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

Oil prices are moving steadily higher in an orderly fashion.

(Source: Barchart.com)

Crude oil inventories fell 7.4 mb compared to the 2.0 mb draw expected.  The SPR fell 0.9 mb, meaning without the addition from the reserve, commercial inventories would have declined 8.2 mb.  We note the SPR is at its lowest level since October 2003.

In the details, U.S. crude oil production rose 0.2 mbpd to 11.2 mbpd.  Exports rose 1.0 mbpd, while imports rose 0.1 mb.  Refining activity continued to rise, increasing 1.3%, exceeding expectations by 0.9%.  The rise in product inventories was due to an increase in refining.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are beginning the summer withdrawal season.  Note that stocks are already below the usual seasonal trough seen in early September.  A normal seasonal decline would result in inventories around 465 mb.  Our seasonal deficit is 69.3 mb.

Based on our oil inventory/price model, fair value is $52.64; using the euro/price model, fair value is $70.16.  The combined model, a broader analysis of the oil price, generates a fair value of $61.12.  Oil prices are still “rich” relative to inventory levels but are in line with the dollar’s level.

Market news:

• A development we have been closely watching has been the financial industry’s reaction to climate change. The ESG movement is a key element of this trend.  The Biden administration has issued an executive order mandating increased disclosures of climate risks for firms.  The SEC has recently issued comments on this issue and will force firms to hold shareholder votes on the topic.  Increasingly, the oil and gas industry is finding it difficult to acquire funding for projects.  As this situation continues, oil supplies will likely decline, which is supporting higher oil prices.
  • The SEC’s action has led to a pushback from the industry.
  • And, the firms themselves, in a bid to improve shareholder value, have become less focused on production at all costs.
  • Some of the majors are considering the sale of shale assets in light of these changes.
• It’s summer, and temperatures are rising. The West is dealing with excessive, record-breaking heat and drought conditions, which are pressuring the electric grids in both California and Texas.
  • California is expanding its use of commercial-scale batteries to deal with the fluctuations caused by alternative energy.
• We have noted for some time that environmentalists are targeting pipelines to reduce oil and gas flows. The Keystone XL pipeline is now officially canceled.  As this tactic expands, it is lifting the value of existing pipelines.

Geopolitical news:

• In recent weeks, about the only bearish news for oil has been the lifting of sanctions on Iran.  News that some sanctions were lifted pushed prices temporarily lower last week.  We do expect that a modicum of return to the 2015 nuclear deal with Iran is possible.  We think that issue is mostly discounted, and Iran will remain a problem for policymakers, even if a deal is reached.
  • Iran has sent two warships to Venezuela, which may be part of a weapons deal.
• Venezuela quietly supported FARC rebels who operated in Colombia for years.  Recently, some of the fringe post-FARC groups have become a problem for Caracas.
• Saudi Aramco (2222, SAR, 35.30) has issued bonds so it can maintain its dividend.  The desire to keep the company an income stock may mean the KSA will keep production restrained.
  • The Saudi embassy in the U.S. is accused of helping its citizens facing criminal charges in the U.S. to flee prosecution.
• Europe is continuing to move forward with a carbon adjustment tax on imports.  This tax would not allow firms to import products from nations with less strict environmental rules.  However, the tariffs also act as a trade barrier.  Meanwhile, the G-7 leaders did not commit to a deadline for ending coal consumption.
• PM Trudeau’s environmental policies are creating conflicts for the Canadian oil and gas industry.
• China may have had a leak at one of its nuclear reactors.

