by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil prices are trying to base but so far have failed to break above resistance at around $80 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 8.4 mb compared to a 2.0 mb draw forecast.  The SPR was unchanged, the first time since the reporting week of May 20, 2022.  The unusually large build was caused by slower than expected recovery in refinery operations.

In the details, U.S. crude oil production was unchanged at 12.2 mbpd.  Exports rose 1.7 mbpd, while imports rose 0.5 mbpd.  Refining activity rose 1.2% to 85.3% of capacity.  The Christmas cold snap closed in a significant level of refining activity, and the industry is slowly recovering.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Last week’s jump in inventory means we are starting the year off with well above average inventory injections.  The chart does show that the usual seasonal pattern was not followed last year.  This is because the average still reflects the restrictions on U.S. oil exports whereas there isn’t much of a discernable pattern to this data now that exports are allowed.

Th chart below shows the sharp drop and partial recovery in refining operations.  Usually, we do see some refinery maintenance this time of year, which will end in early February.  Thus, we may not see a full recovery in refinery operations until later in the quarter.

(Sources:  DOE, CIM)

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.  For the next few months, we expect the SPR level to remain steady, so changes in total stockpiles will be driven solely by commercial adjustments.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001.  Using total stocks since 2015, fair value is $107.07.

Market News:

• As the government’s SPR sales begin to wind down, the potential for higher prices has increased. We do expect a resumption of sales if oil prices threaten $100 per barrel, but it is unlikely that we will see another large sale just because prices are high.  We believe that the SPR sale was an underappreciated bearish factor last year, and if we are correct, an end to selling will likely be more bullish than expected.
  • It is our position that the SPR will never be refilled to its +600 mb level last seen before the recent sales. The structure that the Biden administration has put in place to buy oil makes it very unlikely that purchases will occur.
• The IEA is warning that the reopening of China will lift global oil demand to a new record.
• The Kingdom of Saudi Arabia (KSA) is kicking off investment into the mining sector, likely to diversify its economy away from oil and gas just in case demand for these products fall as green energy expands. The $15 billion starter fund should boost mining investment and will likely support the sector.
  • Saudi Arabia, due to cost structure and low emissions from production, believes it will be the last oil producer standing, even as the world moves away from fossil fuels.
  • In another effort to diversify its energy sources, one that will be most controversial, the KSA has indicated that it will use its domestic uranium to complete the nuclear fuel cycle. In theory, doing so could give the country the wherewithal to develop nuclear weapons.  Given the advanced status of Iran’s program coupled with uncertainty surrounding the U.S. security guarantee, this claim could further raise risks in the region.
• The history of oil is littered with “we are running out” narratives. Daniel Yergin’s The Prize is perhaps the best history of the industry, and at several junctures, the accepted wisdom was that the age of oil was ending because all the fields had been tapped.  What history shows is that supply shortages lift prices, increasing not just exploration activity but also new technologies.  Since oil was discovered in 1859, this cycle has been in place.  Thus, when the Financial Times runs a story about the end of shale, we take it with a bit of skepticism.  In some respects, the story might be right if current conditions remain in place, but, those conditions probably won’t last.  The FT story and the EIA’s short-term forecast for production are predicated on prices staying about where they are.  However, as we have noted, if we assume around a 200 mb decline in commercial stockpiles, which would have occurred had it not been for the SPR draw, we would be looking at $135 per barrel for crude oil.  Prices at that level will probably change behaviors.  Supply issues, such as the lack of workers, capital constraints, regulatory constraints, etc., remain, but all these can be overcome with higher prices.
• There is an old adage in markets that “nothing cures high prices like high prices.” In market theory, price is a signal, and high prices tell consumers to conserve, but more importantly, they reward suppliers who bring product to market.  As prices rise, especially in Europe, we are seeing a notable increase in exploration and development activity in the eastern Mediterranean.  Large natural gas fields are being discovered in a difficult geopolitical environment.  Offshore fields south of Cyprus have brought the involvement of Turkey, Greece, Israel, Lebanon, and even indirectly, Hamas.  Although there has been some degree of cooperation, deep divisions remain; for example, Turkish and Greek vessels routinely threaten each other.  Government instability can also upend agreements, but high prices will make it more likely that these obstacles will be overcome and will improve the supply situation in Europe and the Middle East.

