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

Crude oil prices have been falling on fears of weaker Chinese demand due to COVID issues.  We note that the futures market structure has moved into contango, where the deferred contracts trade at a premium to the spot.  This is a bearish market structure.

(Source: Barchart.com)

Crude oil inventories fell 12.6 mb compared to a 3.1 mb draw forecast.  The SPR declined 1.4 mb, meaning the net draw was 14.0 mb.

In the details, U.S. crude oil production was steady at 12.1 mbpd.  Exports rose 0.7 mbpd, while imports fell 1.0 mbpd.  Refining activity rose 1.3% to 95.2% 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 later this month.  SPR sales have distorted the usual seasonal pattern in this data.  This week’s large draw takes inventories below the seasonal average, though perhaps the most important takeaway is that the usual seasonal pattern in inventory is breaking down.

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 $108.94.

 Refinery runs are elevated as refiners take advantage of favorable crack spreads.

(Sources:  DOE, CIM)

 Market News:

• This is a major week for global oil markets. On December 5, the EU is expected to implement its sanctions on Russian oil exports, specifically targeting the insurance and financing infrastructure of the oil trade.  Tied to these sanctions is U.S. support for a price cap.  The goal of the EU sanctions is to cut Russian oil from world markets and undermine Russia’s ability to conduct the war in Ukraine.  The goal of the price cap is to allow some level of Russian oil flows but at reduced prices.  So far, Moscow says it won’t sell oil under the price cap system.  In addition, the EU hasn’t been able to decide on a price since more hawkish nations want a low price, while others, who are less hawkish, want something closer to the market price.
  • The consensus is that the price cap won’t work because, generally speaking, a consumer can’t usually dictate what the price of a product will be. As consumers, we may decide not to buy at a given price, but we can’t go to the seller and simply set the price.  After all, if we could do that, it would literally be a “free world”!  However, if a buyer has market power, then they can influence the price that sellers can get for their product.  OPEC+ is worried that the price cap mechanism will be turned on them, and that the cap could evolve into a “buyer’s cartel.”  That is a risk, but we doubt that will occur.  In this specific case, however, Russia is deeply vulnerable to the sanctions and cap.  Why?  Russia is dependent on foreign tankers and especially foreign insurance and financing to move oil.  Russian ports can’t handle the largest crude carriers and the supply of smaller vessels is tight. Also, despite its best efforts, Russia has not been able to duplicate the existing insurance and financing system for oil sales, which reduces the number of tankers available to carry Russian oil.  That doesn’t mean there are not rogue carriers, but they are not big enough to matter much.
  • The U.S. wants the cap because it fears that the EU plan will result in a spike in oil prices. It wants to keep Russian oil flowing but reduce the revenue Russia receives.  If Russia holds to the policy that it won’t honor the price cap, it could easily find itself in a situation where it is forced to close in production, and once shut in, that production may be lost indefinitely.  If that occurs, oil prices could jump.
  • It should be noted that Russia is finding fewer takers of its oil, and the Urals benchmark price has fallen to around $52 per barrel. So, even without a cap, the expectations of one seem to be having an impact.
• Although OPEC+ was making noises about cutting production in the face of weak prices, it looks like the cartel is more likely to maintain current production targets.
• Tensions within the ruling coalition have led Norway to delay any new oil and gas leases until 2025, a blow to European energy supplies.
• As diesel prices soar, the “magic” of markets is starting to work. Consumption is easing, and refining operations are increasing, causing inventories to lift.

(Sources: DOE, CIM)

• However, this good news may still not be enough for New England to escape high prices and shortages.
• Europeans have been complaining that the U.S. is profiting from the war in Ukraine[1] by pointing at the massive price differential between U.S. and EU gas prices. However, it turns out the profiteers are European.  Most LNG sold by the U.S. is based on the Henry Hub price, the benchmark for the CME futures contract.  Currently, that’s set at 115% plus $3.00 of the benchmark price.  However, the actual price in Europe is far higher; for example, a $6.00 per MMBTU price at the Henry Hub translates to a €32.59 MWH price.  European utilities are buying at that price and reselling the gas at nearly €119 MWH.
• As global demand weakens and supply chains begin to improve, freight rates are falling rapidly, but that isn’t the case with oil tanker rates. High demand and the scramble to secure transportation before EU sanctions on Russian oil are in place are sending rates to record levels.
• Japan is warning that global LNG supplies are sold out “for years,” but what they mean is that most LNG is sold on long-term contracts. That’s how the infrastructure for LNG is usually financed — a project aligns buyers on long-term contracts at a set price to pay for the build-out of the project and then sends the gas to the buyers regardless of the spot price.  Japanese buyers report that there are no long-term contracts available before 2026, meaning that the “marginal molecule” is being sold at spot rates.
  • Europe’s LNG import capacity is expected to expand by 33% by the end of 2024.
• Germany and Qatar have agreed to a 15-year supply deal for LNG.
• There is growing evidence that the Middle East has reached oil capacity limits and shale oil production has not reacted to high oil prices as it has in the past. However, one bright spot for additional barrels is coming from deep-water offshore projects such as Brazil and Guyana.
• Western Canada is seeing a jump in natural gas production and could become a significant supplier of LNG to the Asia-Pacific region.
• Despite having what appears to be ample generating capacity, China suffers from regular blackouts. The reasons are complicated but involve the lack of market pricing and  regional distrust, which then leads to excess capacity construction.

