Editor’s Note: This is the third in a multi-part series examining the fundamentals behind the structural transformation of the U.S. oil market and the downstream logistics challenges that are resulting.

In Cushing, Okla. – a town of about 9,000 people surrounded by tank farms and crude pipelines – the oil keeps coming.

The Payne County community proudly proclaims itself “pipeline crossroads of the world,” and while it is relatively easy to get oil to Cushing, it is not as easy to get it out. As the delivery and pricing point for the NYMEX’s benchmark West Texas Intermediate (WTI), Cushing terminals can store more than 50 millions barrels of crude oil that ultimately should make its way to refineries on the U.S. Gulf Coast and around the nation.

But Cushing’s tanks are filled to near-capacity – holding a record 38.6 millions barrels of oil – according to the U.S. Energy Information Administration’s (EIA’s) weekly supply report for the week ended February 25.

The supply overhang has led to a steep discount in prompt WTI prices relative to prices for WTI for future month contracts – known as contango – compared with prices for other crude oil grades, including the negative trans-Atlantic arbitrage (spread) to North Sea Brent – the benchmark for international crudes.

Divergence Is No Mystery

Historically, WTI has almost always traded at a premium to Brent. This year, however, something new has happened: Domestic crude priced at Cushing is selling for about US$15 less per barrel (/bbl) on NYMEX than Brent is selling for on the Intercontinental Exchange (ICE).

Normally the emergence of wide price discrepancies creates a signal that directs the market to rebalance. Traders see the differential as an arbitrage opportunity to move lower-cost material to higher-price markets – causing prices to eventually realign. However, this has not happened between WTI and Brent.

The WTI-Brent arb is asymmetrical, because most pipelines between the Gulf Coast and Cushing flow northward, and it’s much easier for the market to correct a widening WTI premium than a widening discount.

However, Brent or Brent-priced crude can be shipped to refineries pretty much anywhere in the world. Oil in storage at Cushing can only be absorbed by refineries in the U.S. Midwest.

A WTI discount implies excess supply, which logistically is more difficult to absorb in the landlocked Cushing area. In the past, market response to a discount involved: On the supply side, lowering discretionary imports from the Gulf; and on the demand side, ramping up local refinery runs.

But pipeline shipments of heavy tar-sands oil from Canada are no longer entirely discretionary and rising North Dakota oil production have created an unprecedented imbalance.

Jim Burkhard, managing director of the Global Oil Group at IHS/CERA, said he believes Cushing is no longer representative of the broader oil market.

“Cushing is not only disconnected from the global crude oil market, it is really disconnected from the U.S. crude oil market as well,” Burkhard told CNBC cable news channel on February 28.

Other energy analysts echo Burkhard’s sentiments.

Jeff Rubin, former chief economist at CIBC World Markets in Canada, predicts the spread between WTI and Brent is going to widen.

“Until TransCanada can connect the ever-increasing flow of crude from the oil sands to refineries on the Gulf of Mexico (not likely until 2013), there is going to be a bigger and bigger disconnect between WTI and global crude demand as more oil piles up at Cushing,” Rubin wrote in early February commentary.

“As that happens, the oil industry and the investment community will look to Brent as the new benchmark for global oil prices,” according to Rubin.

A Limited Distribution System

The culprits for the unprecedented imbalance are not terrorists or speculative traders, but rather the monumental size of the Cushing hub itself. The hub has a limited distribution system that is simply not configured to move inland products to the Gulf Coast for export.

Specifically, a combination of increasing Canadian heavy tar-sands oil, Cushing’s ever-growing storage capacity and a lack of pipeline takeaway to move the oil out is discounting the price of WTI around the world.

“There’s too much going in and not enough going out,” Mike McDonald, chairman of the Oklahoma Independent Petroleum Association (OIPA), told the Tulsa World on February 27.

Hart Energy price data – and McDonald’s calendar – tells the story.

On February 18, 2010, the WTI futures contract sold at Cushing for $79.81/bbl – nearly $3.00 higher than Brent. One year later on February 18, Brent fetched more than $101.00/bbl while WTI traded around $86.50/bbl. Concern about geopolitical tensions in Libya and other oil-producing nations lifted WTI to the $100.00/bbl mark by end-February, but Brent still hovered near $115.

