For the longest time, Permian Basin has been the golden shale area of the United States. Crude output from the Permian has been on fire with the United States becoming the world’s numero uno oil producing country in 2017. While production in the Permian is soaring, its takeaway capacity in the region is not increasing to that proportion. This mismatch presents a massive opportunity to midstream companies as well as the refining players. However, the upstream companies are likely to feel the pinch of the discounted oil prices for quite some time.
Let’s delve deeper for a detailed view on the Permian dilemma that’s altering the dynamics for various energy players and the global oil market at the moment.
‘Permania’ Engulfs the Industry
As we know, the Permian Basin continued to be a moneymaker for many oil producers even during the oil slump, owing to its low-cost high margin operational structure.
Producers and drillers are still snapping up more land in the world’s hottest shale play, which has certainly propelled output. Notably, there has been a flurry of deals in the region recently with companies like Exxon Mobil Corporation, Chevron Corporation, Occidental Petroleum Corporation and Parsley Energy, Inc. among others pumping in billions of dollars to boost their Permian portfolio. Concho Resources Inc.’s (CXO - Free Report) $9.5 billion buyout of RSP Permian and Diamondback Energy, Inc.’s (FANG - Free Report) impending acquisition of Energen Corporation mark the biggest deals in the area, so far this year.
The Permian Basin delivered an unprecedented output for several years with the current capacity of churning out more than 3 million barrels per day (bpd), which is expected to rise by another 2 million bpd within 2023.
However, a major dilemma is emerging now: How to get this entire surging oil production beyond the limited confines of its local hub?
Permian-Pure Plays Caught Up in the Throes of Pipeline Woes
With production growth on a tear in Permian Basin, pipelines of the region are under immense pressure.
In fact, expanding volumes have begun to outstrip the pipeline takeaway capacity of the Permian Basin. This has forced operators to accept steep discounts on their produce. While the disparity in the international benchmarks is not much of an anomaly, there is a growing price differential within the country itself.
Interestingly, while technological advancements including hydraulic fracking have unleashed a shale revolution in both Permian and Oklahoma, oil output from the Permian zone has been mounting more rapidly whereas its takeaway capacity is lagging. Due to this downside, the price differential between WTI from Cushing, Oklahoma — the benchmark for the entire United States — and WTI for Midland, where the Permian Basin is located, has reached above $17 a barrel.
Notably, oil prices have been picking up strength, having increased 16.4% year to date on the back of tightening supplies, geo-political tensions and robust demand. However, deeply discounted crude prices have certainly weighed on the stock market values of Permian-focused explorers. On a year-to-date basis, shares of many Permian-focused stocks have underperformed the broader industry. Shares of Permian majors including Concho Resources, Diamondback, Parsley et al have declined 8.7%, 4.1%, 5.7%, respectively, compared with industry’s decrease of just 0.3%.
Apart from the Permian pure plays, the looming pipeline crunch is now forcing the diversified upstream operators like ConocoPhillips and Noble Energy among others to re-evaluate their strategies. ConocoPhillips now intend to put the brakes on production and deploy some of its rigs to the less congested Eagle Ford region for securing better prices and transportation facilities. Noble Energy plans to move some of its rigs from Permian to DJ basin region, which does not face a takeaway crisis. Other companies like EOG Resources intends to put a pause on Permian production until the required infrastructure is in place.
Well, this is not the first time that the Permian region is facing extensive crude differentials. Even during the 2011-2014 period, the prices regularly fell from $15 a barrel to as low as $40 per barrel below the Gulf Coast levels amid pipeline concerns. Also, other regions like Bakken and Appalachian Basin have encountered similar problems causing price discounts.
While the latest Permian dilemma is inducing deflated regional oil prices, which is likely to hurt the upstream explorers for a while, the midstream and the refining players can definitely strike it rich from the current situation.