 Geopolitical News:

• As the U.S. moves to bolster global oil supplies, it is making deals with previous pariah states in order to increase output. The Biden administration is lifting some sanctions on the Maduro regime in Venezuela in a bid to boost production.  Venezuela’s production is important to the U.S. because most of it is heavy crude oil which is better suited for U.S. refineries.  However, in the short run, production will likely only rise modestly, around 0.3 mbpd.  Venezuela underinvested in the oil industry during the Chavez years, and it will take years of investment just to return to earlier production levels.
• As we noted in our last report, relations with Iran are rapidly deteriorating. Although the Biden administration had hoped to return to the JCPOA and perhaps improve relations, the election of a hardline government in Iran, recent protests, and Iran’s support of Russia in the war in Ukraine have clearly scotched any chance of normalization.
  • The U.S. is amping up secondary sanctions on Asian companies that are purchasing Iranian oil and products.
  • New sanctions are being placed on Iranian officials involved in protest suppression.
  • Another Islamic Revolutionary Guard Corps member has been assassinated in Isfahan, a city in central Iran. No group has taken responsibility.
  • Iran has sentenced four people to death for spying.
  • Turkey has been working all sides in Europe and the Middle East. It has become a center for Russian capital flight and has acquired investment, reserves, and credit lines from the Gulf nations.  And now, it appears to be cooperating with Iran on sending Iranian dissidents to Tehran.
• Recently, OPEC+ roiled oil markets by suggesting it might boost production, only to later deny the reports. Coincident to these rumors are reports that the U.S. will shield Saudi Crown Prince Salman from lawsuits related to the brutal killing of Jamal Khashoggi.  It should be noted that such protections are common for heads of state with the reason being that if the U.S. subjected foreign rulers to lawsuits, other nations could do the same to American presidents.  Nevertheless, the timing did not look good.
• The EU is expanding its monitoring and protection of undersea pipelines and other infrastructure.
• In an unorthodox move, Ghana says it will buy oil products with gold. The country is facing a foreign reserve crunch, with only enough liquid reserves to cover three months of imports.  Ghana holds about $400 million of gold reserves, which have doubled over the past six years.  Although such reports often trigger all sorts of fears that the dollar is losing its reserve currency status, in reality, this decision seems to reflect something quite different.  Ghana lacks dollars and is selling off its gold in order to protect those reserves.
  • Many emerging economies are suffering from shortages caused by debt crises. The inability to buy energy is leading to blackouts.
• The U.K. has decided to buy out China’s investment in a nuclear power plant.
• As we noted recently, refracking is lifting U.S. output.

 Alternative Energy/Policy News:

• Although the world will still be using fossil fuels well into this century, other sources of energy are steadily emerging that will displace oil and gas in various areas. One area we monitor is geothermal energy, which uses the heat from the earth’s interior to generate steam or electricity.  Quaise Energy, a privately held company, is working on deep drilling methods that, if successful, could provide nearly limitless clean energy.
• Another area we monitor is geoengineering. In general, it is a series of techniques designed to directly cool the planet.  This report is a primer on the concepts and potential pitfalls from such programs.
• The major oil-exporting nations are fighting climate change policies to slow the loss of demand for oil and gas.
• The Inflation Reduction Act has restrictions on subsidies for purchasing EVs, specifically, requiring 100% U.S. content on batteries. The EU is furious with this provision.  Europe is facing deindustrialization, as high energy costs are making manufacturing untenable, and the U.S.’s action is accelerating that process.  U.S. automakers are trying to soften the requirements due to the lack of U.S. battery production capacity, and foreign nations are trying to create loopholes,[2] but it should be noted that (a) this bill can’t really be amended easily, and (b) the goal of the policy is the reindustrialization of America, something that both populist and progressives support.
• Lithium processing is heavily dependent on China, but Australia is rapidly expanding its refining capacity.
• This report offers an update on the global EV market.
• The EV market in the U.S. is facing a serious lack of charging stations.
• Nissan (NSANY, $7.07) was once dominant in the EV market as its Leaf model was one of the early EVs, although it later tended to “stand still” while others have passed it. The company now intends to release an SUV EV next year and is also working on a solid-state battery, which would have a longer range and faster recharging times.
• The U.S. is facing a shortage of solar panels. China is a major producer of the panels, and fears that incarcerated labor may be fabricating the product have led to shipments either being held in port or diverted to Europe.

[1] Among other general complaints.

[2] In fact, French President Macron is visiting the U.S. this week and subsidies are expected to be discussed.

  View PDF

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

(The Weekly Energy Update will not be published next week due to Thanksgiving.  The report will return on December 1.)

 Crude oil prices appear to be building in a base in the mid-$80s.

(Source: Barchart.com)

Crude oil inventories fell 5.4 mb compared to a 1.9 mb draw forecast.  The SPR declined 4.1 mb, meaning the net draw was 9.5 mb.