 Geopolitical News:

• The oil price cap is having a modest impact on Russian oil revenue. It is estimated that Russia has lost $172 million of revenue per day, cut from the typical $688 million per day.  So, the loss is notable, but as designed, is not enough to completely cut off oil supplies.
  • India remains an aggressive buyer of Russian crude oil. Chinese shippers are moving Russian oil to Asia.
  • At Davos, participants are worried that it may be next to impossible to run the global economy without access to Russian oil, gas, and basic minerals. Without Russia, prices for these commodities will be much higher.
• Italy announced an effort to develop energy ties to Africa. In some respects, this is nothing new as Eni (E, $31.44), Italy’s energy champion, has had ties to Africa, especially to Libya.  However, the company is now planning to expand ties to numerous other African nations in a bid to move away from Russia as an energy source.
• China and Australia have been at odds over the latter’s call for an international investigation over the origins of COVID-19. The dispute led to a decline in Chinese imports of Australian commodities. However, there does appear to be a softening of Beijing’s stance as China has lifted its ban on coal imports.
• Conoco-Phillips (COP, $120.16) is in talks to sell Venezuelan oil in the U.S. to recoup losses tied to Caracas’s decision to expropriate the company’s assets in 2007. We do note that Venezuela has halted oil exports (likely a temporary situation) as it tries to gain control over its exports.  To avoid sanctions, Caracas has used numerous intermediaries to sell oil.  One of the problems with using such resources is that they can be either unreliable or costly.  As Venezuela “comes out of the cold,” it is trying to end its use of intermediaries, which should mean more revenue for the Maduro regime.
• For a number of reasons, Iranian oil exports are rising. We suspect that the U.S. has been quietly easing up on sanctions, but the biggest reason for the rise in exports is the simple fact that the world needs the oil.
  • Iran has been a key supporter of the Assad regime. The Syrian government is dominated by Alawites, which could be considered an offshoot of Shiite Islam, making Assad a sympathetic figure.  In addition, to the degree Iran can influence Iraq, the so-called “Shiite arc” ranging from Iran to Lebanon needs to include Syria in order for the arc to be completed.  And so, Iran has not just supplied Syria with military support, it has also provided economic support as well.  However, there are always limits to friendship.  As Iran is able to sell more oil on the world market at higher prices, it has ended its practice of selling deeply discounted oil to Syria, leading to further problems for the Syrian economy.
  • In a move that will not sit well in Tehran, the Iraqi PM Mohammed al-Sudani, wants an “indefinite” U.S. troop presence, ostensibly, to counter ISIS.
  • Iran executed a British citizen accused of spying. Tehran’s decision has angered Westminster.
  • The Iranian government is issuing new rules on the hijab. The regime wants to leave the rule in place but soften the penalties.

 Alternative Energy/Policy News:

• The IEA has issued its annual report on the state of energy technology, which skews toward green energy production. There are a number of takeaways but the one that caught our attention is China’s dominance in the production of components for these products.  If the West is going to develop these energy sources, a massive level of investment will be required.
• Sweden announced it has discovered a large deposit of rare earths. Rare earths are not really all that rare, although finding concentrated deposits can be a challenge.  The mining of such products, however, is environmentally difficult and the processing even more so.  Thus, the challenge of overcoming China in this area is, to some degree, tied to either making the process cleaner (and likely more expensive) or accepting the environmental degradation.
• China’s dominance in lithium is seen in the chart below.

(Source:  IEA)

• As this chart shows, China’s dominance in processing rare earths and lithium is a much bigger issue than the mining of ores.
• The U.S. government is supporting lithium mining in the U.S.
• The China-based solar panel firm JA Solar (002459, CNY, 64.10) announced it will build a factory in Phoenix. The factory will produce two gigawatts of panels a year, adding to the 4.5 GW capacity already in place in the U.S.  The fact that a Chinese firm is making an investment in the U.S. does indicate that Beijing is trying to keep market access to the U.S. open.  Japan did something similar in the late 1980s
• One of the well-known problems of wind and solar power is its intermittency. As evidence, Chinese officials are ordering rooftop solar panels to be shut off during the Chinese New Year celebrations.  The holiday will reduce demand and there are fears that solar panels will produce more power than needed.
• As part of the Inflation Reduction Act, the U.S. is supporting subsidies to EV firms. European car makers have been upset about this development, and the EU is complaining that U.S. officials are trying to woo European firms to expand their operations in the U.S. in order to acquire the subsidies.  Now, Germany announced that it would support EU-wide subsidies to counter the U.S. action, something the German automakers have been calling for.  In a sense, EV development is being imbedded into the industrial policies of the U.S. and EU.
• Although EVs get lots of attention in terms of reducing oil consumption in transport, efficiency gains far outpace electrics in terms of cutting demand.
• Changes in farming practices could reduce carbon in the atmosphere. Essentially, farmland could become a “carbon sink” where CO₂ would be captured by plants and held in the ground.  Although agriculture firms are trying to help farmers acquire carbon credits, farmers argue that the benefits from the credits are not enough yet to merit changing farm practices.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil prices continue to come under pressure on worries over economic growth, although there is some evidence that prices may be basing between $72 and $82 per barrel.

