Platts Light Houston Sweet: New pricing for a new market

WHITE PAPER Platts Light Houston Sweet: New pricing for a new market NOVEMBER 2014 WWW.OIL.PLATTS.COM

PLATTS LIGHT HOUSTON SWEET The transformation of the US oil market landscape brought about by the shale revolution and advanced drilling techniques has sparked wholesale changes across much of the industry in recent years. Oil plays once thought to be dead or dying are now producing at or near record highs. Storage terminals have sprung up across the country to house the growing volumes of petroleum. New pipelines have been constructed and existing ones have been reversed in order to ship the crude to market. The final piece in the jigsaw was a pricing mechanism for the new production and crude flows that were not reflected by any of the current benchmarks. In a proactive move to bring price discovery to a growing crude hub, Platts launched a Light Houston Sweet (LHS) assessment in July 2013 in an effort to reflect the evolving crude flows and expanding storage nucleus on the US Gulf Coast. The LHS assessment reflects the value of light sweet crude flowing into Houston, Texas from both the Permian Basin and Cushing, Oklahoma. As of November 2014, over 1.7 million b/d of crude pipeline capacity is delivering both sweet and sour crude into the Houston area, where nearly 60 million barrels of storage and 2.2 million b/d of refining capacity exists. This has led to a burgeoning spot market that could potentially reset the structure of benchmarks in the Americas. These developments beg the need for a benchmark that would fully reflect US Gulf Coast, and global, crude fundamentals. The Platts Light Houston Sweet assessment is part of a series of new assessments launched by Platts in response to the structural shifts taking place in the US crude market, where tight oil exploration and development is reshaping traditional crude flows and refinery demand patterns. The US crude oil market continues to undergo enormous change with production exceeding forecasted levels. The US is now the largest liquids producer in the world, after recently passing Russian output if one combines crude oil production with natural gas liquids and ethanol output. Light sweet crude imports into the US are now almost vestigial as US refiners switch to the new streams pouring into the refining centers. Extensive exploration and production activity in crude oil shale plays such as Eagle Ford and Bakken has boosted domestic crude output for these new light sweet crudes. Hydraulic fracturing has also resurrected drilling activity in established plays such as the Permian Basin, the production center for WTI. This increased production, which has crossed the 1.1 million b/d level for Bakken, 1.8 million b/d for Permian and above 1.1 million b/d for Eagle Ford (crude and condensate), has fundamentally altered wider crude oil dynamics in the US, including a significant impact on benchmark WTI at Cushing, Oklahoma. Total US production remains on an upward path, with output forecast to break above 12 million b/d in 2020, according to Bentek, a division of Platts. The Permian Basin in West Texas and eastern New Mexico has been a hotbed of domestic onshore conventional oil production for decades, and is the source basin for the WTI crude stream, but until recently production had been in long-term decline. That situation has since been totally reversed as high crude prices and developments in horizontal drilling have allowed companies to tap new formations. Bentek estimates that current production in the Permian Basin is about 1.8 million b/d and is set to grow to 2.1 million b/d by 2016. In 2012, Permian Basin production averaged 1.2 million b/d. The US market is resetting itself with new pathways for crude to flow to the coast rather than inland, begging the need for an assessment whose value denotes the intersection of crude oil supply and demand at the new, vibrant market center at the US Gulf coastline. This need has been apparent since 2011, when the US benchmark WTI entered a period of unprecedented relative weakness to international benchmarks. A lack of exit capacity out of Cushing, Oklahoma WTI s storage hub depressed WTI to a record $29.24/b discount to Brent in September 2011. Pipeline operators responded to this crude supply bottleneck with a number of ambitious projects to reroute crude flows, some of which have already been completed. These projects are beginning to relieve the bottleneck at Cushing, but rising US domestic production and an inability to export such production is eventually expected to pressure US crude values relative to the global market. The resetting of the US market to reflect the new supply/ demand fundamentals is already reflecting itself in the substantial narrowing of the Brent/WTI spread, starting in July 2013 as relationships between the two grades began to return to near normalcy. As the Cushing bottleneck has been relieved the glut of oil has moved south to the US Gulf Coast. Crude stocks in Cushing have fallen to approximately 20 million barrels from about 50 million barrels in the summer of 2013, while the front-month Brent/WTI spread narrowed from as wide as $23/ barrel in February 2013 to about $4/barrel in November. A LIGHT SWEET HOUSTON MARKET HUB EMERGES The new pipeline projects, whose inception was sparked by the record discounts for WTI relative to Brent, have provided a gateway for trapped crude oil in the US midcontinent to reach potential buyers on the Texas Gulf Coast. A new grade called Domestic Sweet Blend (DSW) began flowing into Freeport, Texas last year a Cushing-sourced blend that includes WTI. Now with the Seaway Pipeline bringing 400,000 b/d of DSW and Canadian heavy sour into its new Houston terminus, this DSW blend is being consumed by Houston refineries. The reversed Seaway pipeline expansion is currently sending up to 400,000 b/d of crude from Cushing to Enterprise Houston Crude Oil (ECHO) Terminal, and is set to deliver more than double crude capacity by December to 850,000 b/d once the Seaway twin line commences services. This DSW grade, along with Western Canadian Select, has flowed into Houston 2