In the details, U.S. crude oil production rose 0.2 mbpd to 12.1 mbpd.  Exports declined 0.41 mbpd, while imports rose 0.3 mbpd.  Refining activity rose 1.5% to 92.1% 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 later this month.  SPR sales have distorted the usual seasonal pattern in this data.  This week’s large draw is takes inventories back to the seasonal average.

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 2002.  Using total stocks since 2015, fair value is $106.63.

Market News:

• China is reportedly easing some of its Zero-COVID restrictions. If the restrictions are lessened, Chinese energy demand will likely rise, which will tighten global energy markets.  China’s oil demand has been soft, but we may see it ramp up in the coming weeks if the restrictions continue to be modified.
• OPEC+ cut its demand forecast modestly, which supports its decision to reduce output targets. The cartel warns that the markets might face significant supply volatility due to uncertainty surrounding Russian oil sanctions.
• Pakistan has announced natural gas rationing measures, in part because Europe is getting LNG that would normally go to other nations. However, credit concerns may have also played a role in its lack of supply.
• One of the problems the world will face is that the isolation of Russia will likely lead to a permanent decline in oil and gas production. It will be hard to offset these losses.  Comments from Treasury Secretary Yellen, which suggest that sanctions would likely remain in place on Russia even after the war in Ukraine, increase the likelihood that we will see a permanent loss of Russian capacity.
• As we noted last week, tight diesel fuel stocks could lead to high refinery utilization and higher crude oil demand.  The positive side is that it will also likely lead to relatively lower gasoline prices.  From each barrel of crude oil, about 43% is refined into gasoline and 30% into distillates.  Thus, the drive to meet diesel demand will likely mean additional gasoline (and other products too).  This situation is causing record diesel fuel/gasoline
  • The IEA is warning that tight diesel stocks could exacerbate the European energy crisis.
  • New England’s heating oil prices are rising because of tight supplies. Due to shipping regulations (Jones Act) this region tends to import distillates because of their lower cost.  This year, however, Europe is buying the distillate that the region usually gets, leading to very tight supplies.
• The implementations of price caps and insurance restrictions on Russian oil are scheduled for December 5, but to date, no details on how these plans will work have been forthcoming. There are growing concerns that without clarity, shipments might be curtailed.  For example, a tanker insured at a certain price might unknowingly violate the price cap if one isn’t in place.  This outcome could lead to “ghost ships” floating on the high seas with uncertain insurance coverage.
  • The U.S. is trying to sell China on the price cap. Although this seems a bit farfetched, we would not be shocked to see Beijing use participation as a way to force Russia to discount prices on its exports to China.  In other words, China probably won’t officially participate, but it could take advantage of the plan.  We note that China’s purchases of Russian crude oil appear to be declining, which may be due to the lack of storage or weak demand, or the drop could be tied to worries about sanctions. There are reports that Chinese refiners are asking Beijing to protect payment flows and insurance once the caps are in place.  India’s refiners are showing caution in buying Russia oil as well.  The U.S. isn’t opposed to China or India buying Russian oil, it just wants the purchases to follow the price cap.
  • It should be noted that, so far, Russia oil exports have continued despite sanctions.
  • In related Russian news, Germany has nationalized Gazprom’s (GAZP.ME, RUB, 198.00) operation in the country.
• Meanwhile, the EU is still working on a price cap for natural gas. The worry there is that if the cap is set too low, LNG might find its way to other markets. The IEA is warning that the EU needs to begin planning to secure supply now for next year.  So far, European temperatures have been unusually mild, easing the current strain.  Winter forecasts for Europe are calling for a mild winter, which may prevent a major price spike.  LNG prices have started to decline due to oversupply.
  • Although the mild winter has helped, the debt burden from high energy prices is still very large.
• As we have noted in the past, the supply response to high oil and gas prices has been modest, but it hasn’t been non-existent. For example, Mozambique is sending LNG to Europe for the first time.  There are reports of a new oil discovery in Angola, and production is starting in the massive oil fields in offshore Guyana.  All the caveats about investment and the “end of oil” still apply, but there is also evidence that there is still some investment occurring.  Even in the U.S., the Eagle Ford region is showing a rise in activity.
• Water levels on the Mississippi have disrupted barge traffic, affecting the shipping of bulk goods, including grains, coal, and iron.

• About 30% of condensates and other natural gas liquids are shipped by barge, meaning this market is being disrupted as well.  These liquids are used to make petrochemicals and are often part of the refining process.  They are often used as a diluent for heavy crude oils.
• The administration has extended methane regulations to gas-gathering pipelines. Extending regulations tends to raise costs.
• Maintenance issues are taking French nuclear power plants offline and boosting natural gas and diesel demand.

