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 2.6 mb compared to a 1.5 mb build forecast.  The SPR declined 3.4 mb, meaning the net draw was 0.8 mb.

In the details, U.S. crude oil production was steady at 12.0 mbpd.  Exports rose 1.0 mbpd, while imports rose 0.3 mbpd.  Refining activity fell 1.8% to 88.9% of capacity.  We are approaching the end of refinery maintenance season, which means oil demand should begin to rise soon.

(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.  The build seen from October into November is usually strong due to the end of refinery maintenance.  With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

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 2003.  Using total stocks since 2015, fair value is $106.28.

The Emergence of Zero: Since the onset of the war in Ukraine, Europe has been dealing with a natural gas crisis.  Between sanctions and Russia’s actions to reduce exports to the EU, natural gas prices have been on a tear.[1]

(Source: Bloomberg)

As the previous chart shows, natural gas prices from prompt delivery reached €300 per megawatt hour.[2]  However, a truism of markets is that prices engender a reaction.  Consumption has fallen and high prices have attracted LNG flows, leading to nearly full inventory levels.  With commodities, in general, but natural gas, in particular, once storage is maximized, there is really no place for the gas to go.  With liquid fuels, there is often some storage at the tertiary level.  With gasoline, for example, some can be stored in cars and at service stations, and this isn’t counted in national data.  With a gas, however, the ability to store is limited and because temperatures have been unusually mild in northern Europe, consumption for home heating has declined.  This week, prices actually went negative.

(Source: Bloomberg)

This situation is unlikely to last.  The current problem is that there is nowhere for the current flows of gas to go, but once temperatures fall, prompt supply plus inventory will be necessary. What must be remembered about natural gas inventory is that most facilities cannot store gas indefinitely as gas goes into the facility and out of the facility at roughly a steady rate.  In the U.S., storage injections usually end in November and then the gas must be moved into the market whether it is needed or not.  This is why the lowest natural gas futures prices have occurred in January.  If temperatures are warm, prompt supplies are combined with inventory disgorgement, leading to a collapse in prices.[3]

 The Passive Investment Problem: Academic finance has floated a theory called “common ownership.”  It goes like this: an active investor will select stocks within an industry, but a passive investor buys an index that represents the entire industry.  The active investor, as an owner, has different goals than the passive investor.  The active investor may support an individual company’s investment, or pricing policy, which would be designed to improve the profitability or the market power of that individual company.  However, if all the companies in that industry engage in similar behavior, the collective outcome may not be positive for the investors in the individual companies.  On the other hand, the passive investor, because they own the entire industry, would tend not to support actions by companies, for example, to lower prices to gain market share or expand investment to do the same.  Instead, the passive investor should support industry concentration and market power that enhance returns to shareholders.  Simply put, the passive investor has no interest in companies actually competing.  As passive investment begins to dominate, the cost to society may be less production and higher prices, and some have even argued that passive investment is “worse than Marxism.”

Obviously, this theory is highly controversial.  Anti-trust authorities are examining it, the passive industry suggests it doesn’t exist, and the pushback against ESG raises concerns about investment concentration.  What caught our attention is the notion that the common ownership problem may be contributing to the disconnect between commodity prices, in this case oil and gas, and the lack of a supply response.  In other words, we haven’t seen oil investment and production rise despite elevated oil and gas prices.  Although ESG has been blamed for this disconnect, the Dallas FRB survey suggests investor pressure was more important.

Recent data shows that oil production growth is overwhelmingly coming from private companies, since publicly traded companies are refraining from boosting output.

Currently, it is estimated that passive funds hold about 30% of the publicly traded universe of stocks.  That’s up from 10% in 2010.  In a sense, passive investment becomes a form of tacit collusion.  In a classic prisoner’s dilemma, both parties defect, leading them to longer prison sentences than if they both stayed quiet.  This outcome assumes a lack of coordination.  In economic terms, the decision matrix could be invest/don’t invest.  If both parties don’t invest, they receive higher profits, but if one company invests and the other doesn’t, the investing company is better off.  However, if both invest, production expands and prices fall, leading to a worse outcome for the businesses but a better outcome for society (greater supply, lower prices).  Last week, we reported on Harold Hamm’s quest to take Continental Resources (CLR, $73.67) private in order to free his company to boost production and release the firm from the clutches of the indexers.

President Biden is pressing the industry to boost output.  Maybe the solution is to address passive investing instead.