(Source: Barchart.com)

Crude oil inventories jumped 19.0 mb compared to a 3.0 mb draw forecast.  The SPR delined 0.8 mb, meaning the net build was 18.2 mb.  The unusually large build was caused by a large drop in exports, a rise in imports, and continued depressed refinery operations due to the deep cold snap late last year.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.2 mbpd.  Exports fell 2.1 mbpd, while imports rose 0.6 mbpd.  Refining activity rose 4.3% to 84.1% of capacity.  The Christmas cold snap closed in a significant level of refining activity, and the industry is slowly recovering.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Because we are starting the new year, we only have one datapoint for 2023.  The chart does show that the usual seasonal pattern was not followed last year.  This is because the average still reflects the restrictions on U.S. oil exports whereas there isn’t much of a discernable pattern to this data now that exports are allowed.

This chart shows the sharp drop and partial recovery in refining operations.

(Sources:  DOE, CIM)

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001.  Using total stocks since 2015, fair value is $107.08.

Market News:

• As China reopens from its COVID-19 lockdowns, it is increasing its oil import quotas. This decision is likely bullish for crude oil prices.  China is expected to buy a significant amount of Russian crude for this reopening, which should be available as the EU price cap has reduced Russian exports.
• OPEC+ production rose modestly in December.
• The DOE is forecasting lower oil prices in 2023 and 2024. For 2023, it is expecting Brent to average $83 per barrel, with $78 per barrel in 2024.  Expectations of rising output are behind the lower price forecast.
• We discussed proposed rules for U.S. refiners last year. Further analysis suggests that the costs of the new rules could lead to about a 700 kbpd loss of gasoline production as older refineries become unprofitable.  Although we could see some “grandfathering,” refining issues remain a concern.
• As we went into winter, the worry for the EU was that a cold winter would lead to a shortage of natural gas and therefore higher prices. Instead, Europe is being blessed with a historically mild winter.  Although these mild temperatures have helped Europe avoid a price crisis this winter, it could portend a hot, dry summer, which could lift natural gas prices later this year.  Last year’s dry summer caused havoc in Europe, affecting river travel and reducing nuclear power production, which was adversely affected by the water being too warm and too scarce to cool reactors.  Although summer remains a secondary demand season for natural gas, rising temperatures will lift natural gas-fired-electricity demand and may disrupt the inventory cycle, increasing the price risk when the eventual cold winter does occur.

(Source)

• The EU did agree on a price cap for natural gas. Although there are concerns that the cap might be too low to discourage conservation and boost supply, that probably won’t be an issue this winter as prices have dropped for EU natural gas.
• The mild winter and sanctions have reduced Russian gas exports to the EU. The U.K. has officially ended its imports of Russian LNG.
• Mostly mild weather has dampened U.S. natural gas prices as well. However, it is important to note that natural gas isn’t frictionless as evidenced by high natural gas prices in California.
• The epic cold snap that hit the U.S. during Christmas led to a massive shut-in of refining capacity. Although there are worries that the restart may be slow, reports suggest it is underway.
• Although oil companies have been reluctant to boost drilling, there does appear to be increased interest in the Permian Basin by the major oil companies. Smaller companies are also increasing investment.
• One of the side effects of fracking is wastewater, which is usually reinjected into the well. This practice is controversial, however, because it is thought to cause earthquakes.  Preventing such events may require the water to be shipped to a disposal site, resulting in increased costs.
• The aggressive selling from the SPR has dampened oil prices, and we estimate that in the absence of SPR sales, oil prices would have reached $135 per barrel. Although the Biden administration has indicated that it wants to buy 3.0 mb of oil to refill the reserve, the above charts suggest that this announcement is, at least so far, a signaling device.  We do note that the government intends to offer a fixed price for the oil, suggesting it is putting in a floor on the market.  As we have noted in earlier reports, it appears that the SPR is being repurposed as a buffer stock.
• Despite the easing of sanctions, Venezuelan oil exports fell last year.
• The U.S. is likely to become a net exporter of energy in 2023.
• Russia is claiming that Germany and Poland are still receiving shipments of Russian oil.
• One bright spot for oil supplies is Guyana, which appears poised to rapidly expand production this year.