 Geopolitical News:

• Iran is becoming increasingly aggressive: it is attacking Iraq, its actions against protesters are exceedingly harsh, it has threatened to attack the Kingdom of Saudi Arabia (KSA), it has been caught sending arms to Yemen, and it has teamed up with Russia to support Moscow’s war effort against Ukraine. It has also attacked Israeli oil shipments in the Persian Gulf region with a drone attack this week.  Yet despite all of this, the U.S. hasn’t taken steps against the regime in Iran. Although there are extensive sanctions on Iran already, more could be done.
  • Iran claims it has built a hypersonic missile. If true, such missiles have no known defenses, which would be a worry for nations in the region.  We note, however, that there is no record that Iran has tested such a vehicle.  Hypersonic missiles are hard to produce and until there is a verified test, we can only assume they have, at best, an untested prototype.
  • Ukrainian analysts have been investigating the Iranian drones used in Russian attacks on Ukraine. They are discovering that, despite sanctions, the drones are mostly constructed with Western parts.
  • MI5 is accusing Iran of attempts to kidnap or kill at least 10 people in the U.K.
  • Iran and Russia are improving ties. As we noted last week, Iran has been selling drones to Russia.  Iran has been under sanctions longer than Russia and is reportedly showing Moscow how to evade trade restrictions.  One of the key metrics to sanctions is the price spread between sanctioned and unsanctioned products.  Although sanctions are not perfect, they usually raise the cost of selling the product, leading to price discounts.  Reports from Asia suggest that the spread on Russian LNG is near market prices, suggesting buyers are willing to risk Western sanctions.
    • Russia and Iran are in talks regarding arms sales; Russia may sell warplanes to Iran.
    • India, which has always had close ties to Russia (it was a buyer of Soviet defense products), has increased economic ties by purchasing Russian oil.
  • Our position has been that the JCPOA is dead. The Biden administration appears to have moved on.  The IAEA reports that Iran has been accumulating highly enriched uranium in contradiction to the program.
    • Iran has issued a death sentence to a protester and is planning on prosecuting 15k protesters currently under arrest, many of whom are minors.
    • Iran continues to attack Kurdish areas of Iraq, arguing that the region is supporting terrorism in Iran. Recent attacks have killed two Kurds.
  • The bottom line is that Iran is behaving in an increasingly reckless manner. The lack of caution may reflect internal tensions as evidenced by the ongoing protests or may suggest that the mullahs have decided that if they side with China and Russia, they will have more ability to project power.  The U.S. would normally clamp down on Tehran under these circumstances but fears of rising oil prices appear to be hampering America’s response.  The administration may be forced, at some point, to simply allow oil prices to rise in order to control Iran’s behavior.
  • Although U.S./Saudi relations have clearly cooled, the recent threat from Iran does show that, despite tensions, Riyadh needs U.S protection. Washington is using this fact to extract concessions.  For example, the Saudis voted for a U.N. resolution not to recognize the recent Russian annexation of Ukraine’s territory.  Riyadh also participated in talks to engineer a prisoner swap between Ukraine and Russia.  So far, this hasn’t led to more oil production, but we will continue to watch closely for evidence of a change.
    • Although the KSA has officially cut diplomatic relations with Iran, the two nations have been holding backchannel talks in Iraq. One issue is that both nations want a stable Iraq because instability there could adversely affect both countries.
    • Last week, we noted that President Xi was making a state visit to the KSA. Trade ties and regional security are the topics for discussion.
  • One of the fallouts of the war in Ukraine is the loss of cheap oil and natural gas to Germany. This feedstock was a key component to Germany’s vaunted industrial base, but as costs rise, it will likely force German firms to relocate to areas with cheaper energy sources.

 Alternative Energy/Policy News:

• For the most part, we view COP-27 as environmental theater since without an enforcement mechanism, environmental promises are just that. However, we do note that there has been some movement to reduce coal usage in power production.
  • The U.S., Japan, and the EU have agreed to offer $20 billion to Indonesia to move away from coal.
  • Thwarting this effort is China, who still holds that due to reliability issues, it must burn more coal to ensure energy security.
• California voters did not support a measure to fund EV charging stations by raising taxes on high-income citizens. Without this funding, it isn’t clear how the state will prepare to shift from gasoline to electric vehicles.
• Meanwhile, China’s share of the global EV market continues to grow.
  • BMW (BMWYY, $29.46) is building a $1.4 billion operation to expand battery production in China.
• As biofuel research expands, there is a growing concern that without regulatory guidance, the potential for the fuel source will be hampered by inconsistent standards.
• Separating hydrogen from water creates a clean (“green”) product. Unfortunately, it is also energy intensive and expensive.  Four U.S. nuclear power reactors are part of a study to see if nuclear power can be used to generate green hydrogen.  Meanwhile, a raft of startups are trying to develop other ways to bring down the cost of green hydrogen.
• The U.S. has blocked 1,000 shipments of solar energy components from China on grounds that the products were made by slave labor. There have been rising tensions between the solar installation industry and the non-Chinese solar component industry.  The former wants the cheapest product it can find, while the latter wants to compete with China, the world’s low-cost producer.  As U.S./Chinese relations deteriorate, the non-Chinese production industry is seeing an opportunity.
• Leaded fuel was used to counter engine knock, though, unfortunately, lead is highly toxic so it was phased out of gasoline in the U.S. over three decades ago. However, small aircraft were excluded from the move to unleaded fuels but are finally making the switch.
• One of the problems of solar and wind energy is that it’s unreliable, so as it expands, utilities must still keep conventional capacity available for periods when the power generated from wind or solar is lacking. The expansion of wind and solar in the western U.S. is leading to reliability issues.
• We are still in the early stages of battery technology. The current industry standard for EVs, the lithium-ion battery, has some flaws as it’s prone to fires, it’s expensive to produce, and it doesn’t have a long life.  But, in its favor, it does recharge quickly and is lightweight.  The next new thing may be the sodium-ion battery.  It’s a bit heavier than the lithium-ion battery, and not as energy dense. New technology, though, is showing rapid improvement.  If it flies, it would dramatically reduce the cost of EVs and have much faster recharging capabilities.  Better and cheaper batteries are likely the key to widespread EV adoption.
  • Asian battery producers have been reluctant to invest in Australian mining that would provide raw materials for batteries, putting the makers at risk of supply shortages.
  • EV makers are looking to vertically integrate their operations with miners of key battery materials and with battery manufactures to create secure supply chains.
  • China uses lithium-iron-phosphate batteries which are cheaper but have less range than batteries that use nickel.