Policy: Last week, we discussed the situation with SPR policy and what appears to be the evolution toward using the reserve as a buffer stock.  Although the White House continues to argue that the releases are not politically motivated, it is hard not to observe that the releases are occurring before the midterm elections.

This chart overlays how many gallons of gasoline can be purchased at the current average U.S. gasoline price and the hourly wage for non-supervisory workers.  The higher the number, the better off the gasoline purchaser’s position.  Since 1996, when the gallon per hour measure is less than eight, the presidential approval rating averages 42.8%, while measures higher than eight average a 54.7% approval rating.  Lower gasoline prices don’t always help approval ratings (they didn’t do much for President Trump), but it is pretty obvious that they are having an impact now.

The SPR has seen the steepest decline in its history.  We note media sources are suggesting that there is still plenty within the reserve for emergencies.  That is only partially true as these comments ignore the fact that we have seen a larger decline in sour crude, which is preferred by U.S. refineries.  Although sweet crude is usable, it is more likely to be exported.  Thus, if the goal is the optimization of protecting Americans from a supply outage, it would make more sense to export sweet crude to lower global prices.  The fact that sour crude was drawn suggests that the primary goal is to lower gasoline prices.

As we have noted, the White House is promising to keep draining the reserve, but it is also promising to start buying crude oil in the $72 to $67 range.  We harbor serious doubts this buying will ever occur, as does the industry, but that promise is in the public record and could affect prices.

Finally, one of the overlooked elements of the SPR’s release was that cars don’t use crude oil; rather, they use gasoline (and a few use diesel).  Refining capacity has been constrained for some time, and industry officials told the energy secretary that recently shuttered refineries are unlikely to reopen.

 Market News:

• The IEA is warning that the current situation is the first actual global energy crisis.
• Germany is reluctant to support a price cap for natural gas, fearing that if the price is set too low, it could lead to shortages. EU industries are heavy users of natural gas, and if prices remain elevated, it is unclear if European industrial production can be maintained.  For example, BASF (BASF, $11.38) announced it will “permanently downsize” its operations in Europe due to high energy prices.  Petrochemicals are dependent on natural gas for feedstock, meaning that the loss of Russian gas makes operations in Europe tenuous.
• Although EU gas inventories are near capacity, the interconnectedness of the system has never been tested with this degree of stress before. If all works perfectly, flows must cross national borders.  If nations decide to hoard gas to protect their own markets, shortages may emerge even with ample inventories.
  • Germany and Spain are at odds with France over a pipeline proposal that would expand capacity from the Iberian Peninsula to Germany. France opposes the pipeline for economic and environmental reasons.
  • France’s nuclear power industry has suffered a spate of maintenance issues. Currently, 26 of its 56 reactors are offline due to problems ranging from basic maintenance to corrosion issues.  If these issues are not resolved soon, it could mean higher demand for natural gas, fuel oil, and coal.
  • In eastern Europe, households are scrambling to heat their homes by using lignite, wood, or even trash.
• Although the U.S. is a net exporter of natural gas, the transportation system for gas (in the domestic U.S., most gas moves by pipeline) creates situations where some parts of the country require imports to meet demand. New England requires LNG imports to balance the market and is facing tight supplies as it competes with Europe for available supplies.
• Turkey has been straddling the conflict in Ukraine since it began. For example, it provided drones to Ukraine early in the conflict.  It has also engaged in talks with Russia about becoming a natural gas hub.  Turkey is already a transit state for oil from Iraq and Azerbaijan.  Iran is planning on expanding natural gas exports to Turkey, and we would expect these flows to be eventually destined for Europe.
• A rise in COVID-19 cases in China’s coal-producing areas could lead to constrained supplies.
• Slow Chinese growth is freeing up product supplies for export. China’s September diesel exports rose to their highest level since July 2021.
• The U.S. will hold an auction for offshore oil development in March. This auction was part of the Inflation Reduction Act.
• China has made a large shale gas find in the Sichuan Basin.
• Shell (SHEL, $53.32) has announced its participation in a Qatar natural gas development.

