Intermediate (WTI). This is because the price producers in the Permian realization on their oil is generally closer to the Midland crude price; when Midland crude prices decrease, they receive less revenue from the oil they produce. Some companies this affects includes Range Resources (RRC), Laredo Petroleum (LPI), Concho Resources (CXO), and EOG Resources (EOG).
Midland crude traded as much as $14/barrel under WTI crude at the beginning of this year, but narrowed throughout 1Q13. Recently, Midland has actually traded at a premium compared to WTI crude, closing at $0.65/barrel above WTI last Friday, May 3rd. This is compared to the prior Friday’s close of $0.15/barrel below WTI.
Note that Midland crude has historically traded in line with WTI, as seen in the above graph. However, recently Permian production has ramped up significantly. Consequently, any disruption in takeaway capacity, which had been tight, caused spreads to blow out. For instance, if a pipeline that normally takes crude out of the Permian goes down for some reason, the crude must be redirected to other pipelines or find other transport. If these other options are fully utilized, it could cause a temporary glut of Permian crude, pushing prices downward. Additionally, takeaway capacity in the Permian had lagged the growth in production for some time, which had caused a price divergence between Midland crude (which is priced in West Texas) and WTI (which is priced at Cushing, Oklahoma). Companies in the Permian generally receive a price closer to Midland crude than WTI, so this price divergence had hit revenues of Permian producers.
From October through January, the spread widened significantly. The spread affected 4Q12 earnings of certain Permian producers, such as Concho Resources (CXO). CXO recently reported that in 4Q12 it realized a price of $81.28/barrel for its crude, compared to the WTI price of $88.17/barrel. The spread also remained wide into the beginning of 1Q13 and affected the earnings of some producers. On CXO’s 1Q13 earnings call, CEO Tim Leach noted, “We are pleased with the operational performance of our business despite the unprecedented widening of the Permian oil basis differential during the quarter. As we discussed on our last call, the Midland-to-Cushing basis differential had a $7.80 per barrel impact on our first quarter realizations. Much of this was related to the impact of hurricane Sandy and the extended Borger refinery outage. These challenges seem to be behind us and new pipeline capacity has already started to move Permian crude to the Gulf Coast.” For 1Q13, CXO received an average price for its oil of $82.49/barrel compared to the average price of WTI over the same period of $94.36/barrel.
Currently, Midland is even trading at a slight premium to WTI as infrastructure, such as the Magellan Midstream Partners’ (MMP) Longhorn pipeline, have started service and helped to alleviate bottlenecks in the area. Additionally, Sunoco Logistics Partners (SXL) plans to start two projects which will increase crude takeaway service from the Permian in 2Q13.
Midland crude’s recent move to trade at a slight premium to WTI and the recent few weeks of spread tightening results in a positive medium-term catalyst for Permian names. However, if takeaway capacity becomes tight, disruptions, like those CXO mentioned on its 3Q12 call, can have the effect of causing the spread to widen significantly again. More capacity coming online, such as the reversal of the Longhorn Pipeline, can mitigate these risks. Investors holding names with Permian exposure, such as CXO, LPI, RRC, and EOG, may find it prudent to monitor the Midland-WTI spread. Additionally, several names with Permian exposure can be found in the Vanguard Energy ETF (VDE).
© 2013 Market Realist, Inc.