The United States Oil ETF (NYSEARCA:USO) was one of the top financial topics of 2014. It had performed admirably early in the year, but oil prices crashed and US unconventional economics have come into question. The selloff in oil has made little sense, and when it began many funds were overweight E&Ps, and hit hard trying to get out of those positions. Others have lost considerable investments trying to call the bottom in oil. The question is where will oil find a bottom, and when will this occur? Many think we are already there, but some estimates have oil going lower in 2015. We will go over the reasons we feel why oil is headed lower and how we are trading it.
We have been bearish oil and covered this in several write ups on Bakken operators that may not be economic at today’s oil price. Keep in mind the Bakken faces a more difficult situation as diffferentials are greater than in other US plays. In 2014, the average Bakken differential was approximately $11/bbl or $12/bbl less than WTI. We expect the average in 2015 to be between $13/bbl and $14/bbl. Currently this differential is closer to $16/bbl and we think its possible it will widen more. Differentials, whether Bakken, Permian and Eagle Ford crude, are different from one area to the next as they reflect several things like cost of transport, type of crude, demand, etc. The widening of Bakken differentials are mostly due to transport methods, but also we are seeing a decrease in demand as inventories continue to build in the US.
The Bakken doesn’t have the advantages of Texas crude, as there is only one small refinery in Mandan, North Dakota. The Eagle Ford is only a short distance from some of the largest, and most complex US refineries. Since there is limited pipe capacity, rail has become the main driving force to get Bakken crude out of the state. North Dakota production continues to outpace pipeline construction, but Pipelines cost hundreds of millions to billions of dollars to construct. Midstream companies won’t break ground until it has about 80% of the pipe filled via contract. Pipelines also like longer term deals. The rails are much easier, as costs are lower. Rail loading and unloading terminals cost much less and can be constructed quicker. Railroad crude transport deals are much shorter where three year deals are common. The pipeline advantage is cost, as its much cheaper than railing crude. We would expect that once pipeline capacity meet current production, Bakken differentials will tighten to approximately $6/bbl.