 Geopolitical News:

• The EU has announced sanctions on Iran due to Tehran’s decision to provide drones to Russia. Protests continue in Iran, and this article provides an anecdotal “feel” for how the protests appear on the ground.  One of the more interesting quotes discusses the worries of the government: “They are really worried that Iran will become like Syria.”  We suspect the market’s take on the protests is that if the government falls, it will be bullish for oil.  However, if the end of the regime results in chaos, we could have a situation similar to Libya, where oil flows, even if permitted, become intermittent due to internal power struggles.
  • Protest participants are moving beyond students and women to the labor movement. The security forces are cracking down with increasing ferocity, leveling charges against hundreds.
  • Two Iranian Revolutionary Guard Corps members, including one colonel, were assassinated in the Baluchestan province. This area has always been difficult for Iran to control, but unrest has been rising along with tensions elsewhere.
  • Tehran is moving more deeply into Russia’s camp.
• One of the reasons OPEC+ announced target cuts was to counteract the U.S.-sponsored price cap. The White House has countered that the cartel wasn’t the target of the measure; perhaps that is true, but the cap does create a mechanism that could be used against oil producers.
  • Sources claim that Russia can probably evade the price cap and sanctions, although it would require ports and canals to accept Russian insurance. India and China continue to flout Western sanctions.
• According to reports, the Kingdom of Saudi Arabia (KSA) pressured other members of OPEC+ to publicly support the recent target cuts so that the U.S. couldn’t isolate the KSA for criticism.
• The Biden administration has not decided how to “recalibrate” its relations with the KSA. Clearly relations have deteriorated, but the White House seems to want to move slowly on a complete break.  Conditions are so bad that the KSA had to issue a statement saying that the crown prince didn’t privately disparage President Biden.  The NYT has reporting that suggests the administration thought it had a “secret deal” to raise production and thus was caught by surprise over the OPEC+ decision to reduce output.  It appears to us that  relations between the two countries have sunk to a new low, in part because Crown Prince Salman is charting a new foreign policy path that won’t be as dependent on the U.S.  That decision will further disrupt trading patterns that have been in place for decades.
  • We have observed that there is often a divergence between the business community and national security policy. For example, tech firms are often at odds with Washington over China policy.  As the U.S. begins to distance itself from the KSA, we note that financial firms are apparently still on board with Riyadh.
• Although the U.S. has accused the KSA of siding with Russia, perhaps a more important trend is the Saudis’ engagement with China. The KSA has a long history of building relations with oil importers, so when the U.S. was a major oil importer, the KSA aggressively defended its market share to the U.S.  Now that the U.S. is a less important importer, it would be consistent policy for Riyadh to improve relations with Beijing.  However, this policy direction could put Saudi Arabia in direct conflict with the U.S. as relations with Washington and Beijing continue to sour.
• Norway is worried that Russia will sabotage its energy infrastructure. According to reports, unidentified drones, presumably Russian, have been buzzing Norwegian offshore oil and gas platforms.  Norway has become a critical natural gas supply source for Europe, so any disruptions could be a major problem for natural gas supplies.
  • Despite numerous investigations, there has been no official announcement on who sabotaged the Nord Stream pipelines.
• The Venezuelan opposition is contemplating ending its “interim government” claim, which would be a step toward allowing the U.S. to normalize relations with Caracas.
• The new left-wing government in Colombia is at odds with its energy industry. The Petro administration is raising taxes on the coal and oil sector and looking to curtail investment to back climate change reform.

 Alternative Energy/Policy News:

• The SEC appears to be rethinking its proposal to make firms disclose carbon emissions. It is unclear what is causing this reversal, although we suspect some of it is due to the costs of compiling the data.
• Hyundai (HYMTF, $27.10) has started construction on an EV plant in Georgia.
• Climate issues continue to affect a wider circle of issues. The latest labor demand is for formalized time off to address local destruction caused by weather events.
• Although China continues to dominate battery production, the U.S. is seeing a surge in investment and a buildout of a “battery belt” across the lower 48. Meanwhile, U.S. battery infrastructure is at risk for siting constraints.
• Carbon capture is one way fossil fuel companies can address climate change issues. As CO₂ is generated by burning fossil fuels, capturing that gas and storing it would allow for continued consumption.  As investment grows, we should see in the next few years if such projects actually work.
• Climate change remains controversial, and last week we noted that the insurance industry is moving to factor this concern into policies. The survey from the insurer AXA (AXA_SA, $24.61) indicates that climate change is the primary concern of insurers.

[1] So much so that U.S. exports of fertilizer to the EU have soared, taking advantage of lower relative natural gas prices.

[2] That’s over $1,000 per MMBtu.

[3] There are some natural gas prices in the Permian that are approaching zero due to the lack of takeaway capacity.

  View PDF

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

Crude oil prices remain in a downtrend as concerns about global growth, especially with China, are weighing on prices.

