? The Caribbean Crude Storage Market Growing influence of Chinese companies and opportunities for crude exports.

Morningstar Commodities Research 15 July 2016

Storage Market Outlook

Sandy Fielden Director, Oil and Products Research +1 512 431-8044 [email protected]

Demand for storage capacity has grown worldwide in the past two years in the face of a glut of crude

This note provides highlights from our recently published "Caribbean Crude Storage Outlook."

supplies. Of at least 13 existing Caribbean terminals (Exhibit 1), nine offer advantageous locations for crude storage, and those facilities are being expanded. Current Caribbean terminals are heavily used by Venezuela for crude blending and distribution to regional and international customers. China is neck and neck with the U.S. as the world’s largest crude importer and is making a significant strategic investment in Caribbean terminals to cement crude supply deals with South American producers. Two U.S. midstream operators, Buckeye Partners and NuStar Energy, own Caribbean terminals and have expanded storage capacity. Private equity fund ArcLight Capital Partners and trader Freepoint Commodities together purchased a huge terminal and shuttered a refinery on St. Croix in the U.S. Virgin Islands in January and have leased most of the working storage to China Petroleum & Chemical, or Sinopec. Light U.S. crude exports to the region are feeding a growing market for diluent to blend heavy crude. The Caribbean region and surrounding countries are the demand center for booming refined product exports from U.S. refineries that suggest opportunities for regional refinery expansion. Exhibit 1 Storage Facilities for Crude in the Caribbean

Source: Morningstar

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Buoyant Crude Storage Demand Crude prices have dropped by 50% since June 2014 to around $50 per barrel in the face of a global supply surplus. Falling prices led to a contango market structure that encourages crude storage because prices for future delivery are higher than today. As a result, crude inventory levels in the U.S. and overseas have risen to record levels in the past six months. Although total U.S. commercial crude-oil inventories have retreated by about 3% from their late May 2016 record high of 541 million barrels, they are still 33% above their five-year average for this time of year. Crude inventory levels in the Gulf Coast region also reached record levels of over 284 million barrels in April and are still 39% above the five-year average. The U.S. Energy Information Administration reports that storage capacity in the Gulf Coast region increased by 13 million barrels between September 2014 and May 2016 to accommodate increased demand. More newbuild storage capacity is on the way—including an 11-million-barrel underground cavern in Houston, Texas, being built by Fairway Energy Partners. A new CME futures market for crude storage space at the Louisiana Offshore Oil Port, or LOOP, has attracted strong participation in the past year. In these circumstances, Caribbean terminals represent an attractive working alternative to U.S. onshore storage. The islands have nine operational crude and refined product terminals with nameplate storage capacity of 140 million barrels of oil—roughly 50% of current Gulf Coast crude inventory. Although most of the working tanks are leased, some facilities are not being used and/or in need of repair, and these are attracting interest and investment from equity capital as well as Chinese companies. Caribbean terminals have market advantages over onshore tanks in the U.S. Gulf Coast region. In the first instance, Caribbean harbors have deep-water ports—meaning they can accommodate the largest oil tankers— very large crude carriers, or VLCCs, with capacity for 1 million to 2 million barrels, and ultralarge crude carriers, or ULCCs, with capacity for 2 million to 3 million barrels. The LOOP is the only U.S. terminal that can accommodate vessels that size. Caribbean terminals are also close to the U.S. Gulf Coast region, where 50 refineries can process as much as 9.3 mmb/d of crude. And the Caribbean is strategically placed at the crossroads of international crude trade routes. Existing Caribbean Storage Users By far the largest tenant of Caribbean storage today is the Venezuelan national oil company Petroleos de Venezuela, or PDVSA, which leases island tanks to build bulk cargoes for export and to blend its heavy crude production with lighter diluents such as the refined product naphtha or light crudes, to better meet the needs of long-term contract buyers in China and India. PDVSA is encountering significant challenges producing enough crude to meet commitments both to term buyers, many of whom have contracts linked to loan repayments, as well as to local Caribbean customers such as Cuba that receive subsidized supplies under the 2005 Petrocaribe treaty. Since prices fell by 50% in 2014, PDVSA has struggled to invest in new production and is now importing light crude from countries such as the U.S. (see our May report "Venezuela Buying U.S. Exports to Prop Up Ailing Crude Production") to blend its heavy crudes into marketable grades. Outside of PDVSA, the largest leaser of Caribbean storage is Sinopec. China produced 4.1 mmb/d of crude in 2015 according to the International Energy Agency and refined 10-11 mmb/d, meaning that it needed to import 6-7 mmb/d. This puts China neck and neck with the U.S. as the largest crude importer