Map of Houston crude oil storage and distribution Source: Platts since January 2013, and is expected to continue to flow in at increased rates. Generally, market participants expect that the majority of Seaway pipeline capacity will carry Canadian heavy crudes, both at current capacity levels and when the additional 450,000 b/d of capacity comes online by the end of 2014. Eagle Ford crude is also flowing into Houston and could potentially find its way into blending for the DSW market at the ECHO terminal, as market participants expect that Houston could become a blending center that would rival the Cushing, Oklahoma, light sweet crude hub. Some of the Eagle Ford streams flowing into Houston are field blends at API levels similar to DSW (42-43 API), and are seen by refiners as a preferred alternative to waterborne Eagle Ford out of Corpus Christi. These waterborne Eagle Ford barrels are more of a tank blend than the supply coming into to Houston, and have challenges for refiners such as uneven distillation and high metals content. At the same time, crude began flowing from the Permian Basin to the Texas Gulf Coast last year thanks to several pipeline projects aimed at delivering WTI to Houston and Beaumont. Permianorigin light sweet crude, which trades as the WTI Midland stream at Midland, Texas, is less of a blend than DSW. In the case of WTI sourced from Midland, field blending from local streams comprise the grade, rather than mixing crudes of more varied quality and origin. Initially, WTI Midland specification crude moved into Houston via the 40,000 b/d Kilgore line into the Oil Tanking International terminal. This line is now moving West Texas Sour (WTS), but other lines to deliver Midland WTI to Houston have since been completed. The first of these lines was Magellan Midstream Partners Longhorn pipeline, a reversal of an existing products pipeline from Crane, Texas, to Magellan s East Houston storage terminal. Magellan initially began moving 75,000 b/d of Midland WTI into the Houston area in April 2013, before ramping up to 225,000 b/d in the third quarter of that year, and an expansion to 275,000 b/d in the summer of 2014. And then in late September 2014, the 300,000 b/d Magellan/Occidental Petroleum BridgeTex pipeline stretching from Colorado City, Texas, to Houston began shipping Permian crude to the East Houston terminal. In total, more than 1.7 million b/d of crude pipeline capacity is flowing into the Houston market, with roughly 1 million b/d of this capacity available to carry light crude. This potential influx of supply will encounter 2.2 million b/d of refining capacity in the Houston/ Galveston area, the largest refining center in North America. 3

HOUSTON MARKET INFRASTRUCTURE Houston is the central hub for hydrocarbon refining and processing in North America, and is the location for several key refined products benchmarks for gasoline, distillates, jet fuel, refinery feedstocks and natural gas liquids. The rebirth of US domestic crude production in the backyard of the Houston refining center has prompted a massive build-up of infrastructure to connect crude oil production to potential buyers along the Texas Gulf Coast. At the heart of this infrastructure wave, from Corpus Christi north to Beaumont/Port Arthur, is the greater Houston refining center where four Houston, one Baytown, and three Texas City refineries total more than 2.2 million b/d of capacity. Compared with Corpus Christi and Beaumont/Port Arthur, Houston has more refining capacity, storage, and waterborne loading infrastructure, which positions the Houston area to remain the core pricing hub in the Americas not only for refined products, as has long been the case, but now for crude as well. Additional storage is being added and distribution systems are being expanded to handle the nearly 1.7 million b/d of crude oil pipeline capacity, completed and proposed, aimed at the greater Houston/Galveston area. With the new crude terminals that have been constructed along with storage at local refineries, nearly 60 million barrels of crude storage sit in the Houston area. At the same time as it was reversing and expanding the Longhorn line to h ship crude to Houston, Magellan expanded its 2 million barrel East Houston storage terminal to 4.4 million barrels. The company also expanded its connectivity to Houston and Texas City refineries to compliment the new inbound capacity from the Permian Basin. The partnership completed new pipeline infrastructure in November 2013 stretching out from the Galena Park terminal to Magellan s Houston Gulf Coast crude distribution system for deliveries to Houston and Texas City area refineries. In December, the twin line for Enterprise and Enbridge s Seaway pipeline is slated to be operational, expanding the capacity of the project to 850,000 b/d. The ECHO storage terminal, the receiving point for both the Seaway Pipeline and Enterprise s Eagle Ford pipeline system, will be increased to more than 6 million barrels of capacity by late 2015 and have access to Enterprise s marine terminal at Morgan s Point on the Houston Ship Channel. Enterprise also intends to increase the connectivity between ECHO and Texas refineries in the same time period. In addition, rail cars of Permian crudes from both Midland and Cushing are reaching the Houston market and access to water, thanks to the Kinder Morgan/Mercuria 210,000 b/d rail terminal project on the Houston Ship Channel. There are additional projects to connect the prolific Permian Basin to other US Gulf Coast ports including Sunoco Logistics Permian Crude pipelines converge on Houston Platts, company reports 4

