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

Crude oil prices remain under pressure due to recession fears.

(Source: Barchart.com)

Crude oil inventories fell 0.2 mb compared to a 2.0 mb build forecast.  The SPR declined 4.6 mb, meaning the net draw was 4.8 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.0 mbpd.  Exports rose 1.1 mbpd, while imports fell 0.5 mbpd.  Refining activity plunged 3.0% to 90.6% of capacity.  We are in the usual period for 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 at 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 could be 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 $107.52.

Market News:

• Hurricane Ian is bearing down on the gulf side of Florida. There isn’t a lot of oil and gas production in the path of the storm, but delays are an issue as the U.S. is exporting a record level of energy products to the world. Hopefully, the delays shouldn’t last long.
• As the G-7 looks to try to sell the world on a price cap for Russian oil (see this report for a primer on how it might work), India appears to be sharply curtailing its purchases. This change in buying pattern doesn’t appear to have anything to do with its attitude toward Russia, but rather it has more to do with higher shipping rates.  As rates have risen due to the global scramble to secure oil supplies, it’s now cheaper to buy African crude oil once shipping costs have been taken into account.
• There is a growing consensus that OPEC+ is considering a $100 per barrel target for oil prices.
• One element of the Inflation Reduction Act was a measure that would have sped up permitting, but in its final version it was removed to be considered as a standalone bill. Environmentalists have been using various delaying tactics to prevent pipeline construction or drilling from occurring, even after companies have complied with regulatory requirements.  Clean energy has faced similar constraints.  Solar and wind power could expand if it were easier to build long distance transmission; however, these structures can also face local opposition.  Manchin (D-WV) tried to lead a bipartisan effort to streamline permitting, but that bill has failed.  Democratic progressives loathe the permitting of pipelines and other infrastructure for fossil fuels.  The GOP didn’t want to give the Democrats a win and likely opposed streamlining permitting for clean energy projects.  Sadly, by looking for the perfect, the good was sacrificed.  The fact that a compromise couldn’t be reached suggests that both wings of the political spectrum believe they can get exactly what they want.  Until that is proven false, we will continue with this world where energy infrastructure is not being built.
  • We note that this isn’t just a U.S. problem as Australia is seeing similar issues.
  • For U.S. LNG to expand (and help wean Europe from Russia), pipelines will need to be built.
• Natural gas prices in Europe are starting to have ripple effects. With U.S. prices significantly less, EU companies are shifting industrial activities that rely on natural gas production to the U.S.  Basics such as bathroom tissue are being affected.  There is growing speculation that the EU will expand gas to crude oil fuel switching, which may lift crude oil demand later this year.  Germany has secured an LNG deal with the UAE as part of its effort to diversify its natural gas supply chain.
• Even as hedging costs rise, EU regulators are resisting calls for support from the energy industry.
• U.S. utilities are starting to warn customers that home-heating costs this winter are poised to rise due to elevated natural gas prices. Overall prices are expected to increase over 17% from last year.
• Norway’s oil production rebounded in August.

 Geopolitical News:

• The Nord Stream 1 and 2 pipelines have been sabotaged. It is unclear who did this, but there is evidence of a gas leak in the Baltic Sea.  Although the Nord Stream pipelines were not sending gas to Europe, the lines were pressurized, and the gas that is leaking was in those pipelines.  The CIA has warned that pipeline infrastructure in Europe is vulnerable.  The leak could mean that no gas from Russia will be available to Germany even if relations were to improve.  Speculation is rife that Russia attacked the pipes (the broad scale of the attacks mostly rules out an accident), although no party has been officially blamed.  Scandinavian seismic stations reported explosions around the pipelines before the leak was discovered.
  • This attack is ominous because it could signal a new element of this war— targeting critical infrastructure. Russian submarines have been noted prowling around undersea cables.  Russia has already been accused of severing fiber optic cables between Svalbard and Norway that are key communication links for NATO.  If Russia decides that attacking energy and communications infrastructure is necessary to win the war in Ukraine, a new risk element will be introduced.  The EU has vowed to protect its energy infrastructure, but given the miles of pipelines involved, no government can guarantee it will protect everything.
• A key reason for the creation of the EU was to manage competition within Europe. After all, the continent suffered two world wars due to unresolved competition, and thus avoiding another one was important.  The EU has expanded and grown to include influence on economic matters.  So far, Brussels has tried to manage the scramble for energy resources.  However, the IEA is warning that if more isn’t done, competition to secure oil and natural gas could lead to chaos and spiraling prices.
  • As we have noted earlier, EU demand has cut supplies of fuel to the emerging world.
• Last week, we noted the unrest that followed the death of a feminist in Iran who was accused of improper head covering. The unrest has continued to spiral, with now over 75 deaths being attributed to the protests.  Even conservative women are joining the protests, which suggests a broadening threat to the regime.  There are reports suggesting that some cities in Iran are no longer controlled by the government.  Historically, the regime tends to react harshly to protests.  As we noted last week, the government has interfered with the internet to undermine the protestors’ ability to coordinate their actions.  Those efforts have expanded, and in response, the U.S. has relaxed rules on tech firms so they can provide services to Iran to help the protestors.  The Starlink system, a satellite internet service built by Elon Musk that has blanketed space with small satellites, is said to be operative and giving protestors internet access.  Although we doubt the regime is at risk, it should be noted that Ayatollah Khamenei is said to be gravely ill, but the most recent reports suggest he may have recovered to some extent.  It bears watching to see if some sort of change in government emerges from Tehran.
  • Protests against Iran have spread to the West.
  • Iran has also launched attacks against Kurdish groups in Iraq. Tehran is accusing various groups of supporting the protests in Iran.  Attacking groups on foreign territory highlights how little sovereignty Iraq has over Iran.
  • Iran has withdrawn its “morality police” that were responsible for the death of Mahsa Amini from public view. We doubt this is permanent, but for now, it looks like Iran is trying to placate the protestors.
  • In related news, the Biden administration says it will continue to engage in talks to return to the JCPOA. Given the protests, making an agreement with Iran looks like a long shot, but the fact that the White House hasn’t broken off talks looks politically risky.
• Although the G-7 continues its plan to introduce a price cap on Russian oil, and the EU is moving toward an embargo and an insurance ban, the U.S. has ruled out secondary sanctions for now. Secondary sanctions would penalize nations and firms that buy Russian oil and gas in violation of sanctions.  The fact that secondary sanctions have not been implemented suggests the West isn’t really serious about inflicting damage on the Russian economy.  Most likely, leaders in the G-7 realize that seriously reducing Russian oil supplies would subject the world economy to crippling increases in oil prices.
• Sanctions on Russian oil shipments are preventing local ship captains from controlling oil tankers from Russia that are traversing the Danish straits. Without the local captains, the likelihood of an oil spill is increased.
• The U.S. has been mediating a natural gas sharing arrangement between Israel and Lebanon. The two nations have both claimed offshore natural gas fields.  Although a deal hasn’t been struck yet, reports suggest they are “close.”

  Alternative Energy/Policy News:

• As urbanization continues, people are being separated from the basic notion that producing any commodity has an impact on the earth. Drilling, mining, farming, and ranching all disturb something.  This op-ed, lamenting the cutting down of forests for a solar farm, is an example.  Solar power is a low-density source of electricity.  To generate it at scale requires great amounts of space.  Clean energy may disturb things less than other forms of energy (or not), but make no mistake, changes will be necessary.
• China is aggressively moving to become a world leader in nuclear power. It has built 39 reactors over the past decade, which is a bit more than 57% of the global total.  The process of building reactors increases the country’s expertise in construction and engineering and provides its economy with electricity that would be hard to disrupt by an outside power.  While the West continues to impede the development of nuclear power, it runs the risk of falling behind China.
• The DOE is providing funding for building green hydrogen infrastructure, setting off a scramble to secure the needed resources.
• Firewood and wood pellet prices are up 20% in France as demand rises.
• One of the problems with forecasting is that models all use past history and relationships to predict the future. Accounting for changes in technology requires guesswork that is highly unreliable.  We note that agriculture researchers are using AI to figure out how to make plants drought-resistant.
• According to the IEA, clean energy progress is lagging.
• As the EV industry grows, recycling the traction batteries from cars will become more important. South Korea has been taking the lead in this industry.
• The scramble for rare earths is heating up.  The world is currently heavily dependent on China for this resource.

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

Crude oil prices remain under pressure on recession fears.

(Source: Barchart.com)

Crude oil inventories rose 1.1 mb compared to a 1.9 mb build forecast.  The SPR declined 6.9 mb, meaning the net draw was 5.8 mb.

In the details, U.S. crude oil production was steady at 12.1 mbpd.  Exports were unchanged while imports rose 1.2 mbpd.  Refining activity rose 2.0% to 93.6% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  The rise in stockpiles over the past two weeks is contra-seasonal.  As the chart shows, we are nearing 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 could be 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 $106.98.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $66 per barrel, so we are seeing about $20 of risk premium in the market.

The SPR

In our weekly reporting above, we have been updating total U.S. oil inventories, both commercial and the SPR.  For years, analysts have tended to treat the two as different entities as commercial inventories are what is available and the SPR was only deployed in emergencies.  Price modeling, therefore, tended to focus on commercial storage.  The separation of commercial and strategic stocks made sense.  However, as our above analysis suggests, we have stopped treating the SPR as an emergency reserve and have begun considering it a buffer stock.

Buffer stocks are sometimes used in commodity markets to dampen price volatility.  When prices rise to a level considered “too high,” the buffer stock manager releases inventory, and when prices are “too low” the commodity is purchased.  In the 1970s, several commodities had buffer stocks, which were managed by producers.  All of them eventually failed because producers set a price well above the market clearing one.  Eventually, the buffer stock became too large, and the manager was forced to “dump” the stocks on the market, leading to a price collapse.  A buffer stock operated by a consumer would likely have the opposite problem since it would want to set a price well below the market clearing one.

Recently, the Biden administration floated an idea that if WTI fell to $80 per barrel or less, the SPR would buy oil to refill it.  We still harbor doubts that oil will ever be purchased by this administration, but this recent “trial balloon” is intriguing.  If this idea becomes policy, it will confirm that the SPR has become a buffer stock and the government is comfortable with an $80 per barrel oil price.  That is probably a high enough price to maintain current output, but if prices remain steady, the inflationary impact (inflation is a rate of change concept) would diminish over time.  In theory, the $80 per barrel becomes a floor, and it is unclear what price would trigger selling (the ceiling price), although one could imagine that a round number like $100 per barrel would be reasonable.  There remain numerous uncertainties about this concept, but we will continue to monitor developments.

Here’s the key point to all this:  from the late 1970s until recently, there was great faith placed on markets to solve problems.  Government intervention into the economy was normalized during the Great Depression and WWII but the inflation of the 1970s undermined the idea that the government could manage the economy.  The infamous gas lines of the 1970s occurred, in part, due to price caps on product.  When it became unprofitable to refine gasoline at the cap price, shortages developed.  Markets do work, but they are focused on efficiency, not equality.  In other words, high gasoline prices did increase available supply and eased demand, but the burden of the policy fell more heavily on lower income households.  The government using the SPR as a buffer stock could suggest a return to the pre-Reagan/Thatcher era.

Market News:

• We want to issue a correction to last week’s report; we implied that the permitting element of the Inflation Reduction Act had already been passed. It was not.  This part was peeled from the bill to be passed separately.  Talks on permitting are currently underway.
• The government has accepted about $190 million of bids for offshore oil development.
• The G-7 price cap idea remains untested, but the IEA notes that when the EU implements its embargo next February, Russian oil demand will fall by 1.9 mbpd.
• As winter approaches, U.S. oil producers warn they will not be able to meet shortfalls as demand rises. Surging LNG exports are pushing U.S. electricity prices higher.
• For reference, this site updates EU natural gas storage.
• One of the factors that has cooled oil prices has been weaker Chinese economic growth. If Beijing becomes serious about stimulating the economy, oil prices will likely rise.
• Over the past several months, we have noted that the data for miles driven by Americans shows a clear reaction to higher gasoline prices. For years, it was a “truism” that driving demand was price insensitive.  However, work from home and the expansion of social media appear to have caused gasoline consumption to become more sensitive to price.
• As energy prices rise in the EU, manufacturing firms are being forced to curtail production.
• Smaller U.S. oil firms have been aggressively expanding oil and gas production, but reports suggest that they have exhausted their most promising fields, which may lead to falling output.
• As energy prices rise in Europe, governments are trying to address this issue. There are two policy paths.  The first is to increase supply, and although that is the preferred solution, it is hard to execute in the short run because it often takes investment and time to lift production.  The other path is to ease the negative impact on consumers by either fixing the price and then allocating the “pain” to either producers or the government, or by subsidizing consumers.  The problem is, once this path has been taken, it becomes a political decision about who will bear the cost.  The U.K. is a good example of what not to do as the support program is likely too broad, offers too much support, and will be funded by government borrowing.  The steady decline in the GBP is evidence that the markets, to quote Queen Victoria, “are not amused.”
  • Due to price turmoil, the German government has nationalized the natural gas distributor Uniper (UNPRF, $2.90). Soaring natural gas and oil prices are making it difficult for firms to hedge their exposure, which could either lead to a supply crisis or a financial market crisis.
• The lack of investment in oil and gas production is a key element to the recent rise in prices. A good example of this lack of investment is Nigeria, where oil production is  about 1.2 mbpd, down from 2.6 mbpd in 2012.  Economic mismanagement and corruption have weakened the incentives to investment, and since oil and gas are depleting assets, the lack of investment means falling output.  This investment issue isn’t just a Nigerian problem as OPEC+ now speaks of “production targets” as opposed to “production quotas,” reflecting the lack of productive capacity.
• The recent heatwave in China has spurred coal demand and has lifted imports of coal from Russia and Indonesia.
  • Strong coal demand has started to trigger investment in mines that can be tapped quickly.
• As we head into another “La Niña” season, Japan is bracing for a cold winter. If the temperatures stay true to form, it will lift LNG demand.

 Geopolitical news:

• Throughout history, Germany and Russia have had periods of economic integration, followed by disengagement. Recent reports that the German government has seized three Russian-owned refineries in Germany suggest disengagement is underway.
• The G-7 is preparing to implement its price cap on Russian oil. The reason for the cap is that the U.S. is afraid that when the EU’s ban on insurance for tankers goes into effect this December, Russian oil flows will slow to a trickle, leading to a spike in prices.  The U.S. has proposed the price-cap idea, where Russia could still export oil that would be granted tanker insurance but at or below a mandated price.  The trick is to establish a price high enough to encourage continued production but low enough to reduce revenues.  We remain skeptical that this plan will work, but if the EU insurance ban goes forward, we could see a drop in available oil supplies and a rise in price.
  • EU leaders are watching growing protests over the war and high energy prices.
• Meanwhile, ties between Russia and Saudi Arabia appear to be tightening.
• Protests against the beating death of a woman in Iran who refused to wear a head covering have become widespread, leading the government to reduce internet connectivity as a way to prevent organizing. According to reports, five protestors have died as security forces attempt to quell unrest.
• In recent interviews, President Raisi of Iran has made it clear that his country won’t rejoin the nuclear deal without guarantees that a future administration won’t exit it again. Since the deal is not a treaty, the Biden administration cannot bind future governments to it.  If this position is maintained, there is little chance that the U.S. will rejoin the pact.  Although the market may take this as bullish, in reality, we harbor doubts that the current sanctions are keeping Iranian oil from global markets.  Thus, the impact of failed negotiations may be minor.

 Alternative energy/policy news:

• There is an old adage in commodities that “nothing cures high prices like high prices.” The idea is that high prices lead consumers to reduce demand and suppliers to boost output.  In the current high-price environment, most of the adjustment has come from consumers.  However, one area often overlooked is increasing efficiency.  A recent report indicated that data centers, server farms that do the calculating that fosters AI and the internet, tend to generate massive levels of heat that is usually vented.  However, with prices for energy high, there are efforts to capture this energy and use it for the production of steam.
• As EVs expand, lithium, a key mineral in batteries, is in high demand. It tends to be found from two sources:  ‘hard rock’ mining and evaporating brine at high altitudes from waters containing lithium.  The latter source is mostly found in South America, primarily Chile.  The former source is distributed around the world, with several mining sites in Canada.  A major, yet undeveloped, mine exists in Quebec.  Despite high demand and high prices, the mine remains uncompleted due to various obstacles.
• Hertz (HTZ, $18.15) announced plans to purchase 175,000 EVs from General Motors (GM, $39.17) over the next five years.
• Modular nuclear reactors hold the promise of expanding nuclear power quickly to less populated regions. Despite their promise, industry expansion has been slow.  There are several reasons.  First, most of the research and development of these reactors are still in the concept and design phases.  This situation is still favorable, because is suggests this product will become increasingly available.  But for now, electricity from small modular nuclear reactors remains in the future.  Second, connecting to the grid remains an issue in some markets.  One possibility would be to site these reactors where current coal-fired plants reside, allowing for rapid connectivity.  And finally, even with modularity, nuclear power remains controversial, which tends to slow development.
• Although key metals for clean energy are found in various places around the world, processing is concentrated in China.

• A leak at a German nuclear power plant has led to its temporary closure.
• One of the benefits of offshore wind energy is that, unlike on land, offshore wind is more constant. Despite this benefit, getting projects completed has been remarkably slow.
• As the West builds out LNG infrastructure, there is a concern that these assets, which have long lives, could become stranded.
• Policies are sold. As governments try to sell clean energy to their citizens, leaders are touting the prosperity the change will bring.  Even in China, with an authoritarian government, there are concerns about whether clean energy will bring economic benefits.  A related element of this goal is that governments are taking steps to favor domestic firms to build out the clean energy industry.  Such actions will likely run afoul of WTO rules.  Our take is that the trade rules will be broken, lending additional evidence that we are ending the current phase of globalization.

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

Crude oil prices remain under pressure on recession fears.

(Source: Barchart.com)

Crude oil inventories rose 2.4 mb compared to a 2.5 mb build forecast.  The SPR declined 8.4 mb, meaning the net draw was 6.0 mb.

In the details, U.S. crude oil production was steady at 12.1 mbpd.  Exports rose 0.1 mbpd, while imports declined 1.0 mbpd.  Refining activity rose 0.6% to 91.5% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  The rise in stockpiles over the past two weeks is contra-seasonal.  As the chart shows, we are nearing 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 could be 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 $106.07.

The SPR has been falling rapidly.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $66 per barrel, so we are seeing about $20 of risk premium in the market.

Natural Gas Update

Now that summer is behind us, it’s time to examine the state of the natural gas market as winter approaches.  Currently, on a rolling 12-month basis, supply is exceeding consumption.

Some of the supply improvement has come from rising net imports.  As the chart below shows, the U.S. was a net importer of natural gas until late 2017 (again, on a rolling 12-month basis).  Since then, the U.S. is a net exporter, hence the negative net import reading. The recent rise in net imports appears to be tied to the Freeport LNG disruption, as LNG exports have fallen.  By next spring, that facility is expected to be at full production, which will reduce American supplies, assuming steady production.

Although supply has been ample, hot summer weather has lifted consumption and puts the U.S. at a modest storage deficit going into autumn.

This model seasonally adjusts storage levels, and the deviation line shows the difference between current and normal storage.

Expectations of rising LNG exports have pushed U.S. natural gas prices well above seasonal norms.  As always, the key to prices in the winter is temperature.  One way to measure the impact of temperature on energy demand is using the concept of the degree day.  The degree day measures the average temperature (high + low/2) compared to 65^o with the idea that no climate control is necessary at that temperature.  If above 65^o, cooling is required while if below, heating is required.  The temperature deviation is then adjusted by population.  Below are the deviations from normal.

Heating degree day values tend to be higher than cooling because extreme cold is more common than extreme heat.  A temperature of 0^o generates a heating degree day where the equivalent would be 130^o for a cooling degree day.  Thus, on the above charts, we have scaled the degree days equally.  Casual observation would suggest that winters have become milder as the last extreme cold month, December 2000, was a heating degree day of 200 which has not been exceeded since.  Such readings were far more common in the 1970s.  On the cooling side, there is a clear upward drift in deviations.  It is quite possible that rising greenhouse gas levels are a factor in both warmer winters and hotter summers, but one cannot rule out longer cycle factors, such as sunspots.  What this means for natural gas markets is that colder winters may not be as bullish a factor as it once was, but summers pay a larger role in demand.

Market news:

• As autumn approaches, natural gas demand tends to decline. Moderate temperatures ease electric demand.  There is always a risk of hurricane disruption in the Gulf of Mexico, but so far this year, the region has been spared from storms.  Hurricane season peaks, on average, by September 10, so there is a growing chance that we will avoid a serious disruption from tropical activity.  Although EU natural gas inventories have increased, it is important to remember that inventory is a supplement to production and imports.  Thus, to ensure ample supplies, barring a mild winter, U.S. LNG flows, which have been critical to the inventory build, will need to continue.  This means that U.S. natural gas prices will remain elevated, unless the U.S. decides to curtail exports.
• A follow-on effect of high natural gas prices is high fertilizer prices as natural gas is an important feedstock for fertilizers, and tight supplies are hammering the European fertilizer industry. In response, Germany has been increasing chemical imports.
  • In addition to fertilizer, vegetable growers often use greenhouses in Europe, and high natural gas prices are leading to production declines.
• One of the surprises over the past 18 months has been the lack of supply response from the oil industry in the face of elevated prices. A key reason is the worry about policy changes leading to stranded assets.  We expect this fear to cap the supply response and keep oil prices high.
• Although the supply situation for crude oil remains bullish, demand is cyclical and as the odds of a recession rise, the potential for demand destruction is increased as well.
• One of the key elements of recent legislation was permitting reforms. Environmentalists and other groups have been using the courts to prevent pipeline construction, for example.  The Inflation Reduction Act is designed to reduce the time of objections to construction.  Interestingly enough, it could work the other way.  Although intermittency is a hinderance to using solar and wind power, long-range electricity distribution could, in theory, counter intermittency by allowing solar or wind power to be sent long distances when it might be dark and calm.  This bill should help that process as well, as often proposals for electricity lines face local objections.

 Geopolitical news:

• It is looking increasingly like a return to the Iran nuclear deal isn’t going to occur. To some extent, it appears that Iran won’t take “yes” for an answer.  The White House has generally accepted Iran’s demands, only to see new ones emerge.  We suspect the Iranian leadership needs an enemy much like the Castros do in Cuba; it is hard to repress one’s population without an ever-present enemy.  We have been skeptical of a deal and despite continued negotiations, it doesn’t look like one is coming.
• Part of managing sanctions is the use of GPS and vessel transponders. Increasingly, software is spoofing this system, reducing the effectiveness of sanctions. Actual interdiction is still possible but would require a much larger military effort.
• Lebanon has been in a financial crisis for some time. Things have gotten worse as the central bank has stopped supplying dollars to energy importers, leading to soaring product prices.

 Alternative energy/policy news:

• Uranium prices have been strong as interest in nuclear power continues to rise. Although nuclear electrical power has been an environmental pariah for a long time, the sources don’t create greenhouse gases.  Unfortunately, Russia is a significant source of uranium.
• Although the logic is questionable, the EU has promoted biomass, mostly wood burning, as a “green” alternative. The EU is now considering tightening the rules on wood burning (mostly pellets) due to the controversy surrounding its impact on the environment.
• Solar power is a popular renewable energy source; however, California is finding that disposing of the panels once their useful life has expired (around 15-20 years) is becoming a problem. The panels contain heavy metals which if dumped in a leaky landfill, could contaminate groundwater.
  • Disruptions in the solar panel supply chain are leading to greater coal consumption.
• Some critical rare earths are mined in Myanmar and lax environmental practices are raising concerns about environmental damage to the country.
• Renewable energy is facing a constraint due to the lack of skilled workers.

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

(The Weekly Energy Update will not be published next week.  The report will return on September 15.)

Crude oil prices remain under pressure on fears of a deal with Iran and weakening economic growth.

(Source: Barchart.com)

Crude oil inventories fell 3.3 mb compared to a 2.5 mb draw forecast.  The SPR declined 3.1 mb, meaning the net draw was 6.4 mb.

In the details, U.S. crude oil production fell 0.2 mbpd to 12.0 mbpd.  Exports fell 0.8 mbpd, while imports were unchanged.  Refining activity rose 0.3% to 93.8% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Clearly, this year is deviating from the normal path of commercial inventory levels although the past months’ inventory changes are more consistent with seasonal behavior.  We will approach the usual seasonal trough for inventories in mid-September.

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 $107.69.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $64 per barrel, so we are seeing about $24 of risk premium in the market.

Market news:

• There are grave concerns about how Europe will manage energy this winter. Natural gas inventories have been rising, but it is probable that the European economy, likely in recession now, will see weaker economic activity in the coming months.  However, conditions are improving and it is possible that, barring an unusually cold winter or some other crisis, the situation might be more manageable than it looked earlier this year.  Some of this improvement is due to European industrial consumers making adjustments.
  • However, even with an improved supply situation, consumer costs will be very high this winter. The U.K. government is warning households to expect an 80% increase in their energy bills.  Europeans are facing difficult choices over home heating or eating.
  • Although the focus remains on this winter, policymakers are starting to realize that disruptions will likely continue for the next several years, meaning a broader response is necessary.
  • As China’s economy slumps, it has been reselling LNG to Europe. Although the EU can certainly use the gas, the concern is that this development will make the EU increasingly dependent on Beijing.
• Russia has halted flows of natural gas over the Nord Stream 1 pipeline for maintenance. The shutdown is supposed to last three days, although there are worries that it could be extended.  One of the issues about these periodic shutdowns is that Russia doesn’t have extensive storage networks for natural gas.  We have been concerned that if Russia starts closing in wells, there could be a permanent loss of production.  Apparently, Russia is avoiding this outcome by massive flaring of natural gas.  In effect, Russia is simply burning the gas into the atmosphere rather than put it in the pipeline.  Flaring does avoid the issue of shutdowns.
  • Russia has suspended natural gas flows to the French industrial company Engie (ENGIY, $11.97) over a contract dispute.
• The Canadian natural gas market is mostly isolated. Although there are pipelines that interconnect to the U.S. system, they occasionally reach capacity, leading to large discounts on Canadian natural gas.  We are seeing that situation now as the chart below shows the U.S. market trading at a nearly $7.00 premium.

(Source:  Bloomberg)

• Canada’s energy industry is heavily dependent on pipelines to the U.S. It is facing numerous threats to close ageing pipelines which, if these blocks are successful, would “bottle up” Canadian oil and natural gas and lead to lower prices.
• Canada would benefit by building out an LNG infrastructure.
• We have been reporting on the negative impact of ESG on oil and gas production. We note that the state of Texas is restricting investments in firms that support ESG investing.
• As natural gas prices rise, ancillary gases are seeing price hikes too. In the U.K., high natural gas prices have made ammonia prices uneconomical.  Carbon dioxide is a by-product of ammonia production and now that gas is in short supply.  Carbon dioxide is used by beer and soft drink makers and is used by the meatpacking industry to stun animals before slaughter.  This situation shows the ripple effects caused by excessively high natural gas prices.
  • Although we haven’t said much about it in this report, we are closely monitoring the intersection of energy and agriculture. Drought is hurting crop yields, but high fertilizer costs look to cause food shortages.
• Elevated natural gas prices are triggering a surge in LNG infrastructure investments. In the immediate term, however, Freeport LNG has pushed back its full recovery until March 2023.
• So far, the Atlantic hurricane season has been quiet, which, given the tightness of energy markets, is remarkably fortunate. This report highlights the risk from tropical storms and how it could disrupt production and LNG exports.
• In Europe, data centers are stockpiling diesel fuel to power local generators in case of blackouts. Major tourist attractions have been dimming the lights to reduce costs.
• Semiconductor production is remarkably energy intensive.

 Geopolitical news:

• One issue we have been watching closely is the political tension caused by high U.S. energy prices juxtaposed with the geopolitical goal of supplying Europe with energy. With midterms looming, the administration is clearly sensitive to domestic energy prices.  The massive SPR withdrawal, which we document each week in the above data, is part of the response.  However, this goal of keeping domestic energy prices low is in conflict with exporting enough energy to keep European nations “onside” with supporting Ukraine.  Over the past week, we have been starting to see signs of cracking.  The U.S. energy secretary is warning U.S. refiners not to increase exports to Europe, and threatening “actions” for companies that don’t comply.  At this point, we don’t think the administration would ban exports, but the idea remains under consideration.
  • Energy nationalism isn’t just a U.S. issue as the U.K. has threatened to cut natural gas interconnecting pipelines to the continent.
• On the other hand, the Russian economy appears to be doing better than expected. Appears is a key word, because the Kremlin hasn’t been forthcoming with economic data since the war started.  A report out of Yale suggests the Russian economy has been crippled by sanctions, but there has been a notable pushback against this claim.  An article in The Economist suggests the Russian economy is holding up, in part, because Russia is still selling oil and natural gas.  Greek tankers seem to be the conduit of much of these sales; however, when the EU enforces new insurance rules later this year, those sales may dry up.  There is no doubt that sanctions have had a negative impact on Russia, but Russia’s reaction to them has also had an ill effect on the West as well.
• There are reports that Israeli warplanes (F-35s) penetrated Iranian airspace. Although unconfirmed, it appears this action was designed to test Iranian radar defenses.  Along with reports that the U.S. and Israel held exercises over the Red Sea to simulate an attack on Iran, this news does suggest the idea of an attack on Iran remains a possibility.
• We also note that tensions between Iraqi Kurds and Iran are escalating, with the latter trying to influence governance and policy in this region of Iraq. Although the Kurds themselves are divided, they are united on the goal of controlling oil and gas flows from their region.  Baghdad has never been comfortable with this arrangement, but at times has been forced to tolerate it.  At present, there is no national Iraqi government in place, and so it is likely that Iran is trying to keep the Kurds from expressing their independence.
  • The U.S. and Iran rarely agree on much, but there are reports Washington and Tehran are not comfortable with the lack of a government in Iraq and Muqtada al-Sadr’s behavior in preventing a new administration from forming. Tensions between Shiite groups aligned with al-Sadr and with Iran led to riots and some fatalities.  At present, the rioting has ended, but tensions remain high.  The crux of this issue between al-Sadr and the other Shiite groups is that Iraq has been governed, since the fall of Saddam Hussein, by a Shiite-dominated legislature that apportions power to all the various Shiite groups.  Much like Lebanon, those not part of al-Sadr’s group want to keep it that way.  Al-Sadr dominated the last elections and wants to control the legislature without sharing power.
• Despite the report above, the U.S., EU and Iran continue to negotiate a return to the JCPOA. The U.S. has responded to Iran’s recent demands, but it isn’t clear that Tehran will accept this proposal or call for additional negotiations.  Iran continues to make demands, suggesting that it isn’t in a rush to resume the pact.
  • Israel has sent its defense minister to Washington along with the head of the Mossad to discuss the negotiations. Israel has opposed the pact.
  • Swedish and German intelligence suggest Iran has been trying to acquire nuclear technology for weapons.
  • As we noted last week, Iran has been holding crude oil, condensate, and products offshore in tankers. It is estimated that this source could rapidly add around 90 mb of oil and related products to global oil supplies.  This expansion is one reason why the administration is pursing a resumption of the deal.
  • It is also becoming clear that the Kingdom of Saudi Arabia is leading an effort to offset the return of Iranian crude oil by pushing for OPEC+ production cuts. This is a clear sign from the KSA of its opposition to a resumption of the agreement.  The drop in oil prices at mid-week was said to be due to OPEC+ signaling no output reductions, which may be an indication that the Iran nuclear deal is stalled.
  • The U.S. Navy had a confrontation with Iranian naval forces in the Persian Gulf. The Iranians apparently tried to capture a U.S. surface drone.
• The sanctions on Russia have mostly removed Moscow from the dollar system. India is starting to settle trade with Russia in INR.  Although this decision clearly benefits India, it isn’t obvious what Russia will do with the INR.
• Fighting has intensified in Libya, which has been in a civil conflict since Qaddafi was ousted in 2011. Often when conflict rises, oil flows are adversely affected.

 Alternative energy/policy news:

• Renewable energy consumption is rising rapidly, with China holding the position of largest consumer.
• California is banning the sale of gasoline powered internal combustion engine vehicles by 2035. If the state holds to this plan, it will likely push automakers to expand EV production.
  • Last week, we noted that Texas was banning firms from conducting business with the state if they had an ESG policy that curtailed investment in fossil fuels. This appears to be a bid to sway national policy via state regulations.  California does similar actions, such as what the above bullet point suggests.  Given that California’s state GDP is 14.6% of U.S. GDP compared to 8.8% for Texas, businesses tend to pay closer attention to the former.
• EVs remain a high-cost vehicle choice. Although there are a few lower cost options, as the chart below suggests, getting into an EV is mostly a $40k+ purchase.

       (Source:  Axios)

• • One factor driving the price of EVs higher is the goal of giving the cars the same range as a gasoline powered vehicle. However, when “fill up” of electricity can be done daily in one’s garage, an EV with a much smaller range might be more practical for everyday use and be cheaper to make.
  • We remain bullish on metals required in the conversion away from fossil fuels because it doesn’t appear that the demand is impossible to fill. At the same time, miners continue to find that local opposition is delaying the building of new mines for the materials required for batteries.

• Where are the hurricanes? So far, this has been a remarkably quiet Atlantic hurricane season.  Strong wind shear in the Caribbean has dissipated tropical waves and there haven’t been a lot of squalls coming from Africa.  It’s still too early to declare an “all clear” as the usual peak is around September 10,  but, given the tightness of the energy markets, a slow hurricane season is a bit of good fortune.
• The Western U.S. is facing a hot week.
• China has seen some rain which has eased drought conditions, but energy conditions remain fraught. China has persistent water issues that appear to be worsening.  The drought is leading to greater coal use.
• Mexico announced the opening of a state-owned lithium miner.
• Nuclear power is making a comeback. We noted recently that Japan is reopening reactors closed after the Fukushima incident.  Germany is reconsidering its decision to end nuclear power.  So is California.  Although strong opposition will likely continue, nuclear offers carbon-free baseload electricity which is attractive.
• One response to climate concerns is geoengineering. Geoengineering is the process of using engineering interventions to cool the planet, reduce carbon in the atmosphere, adjust rainfall, etc.  These interventions are highly controversial because, in theory, they could change weather patterns that could disadvantage some areas of the world while supporting others.  They could also have unanticipated side effects.  Also, given that geoengineering could be introduced by private actors, there is grave concern about how to control the process.  At the same time, we are already seeing efforts by nations in the Middle East to change rainfall patterns through cloud seeding and other techniques.
  • Major oil companies are making further investments into carbon capture.
• Coal is a dirty fuel in more than one way since not only is it the most carbon intensive of fossil fuels, but it also creates water pollution and solid waste. These wastes often are laced with heavy metals.  However, researchers are taking that waste and are working to extract these metals for the potential use in batteries.
• The Danish energy minister is calling for the streamlining of permits for wind farms. We note that permitting issues were a key part of the Inflation Reduction Act.
• “Smart glass” a product that adjusts to light in a way to increase the efficiency of HVAC units in buildings, is expected to expand due to a provision in the Inflation Reduction Act.
• China is expected to continue to dominate the solar panel industry.  However, the emergence of U.S. industrial policy is expected to see the U.S. increase solar equipment manufacturing.

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