Alternative energy/policy news:

• We are seeing a rising drumbeat of interest in hydrogen as an alternative to hydrocarbons.  Although electric vehicles continue to dominate the headlines, it is too soon to count out fuel cells and hydrogen as our future fuel.  We note the administration has launched a hydrogen initiative designed to generate hydrogen from “green” sources at a much lower cost.  Currently, the ordinary way to create hydrogen is to separate it from natural gas.  But, as any high school chemistry student has learned, you can also produce hydrogen by separating it from oxygen in water.  Using green electricity in the process offers promise.  Japan has been supporting hydrogen development.  China is also getting into the mix.
• China has come to dominate the solar panel industry by using aggressive subsidies.  The support has undercut the price of panels, increasing the adoption but decimating the industry outside of China.  Apparently, Beijing has decided to back away from this support.  This is now helping to boost the industry outside of China.  Meanwhile, solar panel installations in the U.S. have risen sharply over the past year.  On a less optimistic note, recent studies suggest solar panels are degrading faster than expected, meaning they may need to be replaced sooner than anticipated.
• One surprise over the past 15 years has been the rise of the fracking industry, which changed the geopolitics of oil.  The U.S. became much less dependent on foreign sources of oil; this changed American foreign policy.  As the U.S. moves away from fossil fuels, it is beginning to look like foreign dependence on rare earth metals may be developing.  Rising demand has lifted the prices of these metals recently, and China dominates their processing.
• The expectation of rising uranium demand is starting to attract interest from hedge funds.
• Climate mitigation plans all generally call for atmospheric carbon removal.  So far, there are no commercially feasible plans for that, but a group of scientists is looking to harness the ocean’s ability to absorb carbon from the air.  Their research seeks to pull carbon from the oceans, thus allowing the oceans to absorb additional carbon from the atmosphere.  The concept is to use calcium and magnesium to capture the carbon in rocks (specifically calcite or magnesite, the stuff of seashells). The researchers are catalyzing the process with electricity.  Interestingly enough, the process creates hydrogen as a byproduct.
• The Biden administration paused oil and gas leases on federal land when it took office.  A judge this week put an injunction on the order, which would allow leasing to resume.  But the issue is only temporarily resolved.
• Voters tend to support environmental restrictions as long as the costs are low.  Swiss voters last week narrowly rejected a plan to reduce CO₂ emissions.
• China’s Belt and Road project has come under fire for funding coal-fired electric projects.  However, a number of the projects have been scuttled due to rising costs.

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

Oil prices have moved above the $60 to $68 per barrel trading range and are testing $70 per barrel.

(Source: Barchart.com)

Crude oil inventories fell 5.2 mb compared to the 3.3 mb draw expected.  The SPR fell 1.3 mb, meaning without the addition from the reserve, commercial inventories would have declined 6.5 mb.

In the details, U.S. crude oil production rose 0.2 mbpd to 11.0 mbpd.  Exports rose 0.4 mbpd while imports rose 1.0 mb.  Refining activity jumped 2.6%, which accounts for the rise in product inventories.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are beginning the summer withdrawal season.  Note that stocks are already below the usual seasonal trough seen in early September.  A normal seasonal decline would result in inventories around 465 mb.  Our seasonal deficit is 64.4 mb.

Based on our oil inventory/price model, fair value is $50.31; using the euro/price model, fair value is $69.15.  The combined model, a broader analysis of the oil price, generates a fair value of $60.16.  Oil prices are outpacing inventory levels but are in line with the dollar’s decline.

Market news:

• Although the Biden administration has numerous “green” policies in the works, the reality is that oil and gas will still be used for the foreseeable future.  And, there are political concerns that lawmakers in oil-producing states need to address.  We note that the administration confirmed a Trump-era project in Alaska, which favors Sen. Murkowski (R-AK).
• Options market activity suggests traders are projecting an increasing likelihood of $100 per barrel of oil.
• China is taking steps to reduce its oil demand by preventing oil firms from selling import permits to small refineries.

Geopolitical news:

• It is well known that China has a stranglehold on rare earths, but more important is that Beijing has even more market power in rare earths processing.  That activity is environmentally “dirty,” and since China was willing to suffer the damage from that industry, the developed world allowed it to dominate.  Now, nations realize that to construct key products for the transition away from fossil fuels, they must maintain relations with China.
• Balancing environmental concerns often collides with economic growth issues.  China is easing some environmental restrictions due to worries about slowing economic growth.
• Iran is expanding its disinformation campaign in the U.S. to create discord.

