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

(N.B.=> due to Independence Day, the next report will be issued on July 14.)

The DOE has resolved its systems issues and released weekly data for 6/17/22 and 6/24/22.  We update the data below.

After a sharp correction on recession worries, crude oil prices are recovering.

(Source: Barchart.com)

Crude oil inventories fell 2.8 mb compared to a 1.0 mb draw forecast.  The SPR declined 7.0 mb, meaning the net draw was 9.8 mb.

In the details, U.S. crude oil production rose from 0.1 mbpd to 12.1 mbpd.  Exports and imports both fell 0.2 mbpd.  Refining activity rose 1.0% to 95.0% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  This week’s report hints we are starting the usual seasonal decline in inventory that should last into early September.  We are not seeing declines similar to last year but something more like the average path.

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 seen in 2004.  Using total stocks since 2015, fair value is $100.86.

With so many crosscurrents in the oil markets, we see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $65 per barrel, so we are seeing about $50 of risk premium in the market.

 Market news:

• Last week, Energy Secretary Granholm met with energy executives. Although the runup to the meeting suggested a “woodshed” moment, in reality, the government really can’t do much to get more product supply to market.  Refineries are running around 95% of capacity, and short of nationalizing the industry and running at a loss, there isn’t much that can be done to ease prices.  It seems the meeting was cordial.  Perhaps the administration realizes (finally!) that lambasting the industry isn’t conducive to cooperation.
  • In a sense, the administration wants the oil and gas industry to expand furiously in the short run, only to strand the assets in the long run. That isn’t likely to work.
  • The White House has proposed a gas tax holiday for the summer. Not surprisingly, Congress seems unlikely to act.  Cutting the tax only to reinstate it in September, about nine weeks before the midterms, won’t be attractive to any incumbent facing election.
  • It’s not just high crude oil prices that have boosted gasoline prices; high corn prices have also boosted ethanol costs..
  • When an oil well is drilled, it is unusual to completely drain all the available hydrocarbons. Most of the oil is tapped through natural pressure.  As pressures fall, oil companies have various techniques to further pull oil out of the ground.  Water and carbon dioxide injections are commonly used to “enhance” production.  Even shale oil is, in a sense, derived from a technique to further wring oil out of existing fields.  Now, oil companies are “re-fracking” existing frack wells to pull out more oil.  This process has lower costs, in part, because all the well infrastructure is in place.
• The Dallas FRB has released its Q2 survey of oil and gas firms in its district. The key takeaway—94% of firms report they are suffering from supply chain issues, and nearly 70% don’t see them getting resolved in less than a year.  The biggest shortages are in equipment and personnel.
  • Despite these hurdles, there is no doubt that Europe can no longer trust Russia for its energy supplies. That means the U.S. could see demand for its energy rise and foster expansion of the American energy sector.
• The DOE estimates the global excess capacity for crude oil is below four mbpd. French President Macron says that the leaders of the UAE and KSA have told him their ability to expand production is severely limited.  Javier Blas of Bloomberg examines the notion that Saudi Aramco (2222, SAR, 39.20) can actually sustain production at 12.0 mbpd.  The level hasn’t been tested in a while, and, quietly, some officials suggest this number may represent a temporary peak, but it’s not a sustainable level.
• The European Parliament is considering a plan that would obligate EU nations to fill their natural gas storage to a level of 80% by winter. As supply turmoil continues, various EU nations are calling on European consumers to reduce consumption now to allow for a supply replenishment.
  • The European chemicals industry is seeing its business model upended. The model was based on cheap, plentiful Russian natural gas.  As that supply curtails, the chemical industry in Europe is scrambling for natural gas, which is a key feedstock.
  • Russia cut flows on Nord Stream 1 to 40% capacity for “pipeline repairs.” There is a growing fear these flows will be permanently curtailed, perhaps to thwart efforts to build storage.
  • Gas supply issues may lead to the reopening of the Groningen gas field, which had been closed because it was thought the depletion was causing earth tremors.
  • The U.K. is considering blocking natural gas interconnecting pipelines to the continent in the case of high demand. The EU is warning that cutting off these connectors could result in the U.K. being isolated from the European natural gas pipeline system.
  • Germany is warning of financial contagion, a kind of “Lehman event” due to Russian gas supply cuts.
  • We are reaching a point where an “all of the above” energy policy is the more likely outcome over a bias toward renewables. The reason?  A nation relying on renewables may find itself forced to deindustrialize.
• Although the public usually believes “oil is oil,” in reality, there are differences. In general, oil is either heavy or light, sour or sweet.  The first group refers to viscosity; some oil flows easily (shale oil, for example) while others are thick (Canadian tar sands, Venezuelan Orinoco).  The second group refers to sulfur contents.  Refineries tend to specialize in these differences.  A refinery constructed to refine sweet/light won’t easily be able to process sour/heavy.  Over the past 20 years, U.S. refineries increasingly invested in the ability to process heavy/sour crude oil on the idea that as production dwindled, the most plentiful oil would be of that grade.  Shale oil upended that forecast, which is why the U.S. mainly exports shale oil and imports heavy/sour crude.  The SPR has both types, but in the most recent release, the government has primarily been selling the heavier/sour grades, which U.S. refineries can process most efficiently.  It is estimated that at the end of October, when this phase of the SPR release ends, the U.S. will only have 179 mb of the heavier/sour crude oil.  This will make the SPR a much less effective price buffer going forward.

 Geopolitical news:

• The G-7 is meeting this week to discuss the Ukraine situation and the energy crisis. As we note below, the climate change agenda has clearly taken a back seat to trying to avoid an energy crisis.  The G-7 has made this switch abundantly clear.  The group admits fostering new investment in oil, gas, and coal may be necessary.
  • The group has unveiled new sanctions on Russia. One item being considered is a price cap on Russian oil.  In other words, the group plus others could decide they would buy Russian oil, but only at a price of $60 per barrel.  This action would limit the revenue to Russia and ease the supply crunch.  Such schemes are ripe for manipulation.  Marc Rich ended up afoul of U.S. law attempting something like this in the 1970s, leading him into exile to Switzerland.
  • Despite G-7 efforts to reduce Russian oil sales and revenues, simply put, the sanctions are really leading to a massive restructuring of oil flows. India is a primary beneficiary.  Interestingly enough, these sales have not led to a rise in the price of Urals crude oil, suggesting that the sanctions have not been fully offset.
  • Not surprisingly, India and China seem to be warming to the idea of a price cap on Russian oil. It shows, to some extent, the limits of China’s support for an ally.
  • The S. continues to offer support to ease the EU’s energy situation, but American supply constraints undermine that effort.
  • The energy crisis in Europe could lead to the fragmentation of the EU.
• Although the EU continues to try to revive the Iran nuclear deal, we still contend the odds of success are nil. Still, our take isn’t curbing the desire of the EU to make a deal.  To some extent, the Biden administration seemed to want this, too, although we have doubted the president really wants to use political capital for this mission.  We note Special Envoy Robert Malley is traveling to Qatar to engage in backchannel discussions with Tehran. The main sticking points remain.  Iran wants guarantees that a future administration will not renege on this arrangement (which is not possible as an administration cannot easily bind a future one), and Iran wants the Islamic Revolutionary Guard Corps removed from the U.S. designation as a Foreign Terrorist organization (which would be politically costly for the Biden administration).
  • Iran has applied[1] to join the BRICS bloc.
  • France is pushing to ease pressures on pariah petrostates such as Iran and Venezuela.
• Meanwhile, there are increasing worries that Israel, backed by its new partners in the Abraham Accords, may attack Iran’s nuclear facilities. Israel successfully destroyed nuclear facilities in Iraq and Syria, but the hardened facilities in Iran were thought to be strong enough to prevent Israel from successfully doing the same.  However, that was before Israel was allied with the Persian Gulf states.  Earlier assessments assumed Israeli warplanes would fly from Israel across semi-hostile territory to strike Iran.  The length of the trip would limit the number of sorties and reduce the chances of success, but if Israel’s warplanes could use bases in the Persian Gulf states, it is likely there would be multiple days, if not weeks, of air operations.  Of course, if the Persian Gulf states cooperated with Israel, it would open them up to Iranian retaliation.  So far, energy markets are mostly ignoring this risk.  Given the political risks that President Biden is taking by traveling to the region, we suspect that the war situation may be the reason for the visit.
• South America is facing turmoil caused by the energy situation:
  • In Ecuador, the government is being forced to retreat from increasing gasoline prices due to protests.
  • In Peru, farmers and truckers are scheduled to go on strike in protests against higher diesel and fertilizer prices.

 Alternative energy/policy news:

• It’s summer in the northern hemisphere, which means rising temperatures and increasing air conditioning demand. We are seeing unusually high temperatures in the Far East, including China, Japan, and Russia, especially Siberia.  Norilsk, Russia, about 180 miles from the Arctic Circle, recorded temperatures in excess of 89^o, a new record.  Japan has issued warnings of potential blackouts from the heat. China is not only facing high temperatures but flooding as well.  China’s temperatures have sent power consumption to new records.
  • Attributing all unusual weather events to climate change is fraught with risk, but Climate Central claims it has developed ways to determine what is caused by higher CO₂ concentrations and what is mere seasonal variation.
• When the Ukraine war broke out, some in the analyst community thought this event would speed up the energy transition. Instead, it appears to be leading to a return to fossil fuels.  It is becoming clear that Europe won’t tolerate deindustrialization in the face of dwindling Russian oil and gas supplies and instead is not only scrambling for oil and natural gas from other sources but is returning to coal.
  • Coal is having a renaissance of sorts in the U.S. as well, as natural gas prices rise.
  • To get an idea of just how strong the demand for coal is, Australia reports that thermal coal (the type used to make electricity) is now trading at a premium to coking coal (used in steel production). Given the higher value added from steel, such a premium is highly unusual.
• Although Tesla (TSLA, USD, 745.46) continues to dominate the EV space in the U.S., it faces increasing competition from the traditional automakers.
  • In the early days of the auto industry, vertical integration was common as the companies wanted secure supply lines. We notice similar behavior with EVs.
• As discussed above, climate change concerns tend to take a “back seat” when conventional energy costs rise. Sadly, addressing high costs by burning coal and oil doesn’t address the problems of rising CO2 levels.  Even without the events of the past few months, it was doubtful that goals would be met by clean energy production.  Direct removal of carbon from the atmosphere remains necessary if temperature containment is to occur.  Fortunately, removal efforts are showing signs of ramping up.  Big tech is a major funder of these efforts.
• Another emerging technology is to expand efforts to tap geothermal energy in the earth’s core. The key to this technology is a Soviet-era technique that employs gyrotrons.

  View PDF

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[1] Strictly speaking, the BIRC isn’t a formal organization, so it isn’t obvious how one “applies.”

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

Crude oil prices continue to rise in an orderly fashion.

(Source: Barchart.com)

Crude oil inventories rose 2.0 mb compared to a 2.0 mb draw forecast.  The SPR declined 7.7 mb, meaning the net draw was 5.8 mb.

In the details, U.S. crude oil production rose from 0.1 mbpd to 12.0 mbpd.  Exports rose 1.5 mbpd, while imports rose 0.8 mbpd.  Refining activity fell 0.5% to 93.7% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  This week’s report is consistent with the average pattern.  Note the average pattern shows declines into 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 seen in 2005.  Using total stocks since 2015, fair value is $97.79.

With so many crosscurrents in the oil markets, we see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $65 per barrel, so we are seeing about $50 of risk premium in the market.

Market news:

• Want a well-crafted primer on why the oil industry is struggling to lift production in the face of high prices? Check out this Odd Lots Podcast, as Joe Weisenthal and Tracy Alloway interview Peter Tertzakian about the hurdles in place that are preventing a greater expansion of output.  The interview makes it perfectly clear that supply problems will be with us for a long time.
• Last week, the IEA warned that global supplies for oil will likely be tight through 2023. Perhaps the biggest issue facing oil markets is that OPEC+ may be close to producing at capacity.  Capacity numbers in OPEC+ are a mixed bag. Throughout history they have usually been inflated because the cartel used capacity data to allocate production quotas.  The higher a nation’s capacity, the more they were allowed to produce.  OPEC+ is expected to allow producers to expand output to pre-pandemic levels in August, but capacity has fallen since then.  By August, it appears only the KSA and UAE will have available capacity, perhaps about 1.6 mbpd.  However, these producers may decide it is unwise to lift output further.  For most of the oil market’s history, there has been a cartel body limiting production.  This situation has led to prices higher than would have existed in a fully free market but with less volatility due to the supply buffer.  If OPEC+ uses up all its capacity, the only buffers will be strategic reserves, which are already being used.
• A couple of weeks ago, a fire at a U.S. LNG facility cut U.S. exports by up to 20%. Although initial reports suggested there would be a three-week outage, it now looks like full throughput won’t return until at least September.  Shortly after this news, Russia announced that gas flows to the EU would be curtailed due to the lack of repair parts, allegedly caused by sanctions.  Several European sources confirm that supplies have been reduced.  In addition, rising temperatures are boosting natural gas demand, making it difficult to build storage.
  • In response, Germany has instructed consumers to conserve energy so inventories can be rebuilt. The government has declared the first “alarm stage” of its gas emergency plan.  The plan has three stages, but essentially, if supplies are inadequate, industrial and commercial users face rationing, and prices will be free to rise.  If so, this action could reduce industrial output this winter.
  • Despite the environmental concerns, EU nations are returning to coal to ensure energy supplies. Germany, The Netherlands, and Austria are reopening some coal generation.  It is becoming clear that environmental goals will be missed to ensure adequate energy supplies.  The EU continues to pay lip service toward environmental goals.  In reality, faced with either an economic crisis or curtailing greenhouse gasses, the latter loses out.  In addition, as coal is being rediscovered, mining firms, like oil companies, have become cautious about expanding production.
  • Even though China has boosted its coal consumption, there are still worries that electricity production could be crimped later this summer due to tight fuel worries.
  • The EU announced a natural gas deal with Israel and Egypt. The U.S. is also making long-term supply commitments to Europe.
  • The IEA is warning the EU that Russia could cut off all natural gas supplies, and they should take steps to address that risk.
• The EU has increased sanctions on ensuring Russian oil and gas shipments. The U.S. is becoming increasingly concerned that this measure may be too effective, reducing supplies further.  Insurance companies may not have the capital to bear the risk of sanctions, meaning shipments may simply not occur.  The Treasury is trying to “thread the needle” of ensuring adequate oil supplies while preventing Russia from benefiting.  That outcome may not be possible.
• As high energy prices weigh on the political fortunes of the party in power, the administration is scrambling to determine ways to reduce energy costs. The Secretary of Energy met yesterday with energy executives.  A gasoline tax holiday has been proposed. Also under consideration are fuel export limits, although such measures would be a foreign policy disaster as they would force the EU and other global consumers to bear higher costs.
  • Relations between the administration and the energy sector are at a low state. The petroleum industry wants regulatory relief.  Environmentalists have been quite successful in blocking pipeline projects, in particular.  The industry wants the processes for building pipelines changed to reduce the ability of the courts to prevent expanding pipelines and other facilities.  Unfortunately, for the president, the environmental wing of the party understands that, due to the marginal cost structure of such facilities, once built, they will be used for decades.[1]  So far, the White House is trying to reduce gasoline prices by badgering the industry, most likely because it has concluded that blaming the industry is better politically than disappointing the environmental wing.
  • One oddity of the current oil market is that while U.S. refining capacity is running above 90%, China is sitting on lots of unused capacity. China manages its refineries primarily for domestic supply.  With the Chinese economy sluggish, product demand has been soft.  So far, China hasn’t shown much interest in lifting product exports.
  • U.S. gasoline prices have eased modestly, just before the July 4 weekend.

 Geopolitical news:

• Colombia has a new president who ran on curtailing Colombia’s oil and gas industry. Although important, oil and gas production has been falling in recent years.
• The Biden administration isn’t alone in trying to push back against high energy prices. Brazil’s president has created a revolving door for the CEOs of Petrobras (PBR, USD, 11.05) over the past year.  The company announced another fuel price hike, which wasn’t popular with the political class. However, the company is considering a temporary price freeze, perhaps to quell the unrest.
• Venezuela’s oil exports to Europe are resuming as the U.S. eases restrictions on Caracas.
• For the past year, we have cast doubt on the nuclear talks with Iran. As the odds of success decline, the potential for a “hot war” between Iran and regional powers is increasing.
  • Iran is apparently fortifying and expanding its nuclear facilities with a new tunnel network.
  • There are reports the U.S. has prescreened Israel’s attack plans to ensure American operations in the region would not be affected.
  • For the past couple of years, Israel has been using assassinations and other covert attacks to undermine Iran’s nuclear program. There are reports these operations are expanding.
  • This week, Iranian small vessels, manned by the Islamic Revolutionary Guard Corps, made a run at two U.S. Navy vessels.
  • The anti-Iran coalition appears to be expanding. We note that Turkey and the KSA appear to be mending relations, which frayed after Saudi operatives murdered Jamal Khashoggi on Turkish soil.  Turkey needs economic support from the KSA, and the latter needs Turkish military support against Iran.
• This report is a good backgrounder on the extent of Russia’s involvement with the EU energy supply. The EU believed that by becoming a large consumer of Russian energy exports, Moscow would avoid actions to jeopardize those sales.  Clearly, that was a mistake.  However, the Ukraine war isn’t just hurting Russia; it is also upsetting Europe’s politics.  We note that recent comments from Jens Plötner, a foreign policy advisor to German Chancellor Scholz, support relations with Russia.  For Germany, breaking the Russian energy habit will be hard.  Chancellor Scholz disavowed the comments from his aforementioned advisor.
• History shows that sanctions regimes are hard to maintain. Sanctions distort markets, often causing divergences between the prices of similar goods that market participants naturally want to arbitrage.  Although there has been a remarkably strong response to sanctions on Russia, we expect that over time, market participants will try to take advantage of the lower-priced sanctioned goods.  Thus, to monitor the degree of sanctions-busting, the Brent/Urals spread should provide some insight into how well sanctions are holding up.

(Source:  Bloomberg)

This chart shows the nearest contract for the Brent/Urals spread.  Before the war, Brent enjoyed roughly a $2 premium on Urals.  It is now around $35 per barrel and, so far, has shown little evidence of narrowing.  In general, if more buyers are able to purchase the cheaper Urals product, one would expect the price to rise, narrowing the spread.  Although we know India and China have been buyers of Russian oil, there still isn’t much evidence to suggest other buyers are participating.  In other words, we know sanctions are being violated, but for now, the degree of violation hasn’t been enough to bring lower oil prices.

Alternative energy/policy news:

• The FAA has announced new emission rules on commercial aircraft.
• The U.S. and several other nations have entered an agreement designed to secure critical minerals for the energy transition.
• If wind and solar power are going to replace fossil fuels, the issue of energy storage is critical. Currently, these renewables require fossil fuel or nuclear backup capacity, requiring redundant investment.  It is becoming clear that lithium-ion batteries are probably not the best solution for this need; this report discusses other metals and batteries being tested for this role.
• Environmental groups have used the courts to create environmental standards. That avenue is under threat from a group of state AGs.  As the U.S. pulls back from its hegemonic role, Congress may move to gain power over the regulatory apparatus.
• The problem of sourcing key metals for batteries has created a global scramble to find supplies. One answer could be recycling; Toyota (TM, USD, 156.80) announced a partnership designed to recycle batteries from its cars.
• The oil and gas industry is teaming up with the geothermal industry in what could prove to be an important expansion of the latter industry using the technology of the former.
• Although the Texas-Louisiana region is a key oil and gas producing region, it will likely also become an important hub for hydrogen.

  View PDF

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[1] The initial costs are high, but the marginal costs are low, meaning that once built, the throughput is cheap.

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

Crude oil prices continue to rise in an orderly fashion.

(Source: Barchart.com)

Crude oil inventories rose 2.0 mb compared to a 2.0 mb draw forecast.  The SPR declined 7.7 mb, meaning the net draw was 5.8 mb.

In the details, U.S. crude oil production rose from 0.1 mbpd to 12.0 mbpd.  Exports rose 1.5 mbpd, while imports rose 0.8 mbpd.  Refining activity fell 0.5% to 93.7% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  This week’s report is consistent with the average pattern.  Note the average pattern shows declines into 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 seen in 2005.  Using total stocks since 2015, fair value is $97.79.

With so many crosscurrents in the oil markets, we see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $65 per barrel, so we are seeing about $50 of risk premium in the market.

Natural Gas Update:

As we head into summer, we wanted to look at current natural gas fundamentals.  First, on a rolling 12-month basis, supply exceeds consumption.

The improved supply situation for the U.S. is partly due to rising production; however, we have also seen lower exports.  Given the U.S. promises to Europe, we look for exports to rise as the summer wears on.

For now, inventories are balanced as we move into summer.  We are in the injection season and thus, expect inventories to rise into November.

This model compares working storage to the estimated normal level.  We will be watching this model closely over the summer.

Market news:

• The Biden administration is attacking the energy industry.
  • Senator Wyden (D-OR) is proposing a 21% surtax on oil company profits considered “excessive,” applied to companies with over $1.0 billion in revenue. This tax would be in addition to normal taxes. Any profit exceeding 10% would be surtaxed.  It is not clear if this legislation would pass.  We doubt any GOP senators would vote for it, and Senator Manchin (D-WV) would probably oppose it as well.  Windfall profit taxes are commonly proposed during periods where energy prices are elevated.  The rationale is that high energy prices cause pain; the political class wants capital to bear some of the cost.  We note similar taxes have been proposed in the U.K.  The economics of such taxes are sketchy.  In general, taxing something means getting less of it.  Taxing oil company profits will not increase supply.  Most likely, Wyden wants to focus voter anger on the oil companies instead of Democratic party policy.
  • A more formidable risk comes from the White House, which is threatening direct measures against the oil companies. The moves are outlined in this letter.  S. Refining capacity has been stagnant for years in the U.S.  The last new refinery of significant size was completed in 1976.  There have been small additions to capacity, usually built around existing facilities.  In general, refinery utilization runs between 80% to 95% of capacity, with the high end occurring in the summer.  Moving above 95% invites trouble.  It is not uncommon to see refinery accidents and explosions if the system runs above 95% for any length of time.  The president is threatening actions, although realistically, there isn’t much he can do.  Even if he took the position, ala’ Hugo Chavez, and nationalized the refiners, he couldn’t get out much more product.  Nationalizing could force the refiners to run at zero profits, which is what I suspect is his ultimate goal.  The refining industry is facing a terrible future.  The administration has taken an anti-fossil fuel position for environmental reasons, which is justifiable.  But, if you set a policy in place, you must bear the consequences.
  • Although the actions and attitudes described above are understandable, the overall outcome probably won’t matter. The president and his party are gambling that blaming the oil companies will be a political strategy to blunt Americans’ anger over high prices.  To quote a famous movie…”it’s a bold strategy, Cotton.  Let’s see if it pays off for them.”
  • As we discuss below, the president is off to the Middle East next month, ostensibly to ask the KSA for more oil. The political optics are terrible.  Instead of visiting Texas or Alberta and engaging these sources for more energy, he will visit the Crown Prince Salman, a man the president described as a “pariah,” a leader who murders journalists.
• We are closely monitoring the natural gas market. A couple of factors are driving the market.
  • We are seeing an early summer heat wave. Last week, the Rockies were dealing with excessive heat, and that heat dome is now moving over the Midwest.  Here in St. Louis, the entire week is expected to be over 90^o, with at least three days over 100^o.  In a normal summer, St. Louis has three days of over 100^o.  The severity of these events is leading forecasters to give heat waves names like we do hurricanes.  High temperatures boost air conditioning use, and since most peaking power units are fired by natural gas, heat waves lift natural gas demand.  We have already seen record electricity demand in Texas.  What is concerning is that this is only June; July and August are usually warmer, so we could be in for a very long, hot summer.  We expect brownouts and blackouts to occur if temps remain elevated.
  • Last week, a fire at an LNG plant in Texas roiled the market. S. prices fell as the loss of the plant will temporarily lift supplies here.  The news got worse as plant managers indicated the repairs would take closer to three months instead of three weeks.  However, it sent EU prices higher, as the disruption will reduce LNG exports.  Prices were already ticking higher as summer arrived in Europe and Russia cuts supplies further.  This plant produces about a fifth of U.S. LNG, so the loss is a major problem.  LNG imports to Europe are increasing but still are expected to be tight this winter.  Before this event, there were concerns about natural gas supplies in Europe; the chances of rationing increased due to the fire.
• Drought continues to reduce western U.S. hydroelectric power, likely boosting demand for natural gas.
• Another U.S. oil refinery is set to close in 2023. Diesel fuel prices are hitting records, and gasoline is averaging $5.00 per gallon.  Crude oil prices remain below their all-time highs.
• S. oil firms remain reluctant to lift production, especially with talk of a windfall profits tax.
• Although it has caught little attention, there are reports that OPEC+ is considering removing all production targets in August. This would allow the cartel to produce full-out.  For most of the oil market’s history, some cartel body has restricted supply.  Market intervention was to prevent reservoir destruction.  Restricting output led to higher than market prices but also brought less volatility.  It is because the cartel always had some reserve capacity it could bring to market when prices surged.  If we are running out of spare capacity, not only could oil prices move much higher, but price volatility could soar.  The combination of less than advertised capacity within OPEC and the likely permanent loss of Russian supplies could lead to a high price/high volatility oil market.
  • We note that OPEC+ output actually fell in May.
• The U.S. and EU are trying to create a situation where the world could still take Russian crude oil but reduce how much Russia could earn on the sales via price caps. The idea is to create an oligopsony of buyers that would cap the price of Russian oil.  However, that outcome is already occurring to some extent, as evidenced by the widespread of Urals oil to Brent.
• PDVSA, the Venezuelan state oil company, is demanding prepayment for oil sales. Apparently, some buyers are taking crude oil from Venezuela and then not paying for the product.
• As global supplies tighten, there is a renewed interest in Canadian tar sands. Given the adverse environmental impact, the interest suggests that high prices are overcoming environmental concerns.
  • China is turning to coal power as the prices of other sources rise.

 Geopolitical news:

• Although the JCPOA talks continue, the news surrounding the talks continues to weaken the case for a resumption of the nuclear deal. Last week, we learned Iran shut off monitoring cameras on its nuclear facilities, and following censure by the IAEA, dismantled the devices.  Iran has publicly questioned the IAEA’s impartiality; if this U.N. body can’t be trusted, there is little the world can do to contain nuclear proliferation.  Iran did offer last-minute meetings to try to stave off censure, but this action failed, further undermining confidence that Iran isn’t on the path to a nuclear weapon.  Our position has been that there was little chance of a resumption of the nuclear deal, and so far, we have seen nothing to dissuade us from this position.
  • Iran and Venezuela have forged a 20-year cooperation agreement after Iran violated U.S. sanctions by delivering oil to Caracas.
  • Israel and Iran have been engaging in unconventional attacks for some time. There is growing evidence that Iraqi Kurdistan is becoming the field of battle.  Iran also believes Israel poisoned two of its scientists, killing both.
• After weeks of discussion, President Biden will visit the KSA and Israel next month. The administration hopes to encourage the KSA to increase oil production.
• Iraq’s largest political bloc resigned after it was unable to form a government. The concern is that Iranian-aligned groups will take power.
• Political conditions in Libya continue to deteriorate, leading to a near cessation of production. Simply put, Libyan output is estimated to be down 1.0 mbpd.  This loss would more than offset OPEC+ promised production hike.
• Algeria has suspended cooperation with Spain after the latter supported Morocco’s plan for Western Sahara[1]. Spain has influence over the disputed territory of Western Sahara, but Morocco controls 80% of the territory.  Unfortunately for Spain, it is dependent on Algeria for its natural gas supplies.  So far, Algeria hasn’t signaled that it would cut off supplies, but given the gas has been sold under long-term contracts at lower than market prices, we could see this dispute used to reset those prices.
• As the EU and the U.S. have either cut off or reduced oil purchases from Russia, Moscow has been forced to redirect sales to other areas. India has been quietly lifting purchases, enjoying deep price discounts.  India is now importing up to 1.0 mbpd compared with sporadic imports before the Russian invasion.  Although Washington opposes these imports, the U.S. has generally overlooked the purchases in order to maintain good relations with India.  However, it appears “enough is enough.”  The U.S. is asking India to “cool it” on the purchases.  If India fails to comply, the U.S. might implement secondary sanctions.
  • India has also raised the ire of the GCC over anti-Islamic comments from Bharatiya Janata Party (BJP) officials. The BJP is a Hindu party and has been accused of suppressing Muslims.
  • Despite sanctions and price discounts, Russia’s oil revenue continues to rise.

 Alternative energy/policy news:

• Although EVs hold great promise to reduce CO2 emissions, it should be recognized that producing these batteries is far from a clean process.
• The IMF is arguing that a realistic carbon tax is more effective in reducing the impact of greenhouse gases than accelerating clean energy.
• The U.S. is moving to standardize charging stations to make them universally compatible.
• As natural gas prices soar, interest in biomass has returned.
• As global grain supplies tighten, the debate over the best use of crops has returned. Specifically, the debate asks the question “should we use grains for fuel?”
• The Pentagon is partly funding a rare earths processing plant in Texas.

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[1] For background on this issue, see here and here.

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

Crude oil prices continue to rise in an orderly fashion.

(Source: Barchart.com)

Crude oil inventories rose 2.0 mb compared to a 3.3 mb draw forecast.  The SPR declined 7.3 mb, meaning the net draw was 5.2 mb.

In the details, U.S. crude oil production was unchanged at 11.9 mbpd.  Exports fell 1.8 mbpd, while imports fell 0.1 mbpd.  Refining activity rose 1.6% to 94.2% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  This week’s report is consistent with the average pattern.  However, we note that this week we had a decline in crude oil exports, which probably won’t be repeated.  Thus, we would expect a larger decline in stocks next week.

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 seen in 2005.  Using total stocks since 2015, fair value is $96.41.

With so many crosscurrents in the oil markets, we see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $65 per barrel, so we are seeing about $50 of risk premium in the market.

Market news:

• Although it has been well documented that the energy industry is suffering from a lack of investment, it appears the LNG industry is enjoying a rise in investment. LNG will be critical for the EU to wean itself off Russian natural gas supplies.  Germany, for example, is aggressively building LNG regasification facilities that will aid in the transition.
  • As LNG exports expand, tanker rates are starting to rise.
  • Tight natural gas supplies have led the natural gas industry to take another look at natural gas flaring. Flaring occurs when oil producers find natural gas in the oil drilling process.  If the well doesn’t have access to pipelines, it is prohibitively expensive to liquify it on site.  However, as prices rise, interest in somehow finding a use for this gas is expected to increase.  One potential use is to hook the gas up to mobile generators to mine bitcoin.
• Due to supply disruptions and geopolitical tensions, there is a natural tendency for nations to hoard supplies. It appears China is maintaining quotas on product exports despite rising Asian demand.
• The only oil company that bid on a lease in the Arctic National Wildlife Refuge has canceled the agreement.
• At the same time, high oil prices are encouraging investment in high-cost projects. The Vaca Muerta (dead cow) shale deposit in Argentina is getting a second look.
• As temperatures rise in the U.S., there are growing warnings of electricity blackouts. The DOE suggests the Midwest may be especially vulnerable.
• Between the abandonment of Russia by Western oil firms and the lack of storage, Russia has increasingly been forced to shut in production in highly complex fields. This development is raising concerns that some Russian oil and gas production will be permanently lost, leading to lasting shortages.

 Geopolitical news:

• Although President Biden has pushed off his Middle East trip until July, elevated oil prices are forcing the president to improve relations with the KSA. As we noted last week, OPEC+ agreed to lift output above its announced intentions.  However, the market is highly skeptical OPEC+ can make a difference, as most cartel producers are at capacity.
  • The political optics of going to Riyadh for oil and not reducing regulations to foster domestic production are unfavorable. But, in reality, given the president’s political coalition, there are no good outcomes here.
  • After promising more oil production, the KSA raised contract oil prices to Asia.
• As the world splits apart, the global oil trade is rapidly becoming regional. This development will lead to regional price differences and increase the potential for spot shortages.  We could see a return to the 1970s, where various designations of the source of different hydrocarbons carried different prices, taxes, and restrictions.  Running afoul of these laws led to Marc Rich fleeing the U.S.
• As we have discussed recently, the U.S. and Venezuela have been opening a dialogue. At the Summit of the Americas meeting this week, Cuba, Nicaragua, and Venezuela have not been invited.  Venezuelan opposition leader Juan Guaidó will attend but only as an observer.  If the Biden administration moves to normalize relations with Venezuela, it is likely Guaidó will be sidelined.

 Alternative energy/policy news:

• At long last, the Biden administration has clarified its position on imported solar panels. The U.S. will waive tariffs on solar panels from Southeast Asia for two years.  The U.S. has implemented tariffs on China, which is the world’s largest producer.  Domestic producers of the panels wanted tariff protection widened because they feared Chinese manufacturers were shipping panels to non-tariffed states, giving them access to the U.S. market without the import tax.  Installers feared that widening the tax would discourage demand.  Although the situation isn’t fully resolved, at least for now, imports from Southeast Asia should continue.
  • The administration is also invoking the Defense Production Act to boost the production of various clean energy products.
• CO₂ levels measured at the Mauna Loa observatory have reached a new record level, more than 50% higher than pre-industrial levels.
• As the world scrambles to adjust to the disruption caused by the Ukraine war, environmentalists fear that climate goals are being ignored.

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

Crude oil prices continue to grind higher despite reports of OPEC+ production increases and record SPR sales.

(Source: Barchart.com)

Crude oil inventories fell 5.1 mb compared to a 3.0 mb draw forecast.  The SPR declined 5.4 mb, meaning the net draw was 10.5 mb.

In the details, U.S. crude oil production was unchanged at 11.9 mbpd.  Exports fell 0.3 mbpd, while imports fell 0.4 mbpd.  Refining activity declined 0.6% to 92.6% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  This week’s report is consistent with last year’s pattern.  If that becomes the path for the next six weeks, a 10% decline in commercial stockpiles is in the offing.

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 seen in 2005.  Using total stocks since 2015, fair value is $92.85.

With so many crosscurrents in the oil markets, we see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $60 per barrel, so we are seeing about $40 of risk premium in the market.

Market news:

• The biggest news this week was the announcement of a partial oil embargo by the EU, but the second runner-up is also critical (the OPEC+ news comes in second). The U.K. has announced a windfall profits tax on energy companies.  The 25% tax is designed to offset the cost of subsidies to U.K. households. The argument for such taxes is that an unusual event has occurred, which will cause pain to the economy.  Without adjustments, households will face the full burden of the event.  A windfall profits tax attempts to split the burden of the event.  However, economics teaches that prices are signals; a jump in prices signals consumers to conserve and producers to expand output.  A windfall profits tax undermines the price effect, leading to more consumption and less supply than would occur without the measure.
• Although a change in power in Washington would likely improve the sentiment for the energy industry in the short run, it probably won’t change the long-term situation. One area of concern is that younger engineers are shunning the industry due to the stigma of contributing to climate change.  If the industry can’t find workers, it will be tough to grow regardless of the pricing environment.
  • We note that the House GOP has released a road map on energy. It’s mostly an “all of the above” plan, with the centerpiece being to streamline the permitting process for large infrastructure projects.
• Over the past year, we have seen several ESG actions taken against oil companies. We note that recently some of these measures have failed to be adopted.  Environmental actions at the company level tend to be limited by the goal of supporting the company’s continuing operations.
• As the world attempts to reconfigure natural gas supply chains, LNG is becoming increasingly important. Funding for new projects in the U.S. is increasing.  However, LNG growth is also affecting the usual seasonal patterns.  U.S. inventories are low despite high prices as more gas is diverted to world markets.
• Despite the EU oil embargo (see below), German consumers are using either EUR or USD to make payments on Russian oil.
  • India is increasing its purchases of Russian oil, enjoying a deep price discount.
  • The EU and the U.S. have enacted stricter sanctions on insurance, which could make it much more difficult to insure oil shipments. If sanctions on marine insurance develop, Russia could find itself unable to find buyers.
• As noted in the data section, the U.S. continues to move oil out of the SPR. Part of the reason for the release was to reduce energy prices.  Unfortunately, for most applications, crude oil isn’t directly used.  It must be refined into a petroleum product first.  Oil prices are high, but product prices, due to the lack of refining capacity, are even higher.
• The G-7 is pressing OPEC+ to lift production.
• Low water levels in the Western U.S. are threatening hydroelectric power.
• Natural gas demand is highest in winter during the home heating season. We have noted steadily rising summer demand as well.  The EIA reports that 88% of households used air conditioning in 2020; during the summer, peak demand is often supplied by natural gas, and air conditioning is a key driver of demand.
  • During the pandemic, there were state and local moratoria on utility shut-offs due to non-payment. It is estimated that 20 million households are behind on their utility bills, a collective arrears of $23 billion.  Although we doubt all these households will suddenly have their utilities shut off, this situation is unprecedented.  We may see a reduction in utility demand without some sort of workout plan.

Geopolitical news:

• At long last, the EU has managed to put together a partial Russian oil embargo. Hungary demanded an exemption and was granted one. Slovakia and the Czech Republic were also granted waivers.  The embargo will be phased in over the next six to eight months.  In the wake of the decision, Brent crude oil rose above $120 per barrel.  Albeit less than perfect, the ban is notable; by year’s end, some 90% of EU imports of Russian crude oil will be cut off.  It should also be noted that the nations exempted from the ban will likely face tariffs, which will discourage imports from Russia.
  • Russia is said to be selling oil to China via ship-to-ship transfers on the high seas. The goal for both parties is to elude sanctions.
  • As is typical of sanctions regimes, Russia is becoming adept at circumventing controls on its exports. Still, the “acid test” of the effectiveness of sanctions is the Urals/Brent spread, which continues to trade at a $35 per barrel discount compared to under $5 before the war.
• The most important impact of the sanctions and the partial import ban is that both are forcing a restructuring of trade and payment flows. Over time, Russia will sell more oil to China and India and less to the West.  At this juncture, the pipeline infrastructure isn’t in place for a seamless adjustment, so supply issues are inevitable.  It’s also important to note that refineries tend to tailor their facilities to specific types of crude oil.  This factor will increase the supply problems and keep prices elevated.
  • One interesting example of the impact of trade flows is that private Indian refiners are benefiting from cheap Russian crude, while state-owned refiners, locked into long-term contracts, are seeing their margins contract.
• The second-biggest story of the week is the OPEC+ announcement that it is increasing its monthly production targets to 65 mbpd from 0.40 mbpd. Although the news may improve the supply situation, the adjustment is rather modest.  On the announcement, oil prices rose.
  • However, we harbor doubts that the cartel producers can hit this number. Most members are already at capacity.  Throughout OPEC’s history, the KSA has tended to fill the gaps created by member states that fail to fulfill their quotas.  Our concern is that the Persian Gulf OPEC members have less spare capacity than advertised and thus may simply be unable to lift production meaningfully.
  • The political optics are plain ugly. President Biden is said to be preparing for a trip to the KSA.  During his campaign, he labeled the KSA a “pariah.”  Now he is traveling, hat in hand, for increased oil supplies.  The political opposition to meeting with the Saudi crown prince is growing.  Going the Riyadh instead of Houston to support higher oil production is hard to explain.
• High levels of corruption in Iran are undermining trust in the regime. A recent building collapse is further evidence of deteriorating trust.  There is also growing civil unrest due to rapidly rising food prices.  Meanwhile, the odds that the U.S. will return to the JCPOA remain long. Iran is demanding the U.S. rescind its labeling of the Iran Revolutionary Guard Corps as a terrorist organization.  That action would make little political sense.  Reducing the likelihood further are U.N. findings that Iran has enriched enough nuclear material to make a nuclear weapon.  Sanctions have become less effective over time.  Their presence limits the number of buyers of Iranian crude oil, forcing a discounted price.
  • One reason the Europeans keep working at talks is that they see Iran as a potential source of natural gas. Even with a deal, there is no guarantee that relations between the U.S. and Iran will improve in the future.  Iran lacks the investment for boosting exports to the EU, and Europe may be reluctant to make those investments only to see them stranded by a change in U.S. policy.
• Iran seized two Greek tankers in the Persian Gulf in retaliation for the Greek seizure of an Iranian tanker at the behest of the U.S.
• Libya’s woes continue. A pipeline leak has reduced export flows.  Rising food prices and the ongoing civil conflict will keep Libyan flows at risk.  Since the fall of the Gaddafi regime, Libyan production and exports have been volatile.  Unfortunately for Europe, the bulk of Libyan exports goes to the continent.
• The UAE and Israel have signed a free trade agreement, removing tariffs on 96% of traded goods. As the U.S. reduces its influence in the region, a coalition, which includes Israel, to isolate Iran has been developing.
• The KSA and Algeria are seeing improved relations. Although differences still exist, Riyadh’s outreach to Algeria could be part of a broader attempt to improve relations across North Africa.

Alternative energy/policy news:

• We expect nuclear power to become more important in the future, but currently, the West is heavily dependent on Russia for fuel. Russia provides about a third of enriched fuel globally.
  • Japan is warming up to nuclear power, a major change since Fukushima.
• Japan is testing the generation of electricity through ocean currents. Ocean currents tend to be more stable than other unconventional energy sources and could become baseload if conditions are favorable.
• S. officials continue to squabble over solar tariffs.
• Volvo (VLVLY, USD, 17.81) announced it has built the first vehicle using fossil-fuel-free steel. There was no discussion of relative costs.  Self-driving EV trucks are starting to show up at mining sites.
• EV sales are forecast to triple by 2025. A key to expanding sales is lowering prices, which is starting to occur.
  • On the other hand, battery makers are complaining about higher input costs.
• Substituting hydrogen for fossil fuels in industrial applications is garnering attention, but the costs involved are daunting.
• If the world is going to shift away from fossil fuels, a massive expansion in mining investment is required. It isn’t happening yet.

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