  View PDF

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

Crude oil prices appear to be building in a base in the mid-$80s.

(Source: Barchart.com)

Crude oil inventories rose 3.9 mb compared to a 0.3 mb build forecast.  The SPR declined 3.6 mb, meaning the net build was 0.3 mb.

In the details, U.S. crude oil production rose 0.2 mbpd to 12.1 mbpd.  Exports declined 0.41 mbpd, while imports rose 0.3 mbpd.  Refining activity rose 1.5% to 92.1% 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 later this month.  SPR sales have distorted the usual seasonal pattern in this data.

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 2002.  Using total stocks since 2015, fair value is $105.36.

 Market News:

• The Biden administration is providing $4.5 billion of funds to subsidize low income household’s heating needs.
• Oil companies continue to temper investments despite high oil prices and strong earnings. One obvious reason is that all the signs suggest that crude oil demand is near peak, if not past it already.  Thus, oil and gas companies must manage in a weaker growth environment, which makes new investment rational only if the payoff is rapid and short term.  These worries have stunted production.
  • The EU and U.S. are making counterclaims about whose energy companies are profiteering.
  • On a related note, the DOE has lowered its estimate for 2023 U.S. oil production to 12.31 mbpd.
  • There is increased interest in “refracking,” which is to deploy fracking techniques to already fracked wells to squeeze further production out of existing wells. This could be a low-cost way to lift U.S. output.
• After Fukushima, Japan closed most of its nuclear power reactors and instead began using LNG to generate electricity. With LNG supplies tight, however, the Japanese government is trying to convince the public that returning to nuclear power is wise.  If it can’t persuade them, then natural gas supplies will be even tighter this winter.
  • Developed-economy demand for LNG is causing shortages in the emerging economies.
• We have noted that the SPR sales have been skewed toward sour crude, which is the preferred feedstock of U.S. refiners. These flows have apparently boosted the profits of refiners this year.
• Although current European natural gas prices have dropped due to mild weather and near-term oversupply (over 30 LNG tankers are currently sitting offshore of Europe), the IEA warns that the real shortage might become more evident in the winter of 2023-24.
• Last week, we commented on diesel shortages. We note that China is about to open two new refineries, adding about 0.5 mbpd of capacity.  In light of weak economic growth, China is expected to lift diesel exports to take advantage of high prices.  In preparation for opening the new refineries, China’s oil imports rose last month.
• Canada’s new rules on emissions could reduce future oil and gas production.
• Vietnam has run out of gasoline.

 Geopolitical News:

• There are reports that President Xi is planning a state visit to the Kingdom of Saudi Arabia (KSA), likely in December. Given how fraught U.S./Saudi relations have become, this trip is symbolically important.  The KSA wants to hold significant market share of China’s imports because it perceives China as the world’s dominant oil importer.  The U.S. used to have this role, but the combination of shale oil and imports from Canada have reduced the KSA’s share of the U.S. import market.  However, there is one problem for Riyadh in increasing its reliance on China: Beijing doesn’t have the power projection that the U.S. has, so if the KSA needs to be defended, it likely cannot rely on the PLA to do so.
• Protests and suppression continue in Iran. We do note that Ayatollah Khamenei offered a softer tone to protestors, trying to suggest that there are some who are tools of the West but others who have legitimate complaints.
  • Iran seized a small tanker in the Persian Gulf which it accused of smuggling.
  • Last week, we reported on a threat that Iran was about to attack Saudi Arabia. Apparently, that threat has been eased somewhat.
  • Crypto exchanges have helped Iran evade sanctions.
  • Iran has become an important arms supplier to Russia.
• The U.K. has announced an insurance ban on Russia oil shipments unless the oil is priced at or below the G-7 cap. The plan is expected to be in place by December 5.  Although China and India are not expected to comply, we doubt major shipping chokepoints will allow passage for tankers without Western insurance.  This would mean that the seaborne shipping costs for India and China will likely rise and either discourage imports or force Russia to cut its price.
• One issue that has emerged from the war in Ukraine is that the U.S. was trying to walk a fine line between punishing Russia and trying not to create an energy crisis. The whole price cap structure is a response to worries about losing Russian oil on world markets.  In fact, the price cap was a way to moderate the impact of the EU insurance ban noted in the previous bullet point.  One important “tell” is that if the U.S. really wanted to hurt Russia, it would have enforced secondary sanctions on buyers of Russian oil.  That didn’t happen for a reason.  Adding to evidence of this less-than-full commitment is that the White House has quietly supported major U.S. banks maintaining ties to Russian companies.  We note that Congress has tended to push for more aggressive policies against Russia, and if we see a change in control at the midterms, it may be more difficult for the administration to keep some Russian oil on world markets.
  • The lack of secondary sanctions has allowed Russia to become the largest oil supplier to India.
• Although the G-7 price setting plan probably won’t work, it could become the structure of a buyers’ cartel. Sellers’ cartels, attempting to create a monopoly, are nothing new; but a buyers’ monopsony would be a new twist to the oil market.
• A U.S. aid worker was assassinated in Iraq.