(Source: Barchart.com)

Crude oil inventories fell 1.7 mb compared to a 2.0 mb build forecast.  The SPR declined 3.6 mb, meaning the net draw was 5.3 mb.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.0 mbpd.  Exports rose 1.3 mbpd, while imports fell 0.2 mbpd.  Refining activity fell 0.4% to 89.5% of capacity.  We are approaching the end of refinery maintenance season, which means oil demand should begin to rise soon.

(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.  The build seen from October into November is usually strong due to refinery maintenance.  With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

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 2003.  Using total stocks since 2015, fair value is $105.59.

 Market News:

• In a widely anticipated move, Germany has extended its use of nuclear power plants into next April.
• Although the actual cuts in production from OPEC+, as we noted last week, won’t be as dire as the headlines suggest, it will still remove some barrels from the world’s oil supply. Unfortunately, the U.S. won’t be able to fill the gap, despite rising production in the Permian.
• As world trade flows for energy adjust, Europe is moving away from Russia as an energy supplier and working to establish new flows with other nations. The U.S. has become an important supplier and so has Qatar.
  • Currently, Russia is supplying the EU with about 0.6 mbpd of crude oil. Those flows will be cut off on December 5. Not only will the EU stop importing Russian oil, but European insurance firms will no longer be able to underwrite cargo insurance for oil tankers.  Without this insurance, the costs of Russia shipments will soar because some of the key chokepoints won’t allow vessels to pass without this insurance.  It is not obvious, as we note in the above bullet point, where this crude will come from.  This is where the price cap idea comes into play.  If a buyer were willing to pay less than the cap, insurance would be provided.  Of course, the opposition of OPEC+ to the price cap was likely part of the reason to cut production targets.
    • Interestingly enough, Indian refiners, who have been large buyers of Russian crude oil, have suspended purchases until clarity is provided on how the EU sanctions will work.
  • One potential place for the EU to purchase oil would be from the U.S. SPR. However, some members of Congress are pushing for a bill that would ban the export of SPR crude oil.  However, this action would contradict the original SPR measures created by the IEA.  Under IEA rules, in a global emergency, national SPRs could be under the IEA’s jurisdiction.  The goal of the SPR is to discourage hoarding.  If we were to see national governments prevent the export of SPR oil, it is quite likely that global oil prices would soar.  If this bill gains traction, it could cause further disruption to global oil markets.  However, we could also see a situation where SPR oil would simply displace the domestic oil that would have been exported instead.
  • On the topic of the SPR, the Biden administration has announced additional sales, although the announcement did cause some confusion. There is about 15 mb of sales left in the original announcement and 26 mb scheduled for release next year (as part of a budgetary agreement), but the administration is worried about high gasoline prices and has suggested even more could be sold from the reserve.
    • As we noted in earlier reports, the administration seems to be moving the SPR from a strategic reserve to a buffer stock. Buffer stocks have been used in commodity markets before, with the goal being to stabilize prices.  The trick to managing the stock is getting the price right (which begs the question:  why bother?). Set it too low, and the stock becomes exhausted.  Set it too high, and it becomes too large.  When first floated, the administration suggested $80 as a baseline to begin buying oil.  That has now fallen to a range of $67 to $72.  We don’t expect that ANY oil will be bought by this administration as there does not seem to be a price that is politically low enough.
  • The EU has been able to build natural gas inventories, in part, because weak Chinese demand for LNG has allowed for shipments to be diverted. China is signaling this diversion will end, although Chinese demand is expected to remain sluggish.  China is also indicating that it will increase its energy reserves as winter approaches.
  • As the EU attempts to shift its natural gas supply away from Russia and to LNG, it is finding that bottlenecks at terminals are becoming a problem.
  • The EU has generally been unable to craft a functioning price cap for natural gas, so the group is trying to create other measures to bolster available supply.
  • To a great extent, the world’s energy situation is dependent upon the weather.
• The DOE has issued estimates for this winter’s heating costs, and although natural gas remains the cheapest source of heating, it is poised to have the fastest price increases.
• Although crude oil inventories appear adequate, the situation in diesel fuels is a growing concern.