Window of Opportunity for Midstream Players
The skyrocketing takeaway constraints have triggered a stiff competition among various midstream companies to build, expand or invest in pipelines for ensuring a facile flow of crude from the Permian region.
Epic Midstream Holdings LLC has formed strategic partnerships with Apache Corporation (APA - Free Report) and Noble Energy Inc. for a 730-mile crude oil pipeline, running from Permian to Corpus Christi. The pipeline with a capacity of up to 675,000 barrels of oil per day, is likely to serve the Delaware and Midland portions of the Permian Basin. While the construction of the Epic Crude Oil Pipeline is likely to commence from the fourth quarter of 2018 onward, the facility is expected to come online during the second half of 2019. This is one of the first projects of the company to bolster the Permian takeaway. However, the infrastructural bottlenecks in the region are likely to spur many such projects by the company, aiding its prospects in the process.
To help de-bottleneck the oil flow from Permian, Plains All American Pipeline (PAA - Free Report) is also fast-tracking two of its important projects in the region. The Sunrise Extension endeavor is expected to become functional at partial capacity by this year-end whereas its second major project, Cactus Pipeline II, with a takeaway capacity of around 670,000 bpd, will become fully operational by the end of the first quarter of 2020. The company, currently investing more than $1.6 billion in Permian pipeline projects is estimated to witness a double-digit annual growth rate in its earnings and cash flows over the next two years, which in turn, will also contribute to its payout.
Moreover, Magellan Midstream (MMP - Free Report) intends to build a new pipeline with a capacity of at least 350,000 bpd to assist in the transportation of oil from Permian. The project is anticipated to come into service post mid-2019. The company is already an operator of BridgeTex and Longhorn pipeline, which ships barrels from Permian to Houston Ship Channel. The company is also targeting expansion of its BridgeTex pipeline by 2019. These upcoming ventures are likely to position the company well for augmenting distributable cash flows.
Phillips 66 Partners’ and Andeavor’s Gray Oak Pipeline are also expected to become functional in late 2019 with a capacity of up to 1 million of barrels per day. Energy Transfer Partners, LP has also proposed a new pipeline from Permian to Nederland. However, it is not expected to come into service by 2020. Notably, ExxonMobil is also likely to invest around $2 billion in transportation infrastructural expansion in Permian to successfully move its output to Gulf Coast.
Refining Game Up on Crude Discounts
While on one hand, this is a testing time for the Permian producers, on the other, refining players can surely reap profits from the slashed crude price, which can lift margins. Major refineries like Valero Energy Corporation, Delek US Holdings, Inc. (DK - Free Report) , HollyFrontier Corporation and Marathon petroleum Corporation (MPC - Free Report) have been hugely benefiting from cheap input, which are driving profits for such players.
With 70% of Delek’s refining capacity leveraged to lower Permian pricing, the company is getting access to low-priced crude without a hitch, which in turn, helps adding to its refining margins. Notably, margin contribution from the refining segment was $177 million compared with $16.9 million in the year-ago quarter. Notably, Valero witnessed a year-over-year increase of 45% in its second-quarter profits amid cheaper oil prices. HollyFrontier’s refining margins jumped 46% in the last reported quarter, enhancing the overall profits of the company. Stronger fuel margin, which grew to $15.40 per barrel from $11.32 a year ago, also buoyed the Zacks Rank #2 (Buy) Marathon Petroleum Corporation’s second-quarter earnings.
You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Sorting out the pipeline conundrum is very crucial for the Permian region, which is likely to witness whopping production growth in the coming years. With producers pumping in large amounts of oil amid transport bottlenecks, it’s certainly going to be a trying time ahead, especially for the Permian pure plays. While there are several pipeline projects lined up, it will definitely take a year or more for everything to settle in place.
Until then, the producers’ pain is likely to translate into midstream and refiners’ gain. The refineries can enjoy the reduced crude price till the transport bottleneck problems get fixed. However, once the pipeline projects become operational, the differentials will diminish and the tables will turn with the upstream players emerging winners again.
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