Can LOOP Ever Be a Gulf Coast Cushing? Part 2 Searching for a sour crude benchmark.

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1 ? Can LOOP Ever Be a Gulf Coast Cushing? Part 2 Searching for a sour crude benchmark. Morningstar Commodities Research 10 April 2017 Sandy Fielden Director, Oil and Products Research sandy.fielden@morningstar.com Data Used in This Publication gcme Group gmatrix Markets To discover more about the data sources used, Click Here Migrating Streams of Crude U.S. crude production is once again expanding as drilling rigs return to shale basins and Gulf of Mexico producers bring new fields online. U.S. crude exports reached record levels over 1 million barrels/day in February Yet Gulf Coast refiners representing over 50% of the nation s capacity, still import most of their crude feedstock because domestic grades are too light for their refinery configurations. Gulf Coast infrastructure is front and center, as migrating streams of crude move to where they are needed most. In the circumstances, the Louisiana Offshore Oil Port, blessed with a deep-water port and huge underground storage is a prime candidate to develop into a trading and pricing hub for the Gulf Coast region that could rival the current pipeline capital of the world, located in Cushing, Oklahoma. This is Part 2 of a note discussing LOOP s development and future as a Gulf Coast trading hub. In Part 1 (see Can LOOP Be A Gulf Coast Cushing) we covered LOOP s development as an import terminal and the addition of new connections to production from the Gulf of Mexico and shale basins. We also looked at previous efforts to establish a Gulf Coast sour crude benchmark. This time we discuss LOOP s sour crude storage auctions and related futures contracts as well as the latest sour crude benchmark candidate. LOOP Sour Crude LOOP sour crude is a mix of five component grades, stored underground in cavern 8 at the Clovelly, Louisiana hub. Two of the five components are domestic offshore Gulf of Mexico Mars and Poseidon crudes and the other three are imported Arab Medium, Basrah Light and Kuwait. Any of these grades may be delivered into LOOP sour storage interchangeably. LOOP publish the average API degrees gravity and sulfur characteristics of the sour cavern each month as well as information regarding the volume delivered out of storage. Storage Capacity Auctions LOOP along with Matrix Markets and the CME Group, has operated a monthly auction of storage capacity allocation contracts, or CACs, since March A CAC offers the legal right to store 1,000 barrels of LOOP sour crude during a specified future delivery month. Two types of CACs are sold at the monthly auction, storage futures contracts, or SFCs, and physical forward agreements, or PFAs. SFCs are futures contracts cleared by the CME futures exchange, which requires margin to be posted and provides counterparty guarantees. PFAs are physical agreements traded bilaterally between counterparties in a physical market.

2 Page 2 of 6 Simultaneous with launching SFC futures, CME listed a futures contract for 1000 barrels of LOOP sour crude. Trading in the daily settled LOOP CAC and sour crude contracts allows market participants to jointly manage storage and crude price exposure on the CME exchange. CACs are sold using an auction process because it allows the transparent transfer of storage capacity owned exclusively by LOOP, to market participants. The monthly auctions involve Matrix Markets listing specific storage volumes and maturities for sale as SFCs or PFAs including quarterly blocks. Participants bid on available capacity in an open Dutch auction. After the auction is closed, successful participants are allocated capacity at the lowest clearing price for the volume sold. Exhibit 1 shows the total volumes cleared since the first auction was held in March LOOP s goal is to lease all the available space in cavern 8 through the CAC auction. Total cavern capacity is about 7 million barrels meaning they can potentially allocate 7000 CACs for each delivery month. Greater volumes were cleared in the 2015 auctions because forward capacity allocated at earlier auctions cannot be resold until after it is used, reducing the available inventory for subsequent sales. The average price in 2015 was $0.11/barrel/month with average 9,000 contracts cleared at each auction. Total CAC volume peaked in April 2015 with13,407 CACs cleared at an average $0.05/barrel for delivery between May 2015 and May The average contracts cleared declined to 6,500/month at an average $0.33/barrel during In the first four auctions of 2017 an average 6,125 contracts cleared at $0.24/barrel. As you can see in Exhibit 1, cleared volumes of SFCs and PFAs were roughly equal in 2016 and 2017 but PFAs represented a much higher 72% of the total in Exhibit 1 LOOP Storage Contract Auction Volume 16,000 SFCs PFAs 14,000 12,000 Storage Contracts 10,000 8,000 6,000 4,000 2,000 0 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 Source: Matrix Markets, Morningstar