Express and West Texas Gulf projects to Nederland, Texas, and the Plains All-American Cactus line that could bring WTI to Corpus Christi, Texas via Plains 350,000 b/d Eagle Ford pipeline system. Platts reviewed the possibility of assessing light, sweet crude at Beaumont/Port Arthur in addition to Houston, but the volume of crude oil flowing into Houston, with the prospect of more to come, and access to the largest conglomeration of refining demand in the US renders Houston the most likely place for an active market hub to develop and evolve. WHAT IS LIGHT HOUSTON SWEET? Light Houston Sweet, or LHS, is a new assessment launched by Platts to reflect the value of light sweet crude on the US Gulf Coast specifically, Houston. Since the influx of Canadian crude and rising domestic crude production allowed WTI at Cushing, Oklahoma, to dislocate from the wider market, market participants have shifted hedging and pricing towards alternatives that reflected more global supply/demand fundamentals. A robust domestic reference price is needed to fully reflect the value of US Gulf Coast crude, and the intersection of refinery demand and rising US production. While Light Louisiana Sweet (LLS) has acted as a regional reference price for US Gulf Coast crude since the WTI dislocation, LLS as a benchmark has its own challenges. The nature of LLS as a blend with somewhat limited specifications allows for high variability in its quality, which is undesirable to some refiners and hedgers. At the same time, LLS at St. James, Louisiana, is removed geographically from the hotbed of domestic crude production growth the Eagle Ford and Permian Basin production areas in Texas, and has become stranded with the reversal of Shell Pipeline s Ho-Ho line. With crude now flowing west from Houston into Louisiana, LLS has been isolated to St. James and no longer represents market dynamics on the Gulf Coast. Pipeline infrastructure, both current and proposed, favors Houston as a market center, with more than 1.7 million b/d of pipelines poised to bring various grades of crude Eagle Ford, Permian, domestic light sweet, and Canadian heavy to the area. Several pricing markers will likely emerge from this meeting of domestic crude movements and refinery demand. Platts reviewed the infrastructure developments and the different grades flowing into Houston to determine what type of crude it should assess as the basis for its Light Houston Sweet marker. Eagle Ford, with its meteoric rise in production and ample reserves, was considered as a potential basis for LHS at Houston, but its variability in quality precludes it from being a widely used marker. A reference price for Eagle Ford will likely be needed by the industry to reflect the value of waterborne loadings at Corpus Christi, where a vibrant market has developed. A market for Eagle Ford in Houston Crude Oil Quality Association Recommended Specifications for Domestic Light Sweet API Sulfur Micro Carbon Residue Vanadium Nickel Total Acid Number (TAN) Distillation Yield (% vol) 37 to 42 degrees 0.42% typical 2.4% wt maximum 15 ppm maximum 8 ppm maximum 0.28 mg KOH/g maximum 50% between 450-570 degrees F WTI Midland at Magellan East Houston Specification Basis API Sulfur Micro Carbon Residue Vanadium Nickel Total Acid Number (TAN) 42 degrees maximum 0.45% maximum 1.1% wt typical 4ppm typical 2ppm typical 0.1 mg KOH/g typical has developed too, but lacks the liquidity and spot transactions to be considered for an assessment, at this point. Platts also considered Domestic Sweet Blend as a basis for its LHS marker. Domestic Sweet is currently flowing into Houston at an estimated 120,000 b/d on the Seaway pipeline, but quality variability has raised concerns amongst the refining community. DSW from Cushing is flowing in the Seaway line with Canadian grade Western Canadian Select (WCS), and some of this comingling has increased the sulfur and metals content of the grade. Blending practices at the Cushing NYMEX crude hub have altered the quality consistency in DSW. The growth in US condensate production and increased flows of Canadian heavy into Cushing have prompted some market participants to blend Domestic Sweet with condensate and heavy crude, generating a crude barrel that is relatively high in light ends content, metals, and micro carbon residue and has an uneven distillation curve (high light ends and high residual fuel oil yields). The Crude Oil Quality Association has proposed a series of specifications that would make Domestic Sweet at Cushing more merchantable and consistent (please see the table below for these specifications). NYMEX has previously said it would add these specifications to the basis of its light sweet futures contract at Cushing, but as of November 2014, they have not yet been adopted. Because of those quality issues, Domestic Sweet Blend has traded at sizeable discounts to the WTI Midland quality of crude now flowing into Houston from the Permian Basin. WTI at Midland is sourced from Permian Basin produced streams, both conventional and unconventional. Field blending is taking place with conventional WTI streams mixed with lighter, lower sulfur unconventionally produced Permian barrels, and the result is a consistent quality without high metals or a dumb-bell distillation curve (high light ends and high residual fuel oil yields). 5