(Sources:  DOE, CIM)

• Diesel fuel is often used for emergency electricity generation, and so, if there are disruptions in electricity this winter, demand could rise into a tight market which will then lift crude oil prices as well.
• One of the factors that has reduced U.S. crude oil production has been the demand from investors that companies focus on profits and returns to shareholders. This desire is partly driven by the ESG movement and the fears that peak oil demand is near.  If oil and gas are going to be industries in decline, then shareholders will tend to focus on near-term returns.  In terms of net-zero promises, there is evidence to suggest that publicly traded firms are more sensitive to such goals than are private firms.  It appears that such pressures are leading Harold Hamm to take Continental Resources (CLR, $73.68) private.
• Prime Minister Truss of the U.K. has essentially lost control of her government after proposing a radical economic program that the financial markets fundamentally rejected. The new Chancellor, Jeremy Hunt, has reversed nearly her entire fiscal package.  Part of the original package was massive support measures to protect businesses and consumers from higher energy prices.  The original bill was expected to cost £60 billion and its generosity was part of the reason that the financial markets panicked.  However, in walking back the package, Hunt didn’t offer a replacement to protect less affluent households that may be at risk due to higher prices.

Geopolitical News:

• Mohammed al-Sudani has been appointed to be the new prime minister of Iraq. It is unclear how long he will be in office because he is not popular with the al-Sadr faction.
• Last week, Saudi Arabia argued that its decision to support a cut in oil production targets was based on market concerns and was not done to support Russia. The U.S. has dismissed the explanation as “spin.”
• Russia is proposing to make Turkey a hub for natural gas transfers. Although clearly attractive for Turkey, we doubt the EU would see this as a viable alternative.  It might not help Russia either, because if Iran ever normalizes relations, Turkey could be a conduit for Iranian gas as well.
• Exxon (XOM, $101.23) announced that it has fully withdrawn from Russia after accusing Moscow of “expropriation.” The charge could signal that the company is planning to sue Russia over its exit.
• Unrest and atrocities continue in Iran. Recently, there was a fire at the infamous Evin prison which houses dissidents and political prisoners.  It appears that the fire was related to recent national protests.  There is a general question about the stability of the regime, and one of the keys to watch for is if the security services turn on the government.  There is little evidence that that most potent Iranian forces have joined the protesters.
• Iran’s support for Russia’s war effort has triggered a response from the U.S. Washington is planning various penalties against Iran that could target third parties.
  • As an aside, the sale of drones to Russia by Iran would seem to make it nearly impossible for the U.S. to return to the JCPOA. Even the Europeans are now acknowledging this outcome.
• In France, protests against high fuel prices have evolved into complaints about inflation in general.
  • In light of the Inflation Reduction Act’s measures to encourage battery makers to build facilities in the U.S., French President Macron is calling for a similar industrial policy for the EU.

 Alternative Energy/Policy News:

• One of the more controversial issues in environmentalism is geoengineering. As defined, these are various technologies designed to offset some environmental ill. Trees, for example, can be used to reduce CO₂.  However, some measures that would reflect sunlight out into space in order to keep the planet cool could raise fears concerning unexpected side effects such as changing rainfall patterns that could then create distributional or geopolitical concerns.  And so, these worries have tended to dampen investment in such technologies.  However, the White House has announced a five-year research study on geoengineering to investigate its various technologies.
• CO₂ emissions growth looks set to unexpectedly slow this year after declining global growth.
• Financial analysts argue that there is ample liquidity available for the private sector to fund alternative energy. However, the bulk of this investing power is in the energy and mining sector, which may not be keen on investments that will harm its basic industry.
• At the CPC conference, General Secretary Xi said China would not “rush” its clean energy transformation, likely meaning that fossil-fuels consumption will remain elevated.
• Although there is a wide debate over climate change and its effects, one area where the impact is quantified is in insurance. The insurance industry and the Treasury are analyzing climate risk, which may result in some areas paying much more for coverage.  Insurers are pushing back against the government’s investigation.
• The SEC is pressing publicly traded firms for information on climate issues. Lobbying efforts to shape regulation are increasing.
• Russian drones have attacked an important sunflower oil terminal in Ukraine. Although this attack will obviously affect the world supply of edible oils, it may also have an impact on biofuels.
• Although starting from a low base, carbon capture project activity is increasing rapidly.
• We are also starting to see increased investment in green hydrogen projects.

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

Crude oil prices remain in a downtrend.

(Source: Barchart.com)

Crude oil inventories rose 9.9 mb compared to a 1.0 mb build forecast.  The SPR declined 7.7 mb, meaning the net build was 2.2 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 11.9 mbpd.  Exports fell 1.7 mbpd, while imports rose 0.1 mbpd.  Refining activity fell 1.4% to 89.9% of capacity.  We are clearly in the period of autumn refinery maintenance, so falling refining activity should be expected for the next few weeks.