Alternative energy/policy news:

• Investors and courts are increasing pressure on oil companies.
  • Royal Dutch Shell (RDS.A, USD, 40.10) and Exxon (XOM, USD, 62.89) are being forced to reassess investment models.  Recently, a Dutch court ordered Royal Dutch Shell to cut emissions by 45% by the end of the decade.  The company is starting to take steps to address the court’s decision.
  • Exxon has seen activist groups put three of their members on the company’s board.
  • Chevron (CVX, USD, 109.03) is facing investor pressure as well.
  • Increasingly, oil companies are finding their political influence is waning with governments.  As their impact declines, the regulatory environment will become increasingly hostile.
• We expect these actions to continue, which is bullish for crude oil and natural gas prices.
• The EU has seen its plans for carbon tariffs on industrial products leaked.  Called the “Carbon Border Adjustment Mechanism,” the Europeans are considering tariffs based on carbon prices for fertilizer, metals, cement, and power.  The countries most at risk of the tariff are Russia, the U.K., and Turkey.  We may see a WTO challenge brought to the plan under the idea that the EU is using environmental rules as a form of protectionism.
• Another pattern we have noted is that environmental groups are constraining pipeline development through legal action and protests.  If these actions work, it will strand some assets; at the same time, it makes existing pipelines increasingly valuable.
• We hold that nuclear power will become more popular as it creates zero carbon emissions electricity.  However, opposition to the industry is formidable, as seen by the problems faced by the only new nuclear project in the U.S.
• The U.S. is considering tariffs on Chinese rare earth magnets.  The goal is to build alternative supply sources.  The administration is also trying to support American battery manufacturing.
• Alternative energy has its own quirks—like solar eclipses.
• Although reducing carbon emissions is a necessary step in controlling climate change, to really combat the problem, pulling carbon from the atmosphere will probably be necessary.  There are many projects underway.  Carbon capture projects are also being planned. Current CO² levels hit a new high in May.  Recently, temperatures in the Middle East reached 125.2^o Fahrenheit.
• Ford (F, USD, 15.55) announced it will invest $30 billion in electric vehicles (EV’s) by 2025 and expects that 40% of its sales will be EV’s by 2030.
• China’s Sinopec (SNP, USD, 53.30) is investing in plants designed to make 500,000 tonnes of green hydrogen per year; production is scheduled to begin in 2025.

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

(Due to staff vacation schedules, the next report will be published on June 10.)

 Oil prices continue to trade in a range from $60 to $68 per barrel.

(Source: Barchart.com)

Crude oil inventories fell 1.7 mb compared to the 1.0 mb draw expected.  The SPR fell 1.6 mb, meaning without the addition from the reserve, commercial inventories would have declined 2.3 mb.

In the details, U.S. crude oil production was steady at 11.0 mbpd.  Exports rose 1.5 mbpd while imports rose 0.9 mb.  Refining activity rose 0.2%.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are through the peak of the winter/early spring build season.  In the second half of June, stockpiles usually decline.  Note that stocks are already below the usual seasonal trough seen in early September.  Our seasonal deficit is 51.7 mb.

Based on our oil inventory/price model, fair value is $46.78; using the euro/price model, fair value is $69.77.  The combined model, a broader analysis of the oil price, generates a fair value of $57.58.  Although the slow decline in stockpiles is price supportive, the weakening dollar is much more important in lifting the model’s fair value.

Market news:

• Last week, we noted the IEA reports that outlined the path to zero emissions by 2050.  It essentially argued that to reach this goal would require an immediate halt to oil and gas drilling.  As the dust clears, a few new “known/unknowns” emerge.
  • Is this a real plan or an outline designed to show the impossibility of reaching these targets?
  • Is the IEA really becoming carbon negative?  After all, it was a group designed to represent the interests of the oil-consuming nations against OPEC.
  • The full ramifications of the study are that oil and gas will follow the path of coal, nuclear has to get bigger, consumer lifestyles are going to suffer, and the oil-producing nations are in serious trouble.
  • Private studies tend to confirm the IEA’s position.
  • We are starting to see a pushback against the IEA from member nations.  If the IEA is right and continued investment means targets won’t be hit, investments in climate mitigation (seawalls, tighter building standards, rebuilding of residential housing outside of flood plains, etc.) are going to rise.
• China is adjusting its tax regime on oil and petroleum products.  It will likely lead to heavier crude imports and less exports of product, raising product prices to Asia.
• NOAA is predicting an active hurricane season.  Tropical activity often disrupts energy production and trade flows.
• Drought in the Western U.S. continues unabated and will affect electricity grids.