 Geopolitical News:

• President Biden has admitted that the restart of the nuclear deal with Iran is “dead.” Iran continues to be a geopolitical hot spot for energy.  For example, there are reports that Iran is arming proxies not only in the Levant but also in the south Caucasus.  It is also accelerating its nuclear weapons program.  The U.S. has sanctioned a number of Iranian officials over the protest crackdowns, but given the extensive sanctions already in place, it seems unlikely that this action will have much of an impact.
  • One reason for the escalation in actions designed to be opposed by the U.S. is that there may be divisions within the ruling elite. Ayatollah Khamenei is old and sick, and it is possible that the Islamic Revolutionary Guard Corps may have designs on the leadership, which would end the rule of the clerics.  The hostile actions may be due to internal tensions as both sides try to be the most hardline.
  • The U.S. Navy seized a large shipment of assault rifles destined for the Houthis in Yemen.
  • Iran is suggesting that the Mossad is influencing the Iranian protests.
  • A Belgian citizen has been lashed 48 times for his alleged involvement in espionage. The Belgian foreign ministry has protested the action.
  • Iran’s leadership does appear to be softening its position on the hijab issue that sparked the recent protests.
• After several weeks of investigation, there is still no public evidence of who was responsible for attacking the Nord Stream pipelines.
• The Saudi Royal Family has tended to treat the oil riches as their own. Now, there are reports that the crown prince is using the Sovereign Wealth Fund in a similar manner.

 Alternative Energy/Policy News:

• In a stunning reversal, Japan is ending its phase-out of nuclear power implemented after the Fukushima disaster
• The Korean firm Hanwha (000880, KRW, 27,200) has announced it is building a $2.5 billion solar manufacturing plant in Georgia.
• A new activist group has formed to press major oil companies to reduce carbon emissions.
• The EU expanded its solar power by nearly 50% last year.
• As EVs become more popular, recycling the batteries is becoming an important issue.
  • We note that China continues to dominate the auto battery market.
• Although EVs get much of the attention, hybrids will likely top the automobile space for the near future.
• Because the environmental movement is broad, segments are often at odds with each other. The goal of protecting a wildflower in Nevada may prevent a lithium mine from being built.
• We track new developments in battery technology. Sodium/sulfur probably won’t replace lithium in autos, but it may be a winner for large-scale utility storage.
• One of our geopolitical themes is the shift from efficiency to resiliency in supply chains. U.S. officials are worried about dependence on Asia for solar energy, but shifting production to the U.S. will undoubtedly lift costs.
  • To lower solar panel costs, India is considering lifting tariffs.
• One of the problems facing the alternative energy industry is one seen in conventional energy too—a lack of workers.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

(This will be the last report of 2022; we will resume publication on January 12, 2023.)

Crude oil prices continue to come under pressure on worries over economic growth.  There was likely some bullish positioning in front of the Russian price cap which is probably being liquidated.

(Source: Barchart.com)

Crude oil inventories jumped 10.2 mb compared to a 3.8 mb draw forecast.  The SPR declined 4.7 mb, meaning the net build was 5.5 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.1 mbpd.  Exports and imports rose 0.9 mbpd.  Refining activity fell 3.3% to 92.2% of capacity.  Pipeline issues caused the drop in refinery activity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  This week’s data reversed the recent contra-seasonal pattern of the past few weeks, most likely due to the drop in refinery activity caused by pipeline issues.

Shortly after the war started, we stopped reporting on our basic oil model that uses commercial inventory and the EUR for independent variables.  We have now updated that model, which puts fair value at $73.60 per barrel.  We are currently trading near fair value for the first time since the war began.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001.  Using total stocks since 2015, fair value is $104.10.

Market News:

• We are continuing to watch how the Russian price cap is working. As we noted last week, the first reaction was that shipping was disrupted around the Black Sea.  Russia’s fiscal situation could suffer as well, and although Russia’s breakeven is thought to be around $20 per barrel, fiscally it needs $70 per barrel to balance its budget.  We still don’t know if the price cap is low enough to curtail Russian output, but the disruptions have cut exports.
  • President Putin has threatened to cut oil output in the wake of the price cap.
  • We also note that the gas price cap in the EU has not come together yet.
• The Keystone pipeline has suffered a rupture in Kansas, leaking 14,000 barrels worth of oil. The leak will disrupt oil flows to at least two refining centers.  We may see a drop in production in the coming weeks if the outage persists.
• Up until now, Europe has been helped by mild weather. That string of good fortune appears to be fading, which will likely lift oil and gas demand, and therefore, prices as well.
  • France is reportedly ramping up nuclear power as temps fall.
• Amos Hochstein, the White House international energy envoy, described the U.S. shale industry as “un-American.” He wants the industry to expand production, even though the government has sent rather clear signals that the future of oil demand is in doubt, in part due to policies of the same government.  If the goal is to encourage the industry to lift output, name-calling probably won’t have the desired effect.  At the same time, to be fair to Mr. Hochstein, his “beef’ is mainly with Wall Street, who is demanding a focus on shareholder returns rather than output.  Even with that emphasis, we note that production is rising in the shale patch, although the pace isn’t exactly rapid.
• Germany is making remarkable progress in building out its LNG infrastructure.
• With South Korean ship builders at capacity, orders for new LNG tankers are being sent to China.
• Europe has tentatively passed a carbon tariff. When a nation implements environmental rules of any type, it usually increases the costs of production.  This change puts domestic producers at a disadvantage relative to foreign producers who are likely not under similar restrictions.  In some sense, it is a form of protectionism, but for social goals.  The ability of the tax to level the playing field for European industry is still uncertain.  The levy is designed to be placed on the carbon content emitted during the production of the product, which may not be all that precise.  If the levy is too low, it will still be cheaper to buy it from the “dirty” foreign producer.  If it’s high enough to prevent the import, it will increase costs.
• The IEA is warning that oil markets will likely tighten next year.
• Infrastructure matters—we note that natural gas prices in the Permian Basin have fallen to $0.05 per MMBTU due to the lack of pipeline infrastructure.

 Geopolitical News:

• President Xi made a state visit to the Kingdom of Saudi Arabia (KSA) last week. The two nations inked a “strategic partnership” but, in reality, if the KSA is threatened by its neighbors, we doubt its first call will be to Beijing.  Still, the visit does highlight a drift in the KSA’s relations with the U.S.
  • Fin-Twitter was ablaze with commentary concerning reports that the KSA and China were about to begin settling oil sales in CNY. The fear is that pricing oil in a currency other than USD would undermine the reserve role of the greenback and lead to all sorts of potential ramifications.  However, the change might not be as groundbreaking as it is portrayed.  First, the KSA runs a modest trade surplus with China.  If the KSA is okay with accepting CNY instead of USD, we suspect Riyadh will find investments in China that will be acceptable.  Chinese financial markets are not as deep as U.S. ones, and as the real estate situation shows, in a workout agreement, Chinese investors are given preference.  At the same time, the treatment of USD reserves held by Russia and Iran have to give any nation pause as clearly getting “offside” with the U.S. can have a potentially bad outcome.  So, diversifying away from the dollar would make sense for the KSA, whose relations with the U.S. have become rather strained.
  • The “big deal” would be if the KSA demanded CNY for all oil sales. That would drive up demand to run trade surpluses with China in order to acquire CNY.  Given China’s reluctance to run large trade deficits (and incur the negative impact on employment), we doubt this action will spread beyond the bilateral relationship.
  • China is a newcomer to the region’s geopolitics, and it is getting a feel for just how fraught the region can be. During President Xi’s visit to the UAE, he agreed to a statement supporting the Emirates’ claims that the islands of Greater Tunb, Lesser Tunb, and Abu Musa should be submitted to some sort of international adjudication.  These three islands were part of the UAE when it was formed following the British withdrawal in 1971.  Iran decided to take advantage of the British leaving and seized the islands.  The UAE has wanted them back ever since, but Tehran has no interest in acquiescing.  Either the Chinese diplomats are siding with the UAE in this dispute, or they more likely walked into a conflict.  Iran was quite upset with the communiqué following the China/UAE meeting and is demanding an explanation.
  • Iran and China have had a longstanding relationship as the latter has helped Iran evade Western sanctions. It is worth noting, however, that the relationship may be more transactional than anything else.  As China is acquiring more oil from Russia, its overall trade with Iran is declining.
• Iran’s economy continues to suffer, but that sluggish economy has not led the state to ease its repression. At the same time, Russia and Iran are deepening their military relationship, a situation that will complicate the security of nations aligned against Tehran.
• A hack of Islamic Revolutionary Guard Corps documents details some of the discussions tied to the renewal of the 2015 nuclear deal. Although the veracity of the reports isn’t confirmed, the information provided does suggest that the two sides were always far apart.
• We note that gold purchases by central banks have been rising rapidly, with most of the purchases coming from emerging market central banks. It is quite possible that these banks are worried that the U.S. could reduce the value of their foreign exchange reserves as Washington did to Russia and Iran.  It should be noted that gold has other uses for central banks.  Iran has been trading fuel to Venezuela in return for gold.  Both nations have been under sanctions and have used gold to evade those sanctions.
• The KSA warns that if Iran develops/acquires a nuclear weapon, then “all bets are off,” which suggests a nuclear arms race in the region is likely.
• The U.S. made an outreach to Africa this week as part of a broader program to secure rare earths and other minerals critical to the energy transition. It is not obvious if the African nations will find the American effort useful, however.  Ultimately, Africa needs infrastructure investment (in which China tends to excel) and market access (which the U.S. is reducing from all nations), so this may turn out to be more rhetoric than reality.  Still, the U.S. is promising funding as part of the meeting, which will likely be welcomed.