 Alternative Energy/Policy News:

• Cop-27 is underway this week. We won’t have much to say because we doubt anything binding will emerge.  We do note that the U.S. is proposing a system of carbon credits that can be purchased by firms.  Although the idea makes some sense, it should be noted that no accreditation process has been created, which means it could be merely a form of greenwashing.
• Canada has ordered three Chinese firms to exit the lithium mining sector, citing national security concerns.
• U.S. spending for wind and solar power has been weak this year.
• Geoengineering is the process of directly acting to offset various climate issues. For example, one way to cool the planet is to inject aerosols into the upper atmosphere to reflect sunlight back into space.  Geoengineering is controversial because the potential side effects are hard to predict, and those side effects might be “levied” against those who don’t benefit from the action.  Despite the controversy, DARPA is quietly funding various projects probably because the government wants to know how they would work if we were to reach a situation where such measures became necessary.
• There are a number of new nuclear technologies being developed. Here is a primer on molten salt reactors.
• Researchers claim a breakthrough related to creating renewable jet fuel.
• Similarly, researchers in Singapore note that they have made the process of pulling hydrogen out of water more efficient by using a procedure involving light. Meanwhile, researchers at Rice University have devised a way to pull hydrogen from hydrogen sulfide (rotten egg gas), which is an unwanted byproduct of desulfurization in refining and natural gas processing.
• One of the problems with expanding solar and wind power is that it takes up lots of space and the least costly place to acquire that space is rural areas. However, residents are cooling to these facilities, worried about the impact on farming, ranching, and property values.
• U.S. automakers are lobbying for the Treasury to widen the nations for which EV components can be imported and thus be eligible for subsidies. We suspect this is to leave room for China to participate.
• The EU is growing increasingly upset with the Inflation Reduction Act’s EV subsidy rules that restrict payments to consumers only if they buy vehicles mostly constructed in the U.S. European automakers wanted carve outs so they could participate, but the U.S. countered with “make your own subsidies.”  We could see an EU trade retaliation, but we doubt this will change U.S. policy.
• Last week, we noted that the EU voted to end the sale of internal combustion engines in Europe by 2035. As regulators tally up the potential job losses, there are new calls to delay that transition.

  View PDF

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

Crude oil prices appear to be building in a base in the mid-$80s.

(Source: Barchart.com)

Crude oil inventories fell 3.1 mb compared to a 1.5 mb build forecast.  The SPR declined 1.9 mb, meaning the net draw was 5.0 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 11.9 mbpd.  Exports declined 1.2 mbpd, while imports were steady.  Refining activity rose 1.7% to 90.6% 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 later this month.  SPR sales have distorted the usual seasonal pattern in this data.

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 2002.  Using total stocks since 2015, fair value is $107.47.

The Diesel Scare:

A prominent news personality recently suggested that “the country will run out of diesel fuel by Thanksgiving,” leading to a steady stream of questions to our inbox.  So, here is our take…

Diesel is part of a family of fuels called “distillates.”  Other members of this family include heating oil (diesel with a higher sulfur content) and sometimes jet fuel.  In general, diesel for road use has a lower sulfur content (it’s cleaner, in other words) so other distillates can’t easily be substituted for the diesel.  In the weekly data, diesel demand isn’t broken out from overall distillate demand.  To create a standardized measure of inventory (a mere level won’t tell you how much you have relative to demand), we divide stockpiles into daily demand.  By dividing inventory into consumption, we determine how many days of supply are available given current demand.  We are hearing that there are 21 days of inventory available, but since we can’t confirm diesel demand separate from distillate demand, we can’t confirm that number, although we can say that distillate stocks are tight, around 27 days.

The above chart, which is weekly data going back to 1987, measures current distillate inventories compared to consumption.  As the chart shows, levels are around 25 days, which is “tight.”  On average, the “days to cover” is 35 days with a standard deviation of six days.  So, the current level of 27 days is in the “bucket” of two standard deviations below average.  At the same time, it is important to remember that this number tells us how many days we can go if our only source of distillate is inventory.  That would assume the U.S. refining industry would close, and we couldn’t import any fuel.  That isn’t the case.  It is strictly true that we could run out of distillate by Thanksgiving, but only if we closed the ports and stopped refining completely, which isn’t likely.  Simply put, conditions are tight but not dire.