WTI Midland crude is flowing into Houston on the BridgeTex pipeline at a rate of 300,000 b/d, and the Longhorn pipeline is shipping 275,000 b/d to the East Houston terminal. Roughly 150,000-175,000 b/d of Longhorn s line space will be light sweet crude (WTI). Due to the high pipeline flows into Houston and the consistent quality, Platts determined that the WTI Midland quality should be the quality basis for its LHS assessment. Platts may normalize Domestic Sweet bids, offers, and transactions at Houston to the WTI Midland specification basis. As the Houston market develops, Platts will continue to review the quality comparison between Domestic Sweet and WTI Midland base specifications. The specifications for the LHS quality basis are included in the table below. Platts has defined the location for its LHS marker as Houston comprised by three terminals Magellan East Houston Terminal, Enterprise Houston Crude Oil (ECHO) Terminal, and the Oil Tanking Houston Terminal. These three terminals are in close proximity to the majority of greater Houston refining capacity. As the WTI Midland specification basis for LHS flows into Magellan East Houston, deals for other crudes such as DSW and Eagle Ford will be normalized back to Magellan East Houston. As Houston crude transportation infrastructure develops, Platts may consider additional terminals for inclusion in its LHS assessment basis, for instance if a spot market develops for WTI Midland and DSW at the Kinder Morgan/Mercuria 210,000 b/d rail terminal on the Houston Ship Channel. Platts LHS is assessed on a Free-in-Pipe (FIP) basis. Contractually, title of ownership is transferred when the oil flows into the downstream pipe from the terminal. The timing for Platts LHS assessment aligns with the US pipeline market schedule. The spot month for all US domestic pipeline barrels changes on the first business day after the 25th of the calendar month. It does not roll with the expiration of the front month of light sweet crude on the New York Mercantile Exchange. It continues for the three trading days in which the just-expired month continues to trade in the cash WTI market. For US domestic pipeline barrels, the roll-over date coincides with the date US crude oil pipelines require scheduling to be completed for deliveries in the following month. For instance, from November 26 through December 25, the front-month for all US domestic pipeline barrels is January. On December 26, the front-month for all US domestic pipeline barrels switches to February. If the 26th falls on a weekend or holiday, the next business day marks the beginning of the new scheduling month. But if the 25th is a Saturday or Sunday, then the last business day before the 25th becomes the last assessment day. The minimum volume considered by Platts will be 25,000 barrels, or 1,000 b/d rateable, in line with other US domestic pipeline grades. Platts publishes LHS as a flat price using both fixed-price information and floating price information. In the case of floating prices against WTI, Platts will generally calculate the fixed price assessment using calendar-month average (CMA) WTI or frontmonth WTI as the floating basis, depending on the WTI basis reported in bids, offers, and transactions. In the case of light sweet price information reported against LLS, Platts will calculate the fixed price using LLS trade month. And in the case of information reported on an ICE Brent basis, Platts will calculate the resulting fixed price using an ICE Brent strip that reflects the value of ICE Brent for the relevant pipeline month. In the absence of spot activity for light sweet crude in Houston, Platts will look at related markets such as WTI at Midland, WTI at Cushing, or LLS and adjust its daily LHS assessment accordingly. For any questions, suggestions, or comments, please contact Americas_crude@platts.com, and pricegroup@platts.com. FOR MORE INFORMATION, PLEASE CONTACT THE PLATTS SALES OFFICE NEAREST YOU: Web www.platts.com E-mail support@platts.com NORTH AMERICA EMEA LATIN AMERICA ASIA-PACIFIC RUSSIA +1-800-PLATTS8 (toll-free) +44-(0)20-7176-6111 +54-11-4804-1890 +65-6530-6430 +7-495-783-4141 +1-212-904-3070 (direct) 2014 Platts, McGraw Hill Financial. All rights reserved. Reproduction of this publication in any form is prohibited except with the written permission of Platts. Because of the possibility of human or mechanical error by Platts sources, Platts does not guarantee the accuracy, adequacy, completeness, or availability of any Platts information and is not responsible for any errors or omissions or for the use of such Platts information. Platts gives no express or implied warranties, including, but not limited to, any implied warranties of merchantability or fitness for a particular purpose or use. In no event shall Platts be liable for any direct, indirect, special, or consequential damages in connection with subscribers or others use of this publication. 6