Why Cushing Matters – A Look at the WTI Benchmark

 

 This photograph taken in August 2019 shows progress contractors are making in building Keyera's Wildhorse Terminal at the Cushing terminal. The tanks, which will have a total capacity of about 4 million barrels, are expected to be in service by the middle of next year. [PROVIDED BY GENSCAPE]

In response to the drastic decrease in global demand and over-supply due to the COVID-19 pandemic and the recent OPEC+ meetings in March 2020, the oil market has endured extreme stress, particularly related to logistics, storage, and finance.

With the demand collapse and refinery utilization rates near record lows, storage utilization levels have risen dramatically. The arbitrage price signals have responded to volatile market fundamentals to re-direct barrels to flow into storage due to the declining exports in the US Gulf Coast market.

Consequently, the stress in the oil market is reflected in the price signals from the NYMEX Light Sweet Crude Oil futures contract (also called “WTI futures”), which is based on physical delivery of WTI-type crude oil at the Cushing hub. The physical-delivery requirement of WTI futures is a direct link to the underlying physical market. At futures expiration, the exchange matches the buyers and sellers who elect to make or take delivery of physical oil. As a result of the recent extreme market imbalances between demand (low refinery runs) and supply (rising stocks), the day prior to expiration of the May 2020 WTI futures contract led to negative oil prices as buyers and sellers liquidated their futures positions. Negative prices can occur in commodity markets during times of oversupply and low demand, and these market conditions led to unprecedented price action in the May 2020 WTI futures contract. 

A regulated futures contract provides each buyer and seller with access to the clearinghouse and a financial guarantee for their trades. Despite the extreme market conditions, WTI futures ultimately provided for convergence between the futures and cash markets and performed its critical function as the central clearing mechanism for buyers and sellers in the crude oil market. This paper provides further information on the strengths of Cushing as both a trading and storage hub, most notably its pipeline connectivity, storage logistics, and price discovery role as a global benchmark. All of these strengths will be key as market participants hedge price risk while storage utilization levels rise.

Overview of Cushing logistics

At the heart of the global pricing network, the Cushing hub provides the physical delivery mechanism for the CME Group’s Light Sweet Crude Oil Futures contract. At the time when the WTI futures contract was first listed in 1983, Cushing was a vibrant hub for cash market trading of crude oil with a network of pipelines, refineries, and storage terminals. Today, Cushing is the key nexus of market fundamentals for the global crude oil market, with nearly two dozen pipelines and 20 storage terminals.

According to the EIA, the working storage capacity in Cushing is 76 million barrels, and 91 million barrels of total shell capacity as of September 2019. Currently, the shell capacity in Cushing is approaching 100 million barrels in the second quarter of 2020. The EIA defines the “working storage capacity” and “net available shell capacity” for Cushing and by PADD district.¹ Generally, the working storage capacity accounts for around 85% of the nameplate shell capacity of a tank, given that each storage tank has a roof and a heel that have to be managed by the terminal operator, and they typically are not able to use the full 100% shell capacity.

The pipeline infrastructure in the Cushing market is expansive, with approximately 3.7 million b/d of inflow pipeline capacity to Cushing and 3.1 million barrels per day of outflow capacity. The in-bound pipelines deliver crude oil streams produced in Canada and the US shale oil areas, including the Bakken, Niobrara, and Permian producing areas. The out-bound pipelines supply crude oil to the main refining centers in PADDs 2 and 3.

It is not just the storage or pipeline capacity that make Cushing the critical hub as the delivery point for the global oil benchmark, but also the interconnectivity between a diverse mix of operators at Cushing. The WTI Futures contract allows for delivery through Enterprise or Enbridge facilities in Cushing or at a facility that is connected to either. The Enterprise terminal provides a key junction point in Cushing, capable of facilitating the transfer of tens of millions of barrels of crude oil every month. A firm that elects to take delivery after the termination of the WTI futures must have storage and/or pipeline capacity connected to one of the NYMEX delivery locations in Cushing. From there, the firm can elect to take the oil into storage or into a pipeline with connectivity to PADD 2 refineries and to the Gulf Coast.

The physical-delivery requirement of WTI futures provides a direct link to the underlying physical market, and futures also provide the security of a financially-guaranteed clearinghouse for buyers and sellers. Further, Cushing terminal operators require firms to submit nominations for crude oil flows ahead of the delivery cycle in order to ensure the deliveries scheduled on and off exchange flow unencumbered.