Complicating matters is that Europeans are importing diesel as a backup fuel for electricity generation and heating, both at the utility level as well as the firm and household level.

This is why the administration has floated export controls to ensure domestic supplies.  The problem is that it will be hard to keep the EU supporting the war in Ukraine if Europeans are freezing because the U.S. won’t send diesel.  At the same time, it will be hard to maintain support for the war in the U.S. if tight diesel supplies lift overall inflation.  In the past, when diesel fuel stocks tightened, our exports were much smaller.  So, the export situation has complicated matters.

We do have some refining capacity to tap.  Currently, refinery capacity is running around 89%, so we could see increased production.  Unfortunately, U.S. refinery capacity has been declining for some time as about 3.0 mbpd of refining capacity has closed since 1993.

There is yet another complication.  The Northeast (PADD1) is facing a severe shortage of diesel.  This region uses both natural gas and heating oil for home heating (the rest of the country mostly uses natural gas or propane) and so tight supplies can be a real problem.  Due to the Jones Act, this region usually imports distillate from abroad because it is cheaper to use foreign shipping than higher cost U.S. shippers, who are protected by the act.  But currently, Europe is absorbing the global supplies that would normally end up on the Eastern Seaboard.  It is unclear how this situation will be resolved, but the overall tight distillate market is being exacerbated by the shipping situation to the Northeast.

We don’t expect that the trucking industry will “shut down” due to the lack of diesel; instead, diesel prices will likely rise, which will cause adjustments (more rail traffic, for example, as trains are much more efficient) and delays in shipping.  However, the situation isn’t good.  About the only silver lining is that for every barrel of crude oil refined, roughly a third is distillates and 55% to 60% is gasoline.  As refiners lift production to meet diesel demand, we will get more gasoline in the market.

We also note that a weaker economy will reduce energy demand.  Already, U.S. trucking firms are reporting that shipments are down and we note that European economies are slumping as well.

 Natural Gas Update:

Natural gas prices have been weak lately as the storage injection season is near its end, the tropical storm season spared the oil sensitive regions of the Gulf of Mexico, and so far, temperatures have been mild.  For the most part, the trends in supply and demand are balanced.

On a rolling 12-month basis, there is a modest level of excess demand.  Meanwhile, inventories appear to be in balance.

With supply and demand nearly in balance and inventories in line with seasonal norms, the direction of prices going forward will mostly be a function of temperature.  The official NOAA forecast suggests that most of the nation’s major population centers will be normal to warmer-than-normal this winter.

Of course, even in an otherwise mild winter, a cold snap can have important effects on demand and natural gas prices.  Overall, though, the forecast does offer hope that home heating costs will be manageable.

Market News:

• In the latest IEA annual report, one of the more important assertions is that fossil fuels are approaching peak demand, in part driven by the war in Ukraine. We have doubts that this forecast is correct, but the fact that it exists will tend to affect investment decisions.  In other words, if investors believe peak demand is on the horizon, there will be less incentive for investment, which will tend to crimp supply and lift prices.
  • Interestingly enough, OPEC’s world oil outlook to 2045 suggests that demand will continue to rise.
  • The DOE reports that drilled but uncompleted wells (DUCs) in the shale patch have fallen to near decade lows. DUCs are essentially project inventories, and the drop means that future production growth will be difficult to come by.
• Major oil companies are reporting record-breaking profits. President Biden is floating a windfall profits tax, accusing the oil industry of war profiteering.  In general, such taxes are counterproductive.  If the goal is to increase supply, taxing it works against that outcome.  If production remains low, the case for higher taxes on energy companies will become more compelling.  However, unless the tax is crafted to offer exemptions for increased production, this tax won’t increase production.  And, given the near certainty that the government will be divided after next week’s elections, the White House would have to put the tax through in the “lame duck” session.
• It looks like the price cap idea on Russian crude oil is slowly unraveling. It has been arduous to get enough nations on board with the plan, leading the U.S. to lift the proposed price cap.  At the same time, it may be difficult for Russia to overcome the looming insurance ban, since the country may not have enough ships to avoid reducing exports.
  • Japan warns it cannot “survive” without Russian oil.
  • It is worth noting that even with Russia’s continued sales of oil and gas, flows have been affected. Gazprom (GAZP, RUB, 198.00) admitted its natural gas sales outside the former Soviet Union fell 43% year-to-date.
• Although the U.S. is the world’s largest oil producer, it is also a major consumer as well. Complicating matters is the mismatch between what U.S. drillers produce and what refiners use.  The U.S. tends to produce more sweet/light oil, whereas U.S. refiners prefer sour/heavy crudes.  Thus, the U.S. tends to export the former and import the latter to make the adjustment.  There are two nearby producers that generate sour/heavy oils: Canada and Venezuela.  The former is a major exporter to the U.S.  However, recent prices suggest that Canada could export even more to the U.S. if pipeline constraints were relieved.
• In recent reports, we have discussed how the SPR is evolving from a strategic reserve to a buffer stock. It seems that others are also thinking in a similar fashion.  Buffer stocks in commodities have operated to the benefit of both consumers and producers, but they have a long history of failure.  Scenes of blocks of processed cheese being tossed to the crowds from the back of trucks in the 1980s were the result of a buffer stock of dairy products that were used to keep milk prices above their market-clearing level.  In our current situation, the failure point for the SPR is that there will never be a price low enough to trigger buying for the reserve.  That’s because consumers really like free goods, and once you start buying for the SPR, you are setting a floor price.