 Alternative Energy/Policy News:

• Nuclear fusion, the same process that powers the sun, has held the promise of being the energy of the future, but sadly, more often seems to instead represent a future that never arrives. Thus, the news of a breakthrough should be viewed with hope but also a degree of skepticism.  Fusion generates power by fusing atoms together, as opposed to the conventional fission, which generates power by splitting atoms.  The promise of fusion is game breaking as it would be power that is clean,  free of byproducts, and cheap.  Thus, reports that scientists at the Lawrence Livermore National Laboratory had achieved “net energy gain” made headlines.  Net energy gain means that more energy was generated relative to what was deployed to create fusion.  It is still likely years before commercial applications are possible, but if nuclear fusion is ever achieved, its impact on human life would be astounding.
• The U.S. is funding numerous mineral projects abroad in a bid to secure materials for the energy transition.
  • Lithium prices have been strong due to EV demand, but it does appear that the supply side of the market is improving.
• Meanwhile, government funded research is making progress in developing batteries that are lighter and more energy dense.
  • There are reports that China and Australia are working on sodium-sulfur batteries which would likely be deployed by utilities to smooth electricity flows.
• The UAW has organized a U.S. auto battery plant.
• Although India continues to talk about clean energy, its behavior suggests that coal will remain its most important energy source.
• As drilling rises in tropical forests, there are rising concerns that those activities will weaken the carbon-absorbing value of the forests
• HSBC Holdings (HSBC, $30.82) announced it will no longer fund oil and gas development.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil prices continue to come under pressure on worries over economic growth.

(Source: Barchart.com)

Crude oil inventories fell 5.2 mb compared to a 3.9 mb draw forecast.  The SPR declined 2.1 mb, meaning the net draw was 7.3 mb.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.2 mbpd.  Exports fell 1.5 mbpd, while imports were unchanged.  Refining activity rose 0.3% to 95.5% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  As the chart shows, we are past the seasonal trough in inventories and heading toward the secondary peak which occurs in early Q4.  SPR sales have distorted the usual seasonal pattern in this data.  This week’s draw takes inventories further below the seasonal average, though perhaps the most important takeaway is that the usual seasonal pattern in inventory is breaking down.

Shortly after the war started, we stopped reporting on our basic oil model that uses commercial inventory and the EUR for independent variables.  We have updated that model, which puts fair value at $73.60 per barrel.  We are currently trading near fair value for the first time since the war began.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001.  Using total stocks since 2015, fair value is $106.07.

The Cap:  At long last, the EU has finally agreed on a price cap plan for Russian oil, pending Poland’s approval tomorrow.  The cap price is $60 per barrel, and since the current Urals price is around that level, it’s possible that not much will change.  The price was below what the Eastern Europeans were pushing for—Poland wanted a $30 price.  The U.S., however, was afraid that a price that low, which would effectively ban Russian oil exports, would trigger a major price rally and harm the world (and U.S.) economy.  The current price won’t really stop Russian exports if Russia wants to sell the oil.  Russia’s initial reaction is to refuse to sell oil to nations using the price cap.  We also note that, effective last Monday, the EU and U.K. will stop seaborne oil imports from Russia, which will have a more material impact on the oil markets.  The most likely market reaction is volatility.  The initial reaction to the cap and the OPEC+ decision was a sharp rise in oil prices, but that reaction faded earlier this week.