The problem: There are no pipelines from Cushing to the large refineries on the Gulf Coast. Although several new pipelines are proposed – including one by Calgary, Alberta-based Enbridge, Inc. – Cushing remains something of a bottleneck.

Of the 51.9 millions barrels of crude storage currently available at Cushing, Enbridge’s facility makes up about one-third of that capacity – in 85 giant tanks. According to the company’s website, it plans to build up to another 3 million more barrels of storage, and Enbridge is not alone.

Plains All American and Tulsa’s own Magellan Midstream Partners plan to add 15 million barrels in storage capacity by the end of 2011, according to several media reports.

On February 28, Kinder Morgan and new partners Mercuria Energy and Deeprock Energy Resources announced plans to build 750,000 barrels of crude capacity at Cushing by third-quarter 2011.

But new storage capacity at Cushing – some already on line and more expected in 2011 – has done little to ease concerns. What is unclear is how much of the new capacity is incremental, as opposed to merely replacing old tanks that are being retired.

WTI Will Be ‘Virtually Irrelevant’

Transportation bottlenecks in and around Cushing will force WTI to trade at a “meaningful” discount to other crudes through 2011 and into 2012, according to a recent Bloomberg report quoting Raymond James & Associates, Inc. analysts.

Brent is “the new undisputed champion of global crude price benchmarks,” the analysts said, adding that the pricing gap will likely narrow in coming months. But just how viable Cushing is as a future pricing point on the worldwide market remains to be seen, the analysts said.

“We now think that the current supply glut at Cushing is a structural issue that is unlikely to be fully resolved anytime soon,” the James report concluded. “That means WTI will become much less relevant than it has been historically.”

Delivering less discretionary oil from the Gulf would appear to part of the solution in reducing the mammoth glut at Cushing. But ConocoPhillips – one of the owners of the 430,000 barrel-per-day (b/d) Seaway pipeline – has said it is not interested in reversing the line (see GRFT 2/18/2011).

Furthermore, what domestic producers consider the crucial relief valve: A takeaway leg from Cushing to the Gulf Coast is on hold while TransCanada seeks U.S. government approval for another segment – the XL – from the Canadian border to the upper Midwest.

In the meantime, TransCanada wants to increase the volume of southbound tar-sands crude with the expansion of its Keystone pipeline system. The Keystone leg from Steele City, Neb., to Cushing became operational recently.

On February 28, Enterprise Products Partners said it planned to convert a carbon-dioxide pipeline into a 54,000-b/d crude pipeline to carry oil from the new Bone Springs/Avalon shale play in New Mexico and Texas into the Basin pipeline, which serves storage facilities in Midland, Texas. From there, the oil is bound for Cushing.

OIPA’s McDonald told the Tulsa World he’s concerned the new operational part of the Keystone (for one) – if not countered by takeaway pipeline capacity – could make the WTI price imbalance even worse in the future.

According to a February 14 Raymond James report, the completion of the Steele City-Cushing link adds about 155,000 b/d worth of inbound crude capacity and “stands to compound the bottleneck problem at Cushing in 2011.”

“Unfortunately for U.S. oil producers, the outlook for Keystone XL is somewhat uncertain right now,” the financial firm’s report reads. “Obviously, if Keystone XL is not built, there is no Cushing-to-USGC link.”

Brent Has Its Problems, Too

If WTI is said to have a problem with being too associated with market fundamentals, the opposite could be said to be true of Brent – largely due to the opacity associated with its delivery process.

According to a January 2010 report by Purvin & Gertz – prepared for NYMEX owner CME Group – there is little or no weekly reporting of any Brent supply figures or inventories, therefore it’s hard to make a true comparison of the so-called “broken fundamentals” of WTI with those of Brent.

They further note: “Finally, we’d question that if Brent is such a global benchmark with ‘60%’ global usage according to ICE’s own statements, then why are Brent volumes still only a quarter of WTI’s?”

Four different crudes actually make up the physical Dated Brent quote: Brent, Forties, Ekofisk and Oseberg (BFOE). The BFOE basket was conceived by BP Plc. and price-reporting service, Platts, because volumes of the Brent original have been diminishing with declining production rates.

Unlike WTI – which has the inventories for its delivery point disclosed on a weekly basis by the EIA – those seeking inventory statistics for Brent have to approach the producers directly. Most often, they are not always that accommodating to public information requests.