3 Page 3 of 6 Exhibit 2 shows auction price and volume history for the nearest cleared SFC delivery month. The shaded blue area is the volume of contracts (left axis) and the red line is the clearing price per barrel. Note that the volume and price do not appear to be correlated. This reflects both the higher allocation capacity available in 2015 that we just explained and the limited availability when prices and demand were higher in the spring of To show the relationship between auction prices and the market value of storage, we added the average one-month contango for CME Mars crude futures (one of the component LOOP sour crudes, green line) to the chart. This is the price premium for Mars delivery two months forward versus Mars prompt. If the value is positive, Mars is in contango (higher prices for forward delivery (see our May 2016 note Heating Oil Contango for more on contango), if the value is negative, Mars is in backwardation. Mars contango therefore represents the implied value of storing Mars crude for a month. You can see that after October 2015 when auction prices first exceeded 10 cents/barrel, the LOOP SFC clearing price is nearly always less than the average Mars contango suggesting that storage futures prices are tracking the implied market cost of carry. Exhibit 2 Auction Price and Volume History For Nearby SFCs 1,600 Contract Volume Clearing Price Mars Contango $2.00 1,400 1,200 $1.50 contract volume 1, $1.00 $0.50 $/barrel $ $0.50 3/31/2015 4/30/2015 5/31/2015 6/30/2015 7/31/2015 8/31/2015 9/30/ /31/ /30/ /31/2015 1/31/2016 2/29/2016 3/31/2016 4/30/2016 5/31/2016 6/30/2016 7/31/2016 8/31/2016 9/30/ /31/ /30/ /31/2016 1/31/2017 2/28/2017 3/31/2017 Source: Matrix Markets, CME Group, Morningstar Low Volume Futures Although SFC auction prices have tracked market contango, the successful operation of the LOOP storage auctions over the past two years has not been reflected in a very liquid futures market. As we noted, SFCs are listed by CME and the exchange provides daily settlement price and volume data for LOOP CACs. This data shows that in 2016 an average volume of 853 SFCs was traded by CME, each day a trade occurred, but that trades only occurred on 67 days during the year. In fact the vast majority of volume traded on the same day as the auction, suggesting that participants used futures to fill out storage capacity requirements not available to them at the auction. This indicates high numbers of physical versus financial participants.

4 Page 4 of 6 LOOP storage futures are also unusual because there is a high percentage of open interest at contract expiry, meaning more participants intend to take delivery of the physical storage rather than close out their positions on paper. Typical futures contracts see at best 1%-2% of volume going into delivery because they are primarily used as a paper financial instrument for hedging. In 2015, the average LOOP sour futures open interest at delivery was 19% of the total contract open interest or 1656 contracts, a number that fell to a still-high average 13% in 2016 and 14% so far in To be successful, futures contracts need to attract interest from the financial community and to trade enough volume on a daily basis to make it easy for participants to enter and exit positions without impacting prices adversely. This is not yet the case for LOOP storage futures. Benchmark Sour Crude As noted in Part 1, the successful development of LOOP as a trading hub requires a universally accepted benchmark sour crude to emerge. We described how previous attempts such as the Argus ASCI and Platts U.S. Marker Crude have so far failed to make the grade. Now that might be about to change. In part because of the success of the LOOP sour crude CAC auctions and in part because of the increased connectivity between LOOP storage and the Gulf Coast crude market, both Platts and Argus launched daily LOOP Sour Crude prices in March The Platts assessment is an index based on prices for the five component grades in LOOP sour crude. The Argus assessment is a daily volume-weighted average of all LOOP Sour crude deals. Although CME quote daily settlement prices for the LOOP sour crude futures contract, the new Platts and Argus assessments are the first published daily physical prices. Platts believe most physical LOOP sour trades occur in-tank, meaning they are just electronic transfers of ownership between market participants owning crude in LOOP s cavern 8. LOOP sour crude has some advantages as a candidate for Gulf Coast sour benchmark. The five component crudes are a mix of both domestic and imported crudes representing the mix of crude that Louisiana Gulf Coast refiners typically process. The range of crude components adds to the number of buyers and sellers in the market. LOOP sour also has abundant storage capacity available as well as a seamless in-tank transfer mechanism between owners. But LOOP has drawbacks as a physical location for a successful benchmark sour crude. The primary constraint is ease of access. Delivering crude to LOOP requires unloading a tanker at one of the offshore buoys or access to capacity on one of just two inbound pipelines delivering medium sour crudes Mars and Poseidon more or less directly from the production fields. These connection issues mean, for example, that LOOP crude is not well connected to the Texas refining market and that smaller sellers might have difficulty delivering crude. So, while it is easy to transfer crude in-tank once delivered to LOOP, outside constraints could cause price disruptions. LOOP debutedin 1981 as the largest import terminal in the U.S. The development of LOOP as a successful Gulf Coast crude trading hub now relies as much on exports as it does imports. As we explained in a note last month (see Crude Exports From the West Coast), the relaxation of U.S. regulations preventing most crude exports means that any coastal trading hub should have marine export facilities. LOOP is an obvious choice for exports, given its deep-water location. However, although

5 Page 5 of 6 LOOP management has discussed this possibility, it is currently deemed too expensive. The recent flurry of Mars crude exports from Louisiana when Asian market arbitrage opened up (see our February 2017 note U.S. Crude Exports to Asia) highlighted the lack of export facilities at LOOP. Verdict So Far We believe the Gulf Coast needs a successful crude trading hub that matches up to the role Cushing plays in the Midwest. LOOP is the leading candidate to be that trading hub but is still missing key attributes. Physically LOOP has improved connectivity but needs to do more particularly to develop export capability and access to the Texas market. The storage capacity auctions have been successful so far but are still largely confined to physical market players with little sign of the financial community involvement needed to provide liquidity. That physical bias is still clear in the LOOP CAC futures contract that remains immature. LOOP sour crude remains a great candidate for a Gulf Coast benchmark. It is too soon to judge the success of the Platts index launched last month but it will surely benefit from LOOP addressing connectivity challenges. K

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