New York, 1 August 2011: Reuters

Market players hopeful that the overhang of crude at Cushing, Oklahoma that has depressed U.S. West Texas Intermediate crude futures may ease by late 2012 are losing faith with a key project still on the drawing board. WTI futures are increasingly disconnected from the rest of the world as rising Canadian and Midwestern oil output has pressed up against pipeline capacity constraints, particularly at Cushing, the delivery point for the NYMEX contract.

Despite the huge price differential -more than $21 a barrel at press time- new capacity has been slow to materialize. Since May, the so-called Double E pipeline, a proposed 450,000 barrels per day link between Cushing and Houston, has been seeking long-term commitments from shippers and has twice extended the deadline to sign up for space on the line.

The project, backed by Enterprise Products Partners and Energy Transfer Partners, is making progress, according to a spokesman for Enterprise, adding the delays are due to potential customers needing more time to complete their applications for pipeline capacity.

The dynamism of the North American oil industry is due in no small part to the galaxy of small firms that are able to react faster than lumbering supermajors to new opportunities. But the downside of this model is that many producers lack scale to give significant, long-term commitments for things like pipeline capacity. Without enough long-term commitments, projects never get off the ground.

This lack of financial firepower has undermined past proposals to link Cushing with new markets. Pipeline operators are, as a rule, conservative companies that will not take much risk, particularly on major projects.

Moreover, as pipeline profitability is so closely linked to maximizing utilization, operators shy away from having much, if any redundant capacity. Similarly, it would be a bold bet for a firm without its own oil production, or at least a long-term offtake agreement, to sign up for space.

NATURAL HEDGE

The Double E backers have not provided much guidance on how much of the pipeline's capacity will have to be under a long-term contract for the project to be viable, nor have they indicated what sort of tariff they expect to charge. But a five-year deal to ship 10,000 barrels per day of crude at $2 a barrel - a volume that is just over 2 percent of the line's capacity - is a commitment to paying $7.3 million a year, not a trivial sum for a junior company.

Further complicating the situation is the apparent lack of a first-mover advantage for the Double E for shippers. The Keystone XL pipeline, which will include a connection between Cushing and the Gulf Coast, is still expected to be eventually built despite opposition from environmentalists and a rougher-than-expected regulatory approval process. If both lines are built, the Cushing market may well be balanced, at least in the short term. This summer has already shown that even without a connection to the Gulf Coast that Cushing inventories can decline when oil demand is near a peak. With more pipeline capacity, arbitrageurs may well erase the bulk of the difference in prices.

If that's the case it may well be worth it for some players to hold off on committing to a long-term shipping deal in the hope that enough of their competitors do. Or to put it more bluntly, why spend $7.3 million when you can hope to reap the benefits of better pricing by doing nothing?

Of course, these were the exact sort of issues that led to the creation of big, integrated oil majors a century ago. Vertical integration in the oil industry is out of fashion right now, though, with equity analysts calling on the majors to break themselves up to boost shareholder value. For some firms the breakups probably make sense. Marathon Petroleum, for instance, was sourcing only a tiny fraction of its crude needs from its former upstream arm, so the benefits of integration were small.

Canadian oil sands producers were urged to focus on bitumen production a few years ago when heavy crude prices were very strong and refineries soared in price. But scale and integration clearly now have a place for the oil sands firms. Those with refineries are reaping fat margins, offsetting the lost revenues due to poor crude oil pricing.

In a sense, owning a refinery can be a natural hedge against unforeseen dislocations in the oil market. Those without refineries are now at the market's mercy. Heavy crude producers in Canada are only earning about $75 a barrel right now .

WTI would not have to fall very far before some companies might have to consider shutting down production.

Ends --

By Robert Campbell, Reuters market analyst – for Commodities Now.

The views expressed here are his own.