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in the world. To help secure supplies, the Chinese have entered long-term commitments to lease Caribbean storage to handle blending and build bulk cargoes of crude purchases from Venezuela, Colombia, and Brazil. The most interesting recent investment in Caribbean storage is the January acquisition of the 350 thousand barrels per day Hovensa refinery and storage terminal in St. Croix by ArcLight Capital Partners, through its subsidiary Limetree Bay Terminals (80%) and commodities trader Freepoint Commodities (20%). The refinery, formerly owned jointly by Hess and PDVSA, was shut down in 2012 because of low margins. ArcLight has already leased 10 million barrels of storage capacity to Sinopec and expressed intentions to bring on line the full 32 million barrels of storage this year as well as to invest longer term in infrastructure, including a possible restart of the refinery. Freepoint is largely staffed by former employees of RBS Sempra’s U.S. trading unit and has close ties to Sinopec's trading arm, China International United Petroleum & Chemicals, or Unipec. Two U.S. midstream companies, Buckeye and NuStar own and operate Caribbean storage facilities. NuStar has a 14.4-million-barrel terminal on the island of St. Eustatius. Buckeye owns three terminals, including the flagship Borco Bahamas Hub and smaller facilities on St. Lucia and Puerto Rico. These three terminals make Buckeye the largest storage and terminal owner in the Caribbean, with a total of 41 million barrels of capacity. Refining The Caribbean has 12 operating refineries that are generally in need of investment and largely cater to domestic island needs. The recent ArcLight Capital and Freepoint Commodities investment in the former Hovensa refinery site demonstrates interest from outside investors in building or upgrading regional processing assets. A shuttered Valero refinery in Aruba has also recently been leased by the government of that island to Citgo, a U.S. subsidiary of PDVSA. A growing regional market for refined products represents both an opportunity for trading companies using Caribbean storage to serve Latin American demand as well as a larger potential market for refinery investment. Refined product demand from Central American countries has fueled an export boom for U.S. refiners (see our June report "U.S. Refiners Lose Crude Price Advantage"). Data from the Energy Information Administration shows that U.S. finished gasoline exports to Latin America averaged 284 mb/d, and exports of distillate averaged 215 mb/d in 2010. By 2015, finished gasoline exports had jumped 56% to 444 mb/d and exports of distillate increased 78% to 382 mb/d. However, any new refinery investment in the islands to serve this market will have to address inefficiencies such as fuel costs that led to the shutdown of the Hovensa and Aruba refineries in 2012. Regional Crude Flows Both Brazil and Colombia have produced increased volumes of very heavy crudes in the past few years that have to be blended with lighter crudes or diluent to transport more easily to refineries. Many of these blending operations have been carried out at Caribbean terminals. Crude exports from Mexico’s Petróleos Mexicanos, or Pemex, and PDVSA to the U.S. have declined over the past 10 years. In part this has reflected production declines in both Mexico and Venezuela, but lately it has also reflected lower

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U.S. crude imports because of rising domestic production of light crude from shale. Venezuela is still exporting heavy crude to the U.S. Gulf Coast—in particular to the three refineries owned by subsidiary Citgo—but it is also committed to sell greater volumes to China and India to repay loans. To meet increased crude demand in a lower price environment, PDVSA has increased output of heavy crude, importing light crude as a diluent to blend it to refiners’ tastes. Since the U.S. ban on crude exports was lifted at the end of 2015, increasing volumes of U.S. benchmark West Texas Intermediate have been shipped for this purpose from the Gulf Coast to Curaçao, an island in the southern Caribbean just off the Venezuelan coast. (Data from ClipperData indicates that exports of U.S. crude to Curaçao averaged 46 mb/d between January and May 2016.) PDVSA’s lack of dollars to pay for WTI has led to swap arrangements in which U.S. crude is repaid in kind with heavy Venezuelan crude. Similar swap arrangements have been suggested in the past between the U.S. and Mexico, before the crude export ban was lifted. Such swaps can also be cost-effective if the same vessel is used for both legs to reduce round-trip freight costs. Since domestic shale production of light crude took off in 2011, the U.S. has been long supplies of light sweet crude while continuing to import the heavy crudes preferred by many Gulf Coast refiners. Although Venezuela’s current economic situation hardly reflects a rosy investment picture, such arrangements represent long-term opportunities for increased U.S. crude exports. Caribbean Storage Terminals As stated above, existing nameplate Caribbean oil storage is more than 140 million barrels at nine island terminals and Panama, largely clustered close to Florida in the north and Venezuela in the south. To the north are the Buckeye Borco and Statoil South Riding Point terminals close to the U.S. mainland on the island of Grand Bahama. The other seven terminals are in the southern Caribbean off the northern coast of Venezuela. The use of the southern terminals in Aruba, Bonaire, Curaçao, St Eustatius, and St. Lucia is dominated by PDVSA crude trans-shipment, blending and storage operations. Our Market Outlook details the facilities at each of these terminals and uses ClipperData analysis to show crude flows in and out of associated ports. As an example, Exhibit 2 shows crude discharged at Curaçao between January 2014 and June 2016 that mostly came from nearby Venezuela (shown as Caribbean origin) before 2015 but has included increased shipments from the U.S. Gulf since January 2016.

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Exhibit 2 Crude Discharged at Curaçao

Source: ClipperData

U.S. Crude Export Opportunity In a world after the U.S. crude export ban was lifted in December 2015, producers and shippers are paying more attention to international market opportunities. With WTI trading within $1 per barrel of international competitors such as North Sea Brent, exports may be uneconomic outside of one-off deals. As a result, export flows are more likely to arise from specific requirements such as blending. The close proximity of heavy South American blends to the Caribbean and low freight rates to the islands from the U.S. Gulf suggest that such light-for-heavy crude swaps will be more than a passing fad. For a copy of the full report, please email: [email protected]

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