• It’s important to remember that this isn’t so much a price cap as a plan to restrict Russian oil shipments by denying this oil access to European and U.S. shipping and insurance. Without access to insurance and shipping finance, port and canal operators either won’t handle the cargo or will demand higher processing rates.
  • There are reports that Russia has been amassing tankers in order to avoid sanctions. Although these vessels may ease some of the pressure on global oil supplies, they will probably not be enough to prevent shortages.
  • The initial reaction to the cap is a bit as we expected; although it may not stop shipments, it is causing disruption. A large number of tankers are said to be awaiting passage through the Bosporus Strait as Turkish officials check paperwork.
• Once the EU signs off, the G-7 and Australia will be the next bodies to approve the measure.
• To ensure Poland’s participation, the EU will review the price cap every two months beginning in January.
• In anticipation of the cap and the EU embargo, Asian buyers have been purchasing Russian crude oil and Russia has been boosting production. Now that the deal is in place, we may actually see a slowdown in Russian purchases.
• OPEC+ met over the weekend and left production targets unchanged. There had been talk of both increases and cuts to targets, but in the end, the cartel decided to adopt a “wait and see” approach.
• Here are the key items to watch for in the coming weeks:
  • Russia really can’t afford to cut production significantly. If Russia shuts in wells, it will likely lead to a near-permanent loss of productive capacity.  If the cap had been set much lower, below $40, for example, it might have led to supply loss.  This cap probably won’t do much to change overall supply.
  • Russia is facing increasing budget pressures, and the cap won’t help those.
  • The price cap will, however, change supply patterns. Russia will need to sell more oil to non-EU and non-G-7 nations.  Although this is doable, it will be more costly and could cause short-term disruptions.
  • OPEC+ worries that the price cap could evolve into a buyer’s cartel. That may lead to more hostile actions from the oil producers.
  • Daniel Yergin warns that the price cap may mark a new era where oil is no longer a global commodity.

Market News:

• The White House is seeking to halt SPR sales in the coming years. Congress has tended to use the SPR as a sort of budget “piggy bank” to allow for funding of various projects.  Thus, various sales have already been authorized for future years.  However, with the SPR being drained by the sales completed due to the war in Ukraine, the administration now wants to halt those future sales.  So far, we are not seeing any programs put in place to refill the reserve, but this action does suggest growing concern about the sales.
• Recent data suggests that U.S. drilling activity remains lackluster. Due to regulatory and investment constraints, the U.S. oil and gas industry thus far has not reacted strongly to high oil prices.  We expect that to continue.
• The fertilizer market has been a major concern since the Russian invasion of Ukraine. Both nations are major producers of fertilizers and feedstock for the product.  The UN says that it is near a deal that would allow Russia to export ammonia via a Ukrainian pipeline.  Ammonia is a key element for the economy and resuming this supply is important.  We note that fertilizer prices have been falling recently as markets adjusted to high prices, and the UN news will likely support further price declines.
• One of our firm’s positions is that the unwinding of U.S. hegemony will lead to supply disruptions and trigger hoarding. Confirming this assertion is an announcement that Japan is building a strategic reserve for natural gas.  Japan gets nearly all of its natural gas from LNG and has faced higher prices as European demand for LNG has soared due to the war.
  • India is planning to boost natural gas imports in order to meet summer power demand.
• High prices and weak economic activity have reduced EU natural gas demand.
• If China continues to ease COVID restrictions, oil prices should benefit.
• Saudi Arabia announced it has discovered two new natural gas fields.
• A 2019 study by the NBER showed that lower heating costs prevent winter deaths. The study suggested that the shale gas revolution likely saved 11k lives in the U.S.  If the study is correct, high heating prices may lead to higher mortality rates in Europe this winter.
• Ethanol blending has hit new records.
• Mild temps are bearish for natural gas prices. Meanwhile, U.S. LNG projects are being funded rapidly, although there are concerns that the industry won’t be able to find enough gas to match these projects.
• Glencore (GLNCY, $13.31) is planning to accelerate coal mine closures. The closures have little to do with profitability but are instead being done to meet emissions targets.  The IEA is forecasting that renewables will overtake coal by 2025.
• Russia and China have completed a pipeline to Shanghai.
• New England authorities are warning that if the weather is unusually cold, rolling blackouts might occur. Some of the problem is tied to the Jones Act.