(Source: Bloomberg)

• The current spread of Western Canadian Select and WTI is nearly $30 per barrel, nearly double the average of $16.  Unfortunately, expanding pipelines is difficult, since local opposition tends to be high, and environmentalists have targeted pipeline construction as a way to reduce oil and gas production.  So, instead, the administration is considering easing sanctions on Venezuela.  Caracas has been under sanctions for its repressive tactics and support of drug trafficking.
• After prompting OPEC+ to cut production targets recently, the Saudi oil minister suggested that the Kingdom of Saudi Arabia (KSA) might be willing to lift output if the energy crisis worsens. He also suggested that the recent cuts had more to do with maintaining a supply buffer than lifting prices.
• Recently we have reported that LNG tankers are sitting off the Iberian Peninsula waiting to disgorge their cargos. Initially, it seemed they lacked a space to dock and regassify.  However, recent indications suggest it may be more about waiting for higher prices.  After all, as we noted last week, prices for prompt natural gas briefly turned negative due to weak prompt demand.  Weaker EU demand relative to supply is creating a game of “chicken” for buyers and sellers.  Current sellers who are hedged have to deliver the gas, and if they can’t, they must either take a lower price or offset the position but pay to store the gas on a tanker, which isn’t cheap.
• COVID infections are disrupting China’s coal industry.

 Geopolitical News:

• U.S. forces in the Middle East and the KSA are said to be on “high alert” based on intelligence suggesting that Iran is considering an imminent attack. Riyadh is suggesting Iran is trying to distract its citizens from the ongoing protests.
• As protests continue in Iran, with university students staging strikes, the U.S. has announced additional sanctions and will put the Iran protests to the UN Security Council. Although Russia will protect Iran from UN action, the move is symbolic and will increase global awareness of the protests.
  • Iran announced public trials for over 1,000 protestors, signaling it will continue to escalate its crackdown against the protests.
  • Iran has been aggressively increasing its nuclear processing capabilities, which is rendering the JCPOA meaningless.
• Iraq has elected a new prime minister. Mohammed al-Sudani is considered to be an ally of Iran.  It remains to be seen if he can hold his government together, given that the al-Sadr faction, which controls the most seats in the legislature, opposes Iran.
• One way the U.S. might retaliate against the KSA’s support of OPEC+ production cuts is by slowing the pace of arms sales to the Saudis. On a related note, the UAE has indicated that it opposed the KSA’s push to cut production targets, suggesting some divisions within the cartel.
• The new president of Colombia, Gustavo Petro, recently met with Venezuelan President Maduro in a bid to improve relations. The previous government ended formal relations in 2019.

 Alternative Energy/Policy News:

• Although nuclear energy remains controversial, it does not give off any greenhouse gases during the production of electricity. Therefore, Western governments are slowly considering the expansion of nuclear power.  However, Russia and Kazakhstan are significant global suppliers of uranium, meaning that without new sources, the West is merely trading one vulnerability (oil and gas) for another.  The U.S. is actively considering policies to develop domestic uranium sources to support the nuclear power industry.
• The EU is not pleased with the recently passed Inflation Reduction Act as the provision tailors subsidies for purchasing EVs to those made in the U.S. This rule either prevents the buyer of a European EV import to receive the subsidy, or it forces a European automaker to make the car in the U.S.  Needless to say, the EU isn’t thrilled with this new law and wants carveouts or loopholes added or it will consider retaliation.  However, if the goal of the administration was to boost jobs in the U.S., allowing carveouts defeats the purpose.  USTR Tai is in Europe trying to make Washington’s case; so far, though, she isn’t budging on ending the preference of U.S. production.
• California is planning on ending the sale of natural gas-fired furnaces and water heaters by 2035. Natural gas utilities in the state are looking to repurpose their pipeline networks, perhaps for hydrogen.
• Copper is a critical metal in the energy transition, but current production is running below demand and there doesn’t appear to be enough investment to meet future demand. Prices have soared on the imbalances.
  • Nickel is also important. Indonesia, the world’s largest producer, is floating the idea of a cartel body for the metal.
  • California is trying to boost lithium production; however, its current tax policy is based on the amount extracted rather than the price, which may discourage investment.
• The government is supporting efforts to create electro-fuels, which are biofuels without the crops. By combining electricity, carbon dioxide, and algae, biofuels can be created.  Although such fuels make environmental sense, they will face opposition from the farm lobby.
• Although Australia is a large producer of rare earths, the country’s resource minister indicated that his nation cannot, in the near term, replace China.
• The EU plans to end the sales of internal combustion engines by 2035.
• Renewable energy capacity is growing rapidly.
• In contrast, Germany is tearing down a wind farm to facilitate a lignite coal mine.

  View PDF