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Permian faces pipeline crunch

The west Texas oil and gas play could see growth crimped if major infrastructure projects aren’t completed in time

The Permian tight oil field is growing fast—maybe too fast. With oil and gas output surging from the west Texas superbasin at a more rapid rate than expected this year, producers increasingly fear pipeline builders won't be able to keep up with output. This could cause costly bottlenecks and even throttle growth.

All signs point to continued strong production growth from the Permian. Output jumped from 2.62m barrels a day last September to 3.16m b/d in April—an average of more than 80,000 b/d per month, according to data from the Energy Information Administration. The upward rig count trend implies yet more is to come. Drillers added 44 new rigs across the Permian in just the first three months of this year, bringing the total to 444, on higher prices. That's more rigs than were added in the last seven months of 2017.

Considering that there's usually a six-month lag between the trend in the rig count and production, the early 2018 build-up in the rig count should sustain strong output growth through 2018 and into 2019. Exactly how high production will go is a major question, not just for oil markets, but also for producers, refiners and pipeline builders in the region. If the growth rate were to cool to an average of 70,000 b/d a month, output would reach around 3.7m b/d by the end of the year and could top 4.5m b/d by the end of 2019. That's higher than most in the market expect, with current consensus closer to 3.4m b/d, rising to 3.5m b/d by the end of this year.

Although relatively small in absolute terms, the roughly 200,000 b/d difference implied in the current production growth rate and lower market expectation could have major ramifications. That's because total existing pipeline takeaway capacity is around 3m b/d and there's local refining capacity of around 470,000 b/d, bringing the total to around 3.47m b/d, according to data compiled by Raymond James.

Capacity expansion plans

There are a handful of proposed oil pipeline expansions slated for this year that will be vital to heading off a potential bottleneck in crude takeaway capacity. Enterprise says it can expand its newly-minted Midland-to-Sealy pipeline this year from 450,000 b/d to 550,000 b/d by installing new pumps and taking other measures. Energy Transfer is also tentatively planning to add an additional 200,000 b/d to its Permian Express 3 line, bringing the pipeline's total capacity to 300,000 b/d. If both come online, and it's a big if, takeaway capacity would rise 300,000 b/d to around 3.77m b/d. A more likely scenario would see just one of the expansions materialise, potentially adding around 200,000 b/d.

Recent moves in price differentials around the Permian indicate pipeline capacity is already tight and the market is worried about further tightening through the end of the year. Because all new pipeline capacity is taking Permian crude directly to the Gulf Coast's refineries and export terminals, rather than to Cushing storage, the WTI Midland-Magellan East Houston (MEH) price differentials are the most important to watch. In March, the WTI Midland benchmark discount to MEH jumped from its typical level of around $1/b to $5/b, reflecting the fact that production was pushing up against takeaway capacity. The $5/b discount is a big hit to producers' bottom line, but manageable.

If enough new capacity comes online from the two major planned expansions by the end of the year, this $5/b discount could be as bad as it gets for the Permian's producers. However, if those expansions fall through, or if production accelerates, the discount could really start to bite. The Permian has gone through two major pipeline crunches in the recent past. For much of 2012, Permian crude traded at a roughly $5/b discount on similar infrastructure constraints. Production growth again outpaced pipelines in 2014, leading to a steady discount of more than $7/b for Permian oil that year. Both episodes forced a slowdown in crude output growth. A repeat of that this year would have significant implications for an oil market that's now counting on the Permian to help meet a sizable chunk of global demand growth.

Beyond the end of this year, the oil pipeline picture looks more comfortable, with a raft of new projects due to start up in 2019. Three new-build projects alone will add some 1.18m b/d of new pipeline capacity by the end of the year. EPIC's 440,000 b/d pipeline from Midland to the Gulf Coast will likely start up first, with a target to start flowing in the first quarter of the year. A joint venture between Phillips 66 and Enbridge are building the 385,000-b/d Gray Oak Pipeline that will link the Permian with Phillips 66's Sweeny Refinery and other plants along the Gulf Coast. Magellan Midstream has launched an open season to gauge interest in a new 350,000-b/d pipeline out of the Permian that it says could startup by the end of 2019.

The pipeline building boom could see total takeaway capacity hit as much as 6m b/d by 2020, giving ample runway for Permian producers to step on the pedal after the potential crunch period in late 2018 and early 2019.

Gas headache

However, oil pipelines are only part of the Permian's infrastructure puzzle. Pipeline builders will also have to keep up with the Permian's booming gas output, which comes alongside crude production. Analysts at Bernstein Research, an investment bank, point to a similar timeframe for a pipeline crunch as on the oil side. They argue that if a major new gas pipeline linking the Permian with the Mexican market being built by Fermaca, a private midstream developer, isn't finished by the end of 2018, the Permian's gas output would run up against existing takeaway capacity. That line has already been delayed, and it now looks like an early-2019 start-up is most likely.

That should worry the Permian's producers. If they didn't have anywhere to send their gas, they'd be left with two bad options. The first would be to start flaring huge amounts of gas, which would require a special waiver from state regulators. The other option would be to curtail oil output. Given how important Permian growth is to the state's economy, it seems likely the authorities would allow flaring, as was done in North Dakota when the Bakken ran into similar pipeline constraints. Either way, gas coming out of the Permian, priced at the Waha hub, is set to trade at a steep discount to Henry Hub for the foreseeable future.

As with the oil pipelines there are a slew of gas pipeline projects coming in late 2019 and 2020 that will ease the bottleneck. Kinder Morgan's major Gulf Coast Express gas pipeline will be the first in late 2019, and will be followed by Enterprise Partners' Permian gas pipeline, NAmerico's Pecos Trail line, and Sempra's Permian-to-Katy project. Those will give producers room to expand again. But getting there could see some pain come to the Permian.

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