 Geopolitical News:

• Although OPEC+ has remained on the sidelines for now, weak oil prices may prompt the cartel to cut targets in the near future.
• Iran announced that it has disbanded its morality police and may ease hijab regulations in light of continued protests. However, state media raised doubts about the veracity of these pronouncements, and the government has not officially given notice that the group has been disbanded.
  • The U.S. Navy has seized an Iranian fishing trawler that was shipping war materials to Yemen.
  • Iran is facing a general strike as protests continue. Twitter evidence suggests that  strike participation is high.  At least 300 Iranians have died in the protests.  The government continues its policy of executing protesters.
  • Western intelligence agencies report an increase in Iranian assassination and kidnapping plots.
  • There are reports that the clerical leadership of Iran is considering ending the presidential system and replacing it with a parliamentary system. Since the conservatives dominate the legislature, this change would expand clerical control.
• The Kingdom of Saudi Arabia’s (KSA) support of OPEC+ production cuts caught the White House off guard, leading the U.S. to issue threats against the kingdom. Though, so far, no appreciable consequences have developed.  In fact, the KSA is preparing for a state visit from General Secretary Xi, in a reminder that the Saudis are hedging their relations.
  • Last week, we noted that the Biden administration granted Crown Prince Salman immunity. This week, a court dismissed a suit against him over the Khashoggi murder due to that decision.
• We are monitoring the recent sabotage of power substations in North Carolina. Although domestic terrorism isn’t unusual in the U.S., most of the time, the terrorists attack government buildings or other areas of high visibility.  Attacking infrastructure would be a new development that could raise fears and trigger hoarding behavior.  So far, no group has been tied to the attack, but reports suggest that whoever did it was knowledgeable about substations.
• As the U.S. eases sanctions on Venezuela, further progress depends on reforms by the Maduro administration. We harbor serious doubts such changes are likely.  Meanwhile, U.S. refiners are lining up to purchase Venezuelan crude oil.
• Turkey and Greece have been enemies for years. Fears that Turkey will disrupt oil shipments through the Bosporus Strait are leading Greece and Bulgaria to discuss an oil pipeline.  Interestingly enough, Russia would be expected to be the primary supplier of oil to this pipeline.  Building it suggests that Greece expects the current supply restrictions to be lifted.
• Slovenia is looking to build a pipeline to handle Algerian gas.

 Alternative Energy/Policy News:

• Last week, French President Macron visited the White House. As expected, he complained about the Inflation Reduction Act’s provisions that only grant subsidies for EV batteries made in the U.S.  As we noted last week, this act is signaling a new American industrial policy that is designed to industrialize the U.S., almost certainly at the expense of our trading partners.  The U.S. has shrewdly “encouraged” the EU to implement its own subsidies, likely relying on the fact that Germany will skew any program to benefit itself at the expense of other EU members, which will tend to weaken support for any program.  France is trying to work with Berlin to establish a united front.  In addition, a subsidy program that would actually rival that of the U.S. will likely upset Washington, which continues to defend Europe and is the primary contributor of arms to the war in Ukraine.
  • Japan is also upset by the Inflation Reduction Act but is making its protests quietly.
  • The U.S. action is designed to create a battery supply that is free from China. Europe seems to be leaning toward Chinese domination.
• The Commerce Department confirmed what is widely known: China has been re-exporting solar panels to third nations in order to evade U.S. sanctions. The U.S. believes that China is using incarcerated labor to build these panels and bars their importation to the U.S.  As a consequence, the U.S. will impose new tariffs on Chinese solar panel imports.  The issue for the U.S. is that without China’s solar panels, costs to U.S. installers will rise significantly and will likely slow adoption.
  • China has overbuilt the solar supply chain, which may pressure prices in the coming months.
• General Motors (GM, $38.85) announced that it is investing in order to expand a Tennessee EV battery plant. Rising prices are threatening EV sales and profitability.
• Environmentalism sometimes works at cross purposes. An endangered toad is blocking a proposed geothermal plant in Nevada.
• Tesla (TSLA, $181.31) has started to deliver its semi rigs.
• BP (BP, $35.00) is increasing its commitment to hydrogen.
• The EPA is considering new regulations on a refinery byproduct called alkylate. By adding it to gasoline, it improves octane and lowers volatility.  It comes from either hydrofluoric acid or sulfuric acid. As they sound, both are potentially harmful chemicals, and the EPA has been pressing the industry to use less difficult chemicals.  Because both are potentially hazardous, refineries usually select one or the other to generate in the refining process and use for formulating gasoline.  The industry fears that if the EPA comes down on one side or the other, it could further reduce U.S. refining capacity.
• Although EVs continue to dominate the non-internal combustion engine vehicle space, Toyota (TM, $141.76) is continuing to develop hydrogen vehicles as an alternative.
• Microsoft (MSFT, $244.73) is developing a process to use limestone to capture carbon dioxide.
• Biotech firms are injecting bacteria into spent oil wells to create hydrogen.

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