Overview of Market Conditions

The unprecedented global market fundamentals have put intense stress on the oil industry in the first half of 2020, as companies respond to the volatile arbitrage price signals and hedge the price risk associated with demand destruction and rising stocks of crude oil.

The first indicator of the energy demand destruction from COVID-19 in the United States was seen in the New York Harbor RBOB gasoline futures contract (“RBOB futures”). The futures market for RBOB Gasoline forecasted demand concerns early when prices traded at a 20-year low of $0.376 on March 23, 2020. RBOB futures is an important indicator for global gasoline as it is the only gasoline futures contract to trade electronically around the clock. In the first quarter of 2020, RBOB futures has averaged 230,000 contracts traded per day with 380,000 contracts in open interest on April 23, 2020.

The impact on gasoline was more immediate due to the timing of the Coronavirus outbreak. Historically, gasoline stocks build in the winter in anticipation of the peak summer driving demand. As it became apparent that the summer driving season would be significantly curtailed, flat price RBOB futures prices started to decline at a faster pace than crude oil prices, which is reflected in the crack spread chart below.

In response to the sharp drop in gasoline prices, the oil refining companies were quick to respond to the price signals, as is evident in the decline in the US refinery utilization rate, which dropped to lows last seen in 2008 after the Lehman financial crisis.

Crude oil production however was not curtailed at the same pace as the reduction in refinery runs. This led to an increase in storage demand as market participants moved barrels into storage. With the over-supply coupled with demand collapse on a global scale, the price arbitrage was not favorable for crude oil exports. Exports have become a major outlet for US crude oil, which enabled US crude to become the marginal barrel of supply in the global energy markets.

One of the first price signals of oversupply of crude oil was the rapid price decline in US domestic crude oil cash markets. By late March 2020, WTI Midland and WTI Houston were trading at widening discounts to the WTI futures benchmark, providing an early indicator that there were supply and demand imbalances in the US crude oil market. This price arbitrage led market participants to direct barrels to flow into storage at Cushing. The chart below shows the general price volatility of the US domestic crude oil grades during the March and April 2020 timeframe. Ultimately, WTI futures provided for convergence between the futures and cash markets at expiry on April 21, 2020.

CME Group has a useful trading tool on its website, called Pace of the Roll, which tracks the daily roll activity taking place in Energy futures products to help analyze the progression of open interest in key benchmark contracts, including WTI futures. The chart below depicts the CME Group’s QuikStrike Pace of the Roll tool on April 17, 2020, which was three trading days before the expiration of the May 2020 WTI futures contract. This chart shows that the open interest positions were higher than average as shown by the orange line. Given the unprecedented global market fundamentals, firms relied more heavily on the WTI futures contract to manage price and counterparty risk.

At futures expiration, CME Group matches the buyers and sellers who elect to make or take delivery of physical oil. As a result of the recent extreme market imbalances between demand (low refinery runs) and supply (rising stocks), the expiration of the May 2020 WTI futures contract led to negative oil prices as buyers and sellers had to settle their futures positions. It is also important to note that after trading negative on both the afternoon of April 20 and the morning of April 21, the May WTI contract ended up with a final settlement price of $10.01, reflecting the successful convergence of futures and cash prices at final settlement. Trading was not interrupted, allowing the market to continue the process of price discovery.

Looking Ahead

It is important to note that CME Group futures markets worked as designed. Our futures prices reflected fundamentals in the physical crude oil market driven by the unprecedented global impacts of the COVID-19 pandemic, including decreased demand for crude, global oversupply, and high levels of US storage utilization. After advance notice to our regulator and the marketplace in early April 2020, CME Group accommodated negative WTI futures prices on April 20 so that clients could manage their risk amid dramatic price moves, while also ensuring the convergence of futures and cash prices. In the end, WTI futures performed its critical function as the central clearing mechanism for buyers and sellers in the crude oil market, and provided a transparent, fair, and robust benchmark price.

Going forward, the unprecedented global market fundamentals will continue to put intense stress on the oil industry in 2020, as companies respond to the volatile arbitrage price signals and hedge the price risk associated with the rising level of crude oil inventories.

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