Geopolitical news:

• Last weekend, we saw Belarus force a civilian airliner to land in Minsk; a dissident was taken off the plane and arrested.  Although the EU did apply some travel sanctions, in reality, the EU is dependent on oil and natural gas flows that transit Belarus.  This fact weakens the ability of nations to apply sanctions.
• On June 18, Iran will hold presidential elections.  The Guardian Council approves candidates for the position, and it has eliminated all the moderate or popular candidates.  This ensures a hardline conservative will take power.
• Oil prices have faced downside pressure on reports the U.S. is close to returning to the nuclear deal with Iran.  One factor often overlooked is that nations try to play their powers off against each other.  U.S. hostility toward Iran has forced Tehran to team up with China and Russia, but that outcome isn’t always in Iran’s best interest.  So, Iran wants better relations with Washington for no reason other than to reduce the influence of China and Iran.
• The KSA is continuing its policies of privatization to improve its fiscal situation.  There are plans to sell off $55 billion of assets over the next four years.
• After years of civil conflict, it appears Libya has come to a peace deal.  It may lead to higher production from the country and certainly more stable flows, and it has a modestly bearish influence on oil prices.

Alternative energy/policy news:

• The U.K. is about to embark on its carbon pricing market; energy firms and others are bracing for higher costs.  France is also expanding its climate regulations, and in an interesting development, the populist right is supporting the measures.
• Nuclear power is also expanding, with 50 new reactors being constructed in 16 different nations.
• The Biden administration is imposing new rules through executive order to combat climate change.  A number of these orders affect financial services, which would likely curtail lending to firms that provide hydrocarbons.
• China’s CO² emissions are up 9% from pre-pandemic levels.
• As the demand for green power rises, oil majors are getting into the business of supplying this energy.
• Indonesia, a major nickel supplier, is going to build battery plants.
• At the time of this writing, Exxon (XOM, USD, 58.47) is facing an activist shareholder who opposes its business model and wants to fill four board seats.  It appears at least two of the seats were won by the activist hedge fund, Engine No. 1.  We view such activities as likely to increase over time and will eventually reduce oil supplies.
• Dutch courts are ordering Royal Dutch Shell (RDS.A, USD, 39.28) to take more aggressive steps to address climate change issues.

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

Oil prices continue to trade in a range from $58 to $68 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 1.3 mb compared to the 2.0 mb build expected.  The SPR fell 1.9 mb, meaning without the addition from the reserve, commercial inventories would have declined 0.6 mb.

In the details, U.S. crude oil production was steady at 11.0 mbpd.  Exports rose 1.5 mbpd while imports rose 0.9 mb.  Refining activity rose 0.2%.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are through the peak of the winter/early spring build season.  In the second half of June, stockpiles usually decline.  Note that stocks are already below the usual seasonal trough seen in early September.  Our seasonal deficit is 53.1 mb.

Based on our oil inventory/price model, fair value is $46.24; using the euro/price model, fair value is $69.19.  The combined model, a broader analysis of the oil price, generates a fair value of $56.99.  Although the slow decline in stockpiles is price supportive, the weakening dollar is much more important in lifting the model’s fair value.

As the economy recovers, distillate demand is accelerating.

Market news:

• The IEA issued some rather draconian news this week, arguing that if the world wants to reach zero carbon emissions by mid-century, investment in oil and gas must stop immediately.  We have been expecting something akin to this at some point, which is why we are more favorable to oil as a commodity compared to oil companies.  Disinvestment from energy is becoming part of the ESG movement; because oil is a depleting asset, ending investment will lead to shortages before demand declines.  It is quite possible that what is happening to oil is what has already happened to coal.
  • Although we suspect disinvestment will lead to higher oil prices, it is also possible that oil companies unconstrained from ESG issues may conclude it is better to increase production before demand is lost.  Russia is apparently considering such a strategy, and if Russia does it, we suspect the KSA will too.