(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.  The build seen in October into November is usually due to refinery maintenance.  With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

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 2003.  Using total stocks since 2015, fair value is $105.85.

The SPR: As we discussed earlier, the SPR has become something of a buffer stock; thus, it makes sense when analyzing prices to consider U.S. inventories as the SPR and commercial stocks combined, as we do above.  Another element of the reserve is its composition.  Oil is broadly described as heavy or light (the measure of viscosity) and sweet or sour (the level of sulfur).  U.S. refineries have made investments over the years to favor sour crudes; the idea was that as fields aged, more oil would be of that variety.[1]  And so, when officials filled the SPR, sour crudes were favored, and until recently, the mix was 60/40 in favor of sour.  However, in the recent withdrawals, sour crudes were drawn much faster than sweet crudes.  Over the past year, 190 mb of crude oil has been pulled from the SPR: 156 mb have been sour, and 44 mb have been sweet.  At present, there are only 213 mb of sour crude remaining in the SPR, meaning its effectiveness to provide supply security has been compromised.

Unsavory Tradeoffs:  The OPEC+ decision to cut allocations by 2.0 mbpd has broad ramifications.  The cartel has argued that falling demand is behind the output decision.  This is what we see so far:

• The Biden administration is clearly upset. The president traveled to Riyadh earlier this year to attempt to improve relations.  Clearly, that didn’t work.  Biden did not have kind things to say about Crown Prince Salman during the U.S. elections, and so relations between the U.S. and the KSA had cooled.  In the aftermath of the OPEC+ decision, the administration has accused the KSA of aligning with Russia and has warned of other measures to counteract the loss of production from the cartel.  The alignment with Russia isn’t just rhetoric.  We note the president of the UAE is visiting St. Petersburg to speak with President Putin.  There are also reports that the U.S. has asked the KSA to delay the announcement for a month (ostensibly to avoid prices increasing heading into the midterms); Riyadh pressed ahead  The White House is indicating that the U.S. will “re-evaluate” relations with the kingdom.
  • The KSA has denied the allegations that it is in league with Russia.
  • Some members of Congress have called for the removal of U.S. military contractors and troops from the region. There have also been discussions of halting arms sales.
  • Additional SPR sales have been announced.
  • NOPEC legislation has been resurrected. This legislation would give the U.S. Attorney General the right to enforce U.S. antitrust laws on foreign national oil companies.  Although it is not clear how that would work exactly, it’s conceivable that it would make it impossible for the affected OPEC+ nations to sell directly to the U.S.  We doubt this legislation will pass as it often returns when the U.S. isn’t happy with the cartel’s behavior.  However, we may be reaching a point where divisions between the U.S. and various cartel members have become strained enough that momentum may build for the bill’s passage.
  • Another measure would build a case to take OPEC+ to the WTO on restraint-of-trade charges.
  • What has not been mentioned yet is some sort of action against Saudi investments in the U.S.
  • Clearly relations are cooling.
• We should note that all of these actions have a clear potential for adverse consequences. Withdrawing troops from the KSA and UAE may create conditions where Iran could undermine these governments, leading to potentially catastrophic outcomes for the West.  Complicating matters is the U.S. political environment.  Currently, a significant element of the electorate believes that if the other party is in power, civilization as we know it is at risk.  Such attitudes lead those in power to take extreme measures to stay in power.  The aggressive SPR sale has elements of maintaining political power at the risk of not having the reserve if a broader crisis emerges.  Some of the discussion of attacking OPEC+ is shaded by seeing the KSA as supporting the GOP.  At the same time, Riyadh should note that attitudes toward the KSA are hardening in a bilateral fashion.
• Finally, it should be remembered that the EU embargo on Russia crude goes into effect on December 5. It may not make sense to punish OPEC+ when the world will need to offset the potential loss of Russian oil.
• At the same time, the administration has been ignoring the effects of some of its actions on the concerns of the Gulf producers. The aggressive draining of the SPR was seen as a clear threat.  The talk of price caps isn’t welcome either.
• One item to keep in mind is that the actual level of cuts will not approach 2.0 mbpd, because the cuts are coming from allocations, not actual production. The actual cuts will likely be closer to 0.8 mbpd, as the Gulf states, who are meeting their production quotas, cut back output.

• The IEA is warning that the OPEC+ cuts could plunge the global economy into recession.
• In addition to expressing anger about the KSA, the U.S. continues to negotiate indirectly with Iran for the latter’s return to the JCPOA. In theory, this could add one to two million barrels per day of oil to world markets, although we have our doubts that there is this much oil available.  The sanctions regime has weakened and thus the available supplies would likely be modest.  However, the “unsavory tradeoffs” include Iran’s human rights problems, and, perhaps more worrisome, it is in the midst of a crackdown on expanding unrest.  The optics of cozying up to Tehran at this particular moment are troublesome as it is estimated that at least 185 people have died, including 19 children.  This is especially the case since the protests appear to be widening with anecdotal evidence that security forces may be joining the rioters.  Energy sector workers are also going on strike in sympathy.  The longer these protests persist, the greater the threat to the regime.  The government seems to have little fear of using force against young protestors but appears to be reluctant to attack oil workers.  We also note that we are seeing some level of dissent from the clerical class.
  • Although we don’t expect the government to fall, we do note that authoritarian regimes tend to collapse without warning. At least initially, an overthrow would be bullish for oil because it isn’t obvious if the lack of government would affect the oil infrastructure.  If a Western-friendly government were to take power, however, we would expect the West to rapidly take steps to support that government, which would almost certainly include lifting sanctions.
• There have been reports that the administration may ease sanctions on Venezuela in a bid to increase oil supplies, although we note they have been denied. The Maduro regime has also been repressive against opponents, and, again, the optics are not good.
• Perhaps the most important point that has been lost in all the controversy is that the world has dramatically underinvested in oil production. As we have noted for months, ESG concerns continue to weigh on non-OPEC supply, but even OPEC+ is underinvested.  The fact that OPEC+ now talks about “production targets” instead of “quotas” shows how much conditions have changed.  As long as investment remains depressed, oil prices will remain elevated and could conceivably move much higher.

The bottom line is that the commodity business can require compromises.  At times, governments can decide that they will bear the cost of higher commodity prices because a producer is so far beyond the pale that cooperation is impossible.  For example, the U.S. has avoided buying Iranian oil since 1979, but in other cases, governments will turn a “blind eye” to such behavior to secure resources.  The Ukraine War has exacerbated these difficult decisions.  The EU delayed applying embargos on Russian oil and gas until early 2023, for example.  We expect more difficult issues to develop in the future.

Market News:

• The EU held talks about setting a natural gas price for the group. The idea is that they agree on a price and if the market price is above that level, the cost would be subsidized.  At the time of this writing, the meeting did not succeed in setting a policy.
• A leak in the Durzhba pipeline was discovered in Poland. Although there are fears of sabotage, first accounts seem to indicate that it was an accident.  The event has reduced oil flows to Germany.
• As the EU ramps up LNG purchases, emerging market (EM) nations are struggling to acquire supplies and the buying will also likely push U.S. prices up as LNG production ramps up.
• The U.K. has announced a new round of drilling licenses for the North Sea. The U.K. government stopped issuing licenses in 2019, promising a comprehensive environmental review.  High prices have prompted the decision to start issuing licenses again.
• In an ominous sign, so-called “ducs,” or drilled but uncompleted wells, inventory is shrinking. This development suggests that wells are being completed faster than new wells are being drilled.  Without rapid investment soon, U.S. production will likely begin to contract.
• In the late 1970s, President Carter gave his famous “malaise” speech, commenting on energy while wearing a cardigan. The message was that sacrifice would be required in the face of high energy prices.[2]  French President Macron is offering a similar message today.  Partly in response, Paris, the “City of Lights” is darker.
• Another element of the 1970s was price caps on energy products. These caps were blamed for the infamous gas lines at filling stations.  Price fixing is one response to scarcity, but if rationing isn’t included, it usually leads to shortages.  Why?  There is a political incentive to set the price below the market-clearing price.  If the market price were acceptable, no one would have an interest in fixing the price.  During WWII, price fixing coupled with rationing worked reasonably well.  However, the incidence of this policy fell on higher income households who had the money to buy more food but were restricted by rationing.  As the war ended, so did rationing, and prices were allowed to fluctuate.  Note that as rations were lifted, food prices jumped after the war.
• China’s LNG demand will remain elevated in the coming years. As we noted above, without increasing investment, the globalization of natural gas will tend to move U.S. domestic prices to overseas prices, meaning Americans will pay more for heating, fertilizers, and electricity.
• Despite these experiences, price caps are being reconsidered as a way to make it through the winter. Several different ideas are being considered, but without proper care, the end result is likely shortages.

• Refinery workers in France have gone on strike and there are numerous reports of spot shortages and tensions at filling stations. The Macron government is trying to force workers back to the refineries but is struggling to enforce its will.  There is talk of wider protests against inflation.
• The Permian Basin has been responsible for nearly all the production growth this year. However, to continue to expand, associated natural gas that comes from drilling must be processed.  Flaring, which could be one way to address this issue, has become untenable.  While there is still some natural gas processing capacity available, without additional investment, production growth could stall.
• Although OPEC+ has called on production cuts, we note that the KSA has signaled a reduction in supplies to Asia. It appears supplies will be met by drawing down inventories.
• Munich Re (MURGY, $24.40), the world’s largest reinsurer, announced restrictions on issuing policies on oil and gas projects. Financing constraints have been a factor in restricting oil and gas production.
• Venture Global (1557028.MC, €10.16) announced a deal to send U.S. LNG to Germany.

Geopolitical News:

• Germany’s unilateral energy price support package continues to raise hackles across the EU. In response, Germany is proposing to support unified EU debt to broaden subsidy support.  Increasingly, the EU and Eurozone have been creating bonds as opposed to member nation debt instruments.
• Sweden’s investigation of the recent Nord Stream pipeline attacks strongly suggests sabotage.
• Last week, we noted that Lebanon and Israel were nearing a deal on production sharing for offshore natural gas development. A deal has been tentatively agreed upon but will need ratification by both governments.  We expect it to pass as Israel wants energy security without the distraction of tensions with Lebanon, and Lebanon desperately needs the revenue from natural gas sales.  The U.S. cheered the arrangement, which may ease tensions between Israel and Hezbollah, which dominates the Lebanese government.
• Iran has been an observer of the Shanghai Cooperation Organization (SCO) since 2005. It has wanted to join the group, but the leadership was uncomfortable admitting a member under sanctions, fearing that the SCO would face scrutiny from the West.  However, now that Russia, a long-time member of the SCO, is under sanctions, there is a higher likelihood that Iran will be admitted. If so, the SCO will probably become an anti-U.S. organization.
  • In Iran, state television was hacked during a news bulletin.
  • The IAEA reports that Iran is aggressively moving to expand uranium enrichment at its underground facility at Natanz. This news will raise questions about the wisdom of returning to the JCPOA.
• The U.S. energy industry is warning against implementing product export constraints.

 Alternative Energy/Policy News:

• Florida’s electrical grid has reportedly recovered rather quickly in light of the hurricane devastation. The grid was strengthened by using concrete and steel power poles and burying power lines underground. Areas that built solar capacity have mostly emerged unscathed.
• One problem with EVs is their high cost. Ford (F, $12.16) has announced a second price increase of the F-150 Lightning since summer.  The base model now costs over $50k.
• The recently passed Inflation Reduction Act has provisions that provide large subsidies for EVs if the vehicle is mostly made in the U.S. with American components. The EU is crying foul, suggesting this is protectionism.
• Copper is critical to EVs, and the West is short on copper supplies.
• Austria is challenging the EU ruling that nuclear power and natural gas are “green” fuels. This suit joins others from environmental groups.  If the challenges are successful, ESG guidelines will restrict investment in these two sources of energy.
• General Motors (GM, $32.65) has decided to expand its battery production to include electricity storage for home and commercial use. For homeowners, this possibility will be tied to an EV.
• Researchers have developed a prototype lithium battery with 40% more capacity.
• A new cobalt mine, the only one of its kind in the U.S., recently opened.
• The EU wind industry is contracting due to rising input costs.
• New Zealand is applying taxes on livestock to curtail methane emissions.
• The uranium miner Cameco (CCJ, $21.95) announced an investment in the nuclear power division of Westinghouse, which is owned by Brookfield Partners (BBU, $19.48). Cameco’s investment looks like a bid to vertically integrate.

[1] This decision turned out to be a mistake.  Crude oil from fracking turned out to be sweet, meaning that it wasn’t ideal for U.S. refiners.  Thus, sweet crude is usually exported, forcing the U.S. to import sour crudes.  In broad terms, this means the U.S. is oil independent, but in practical terms, it’s not, due to the sweet/sour imbalance.

[2] It wasn’t a popular speech.

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