Geopolitical news:

• In a surprising development, the U.S. has decided to waive sanctions on the company and CEO involved in the Nord Stream 2 project.  The U.S. has been warning for months that it didn’t want to see the pipeline completed and was preparing to implement sanctions if the program wasn’t halted.  The Biden administration even appointed a special envoy to the project.  Instead, the administration will sanction the actual vessels involved but spare the CEO of the project, a former Stasi member who has close ties to Vladimir Putin, from direct sanctions.
  • The administration’s caving on this issue is remarkable.  First, it’s a major win for Russia.  The pipeline will allow Russia to bypass pipelines in Ukraine, removing a chokepoint for natural gas sales.  Second, although it protects Germany from Ukrainian disruptions, it makes Berlin more dependent on Russian energy.  The U.S. has wanted to sell LNG to Europe so completing the pipeline will reduce demand for American gas.  Third, it adds to fears in Eastern Europe that Germany is allying with Russia to their detriment.  Fourth, it makes the U.S. complicit in isolating Eastern Europe.
  • We suspect the administration wanted to curry favor with the Merkel government.  If so, this decision appears short-sighted.  Germany is holding national elections in September.  The Greens, who lead in current polls, oppose Nord Stream 2.  Therefore, if the administration had simply waited, it would likely have had a German government more aligned with its interests.
  • It is possible the Biden administration may rethink this position.  In other words, this action may be a trial balloon.  However, if the U.S. maintains this decision, it appears to us to be giving a major win to Russia, who, by the way, has provided support for the hackers who recently struck the Colonial pipeline.
• Russia is facing carbon taxes on its energy exports to Europe; EU energy consumers are starting to complain.
• As the Biden administration moves to return to the Iran nuclear deal, it is important to remember that the Obama administration considered it an intermediate step to establishing Iran as the regional hegemon.  It is also important to note that Iran, even in its current economic turmoil, spends an estimated $15 billion to $20 billion per year supporting its proxies in the region.  If sanctions are lifted, it will support the activities of its proxies.
• The Maduro government has closed the last independent newspaper in Venezuela.

Alternative energy/policy news:

• The Supreme Court gave a victory to the oil and gas industry this week.  The city of Baltimore has sued 20 major companies over climate change and wanted to try the case in Maryland’s state courts.  The highest court agreed with the industry that a more appropriate venue would be Federal courts.
• To meet carbon stabilization, it is generally thought that carbon reduction will likely be necessary.  This process can be as simple as planting trees or as sophisticated as factories that pull CO² out of the air.
• One of the problems with solar and wind energy is that it is interrupted.  At sundown, or if the wind doesn’t blow, power is removed.  So far, the solution has been to have natural gas turbines that can be fired up when renewable energy is not available.  However, there is increasing investment in batteries that will store electricity during the daytime and when there is wind and discharge it when solar energy and wind energy are lacking.  If this becomes a trend, it will be a serious threat to natural gas demand.
• Another element of using less carbon is the electrifying of the economy.
• Although EVs continue to dominate the movement away from gasoline and diesel, hydrogen is still an alternative.

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

Tightening supplies have lifted crude oil prices toward the top of the recent trading range.

(Source: Barchart.com)

Crude oil inventories declined 0.4 mb compared to the 1.8 mb build expected.  The SPR fell 1.4 mb, meaning without the addition from the reserve, commercial inventories would have declined 1.8 mb.

In the details, U.S. crude oil production rose 0.1 mbpd to 11.0 mbpd.  Exports fell 2.3 mbpd while imports were unchanged.  Refining activity declined 0.4 mbpd.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are through the peak of the winter/early spring build season.  In the second half of June, stockpiles usually decline.  Note that stocks are already below the usual seasonal trough seen in early September.  Our seasonal deficit is 52.6 mb.

Based on our oil inventory/price model, fair value is $46.65; using the euro/price model, fair value is $68.54.  The combined model, a broader analysis of the oil price, generates a fair value of $56.86.  Although the slow decline in stockpiles is price supportive, the weakening dollar is much more important in lifting the model’s fair value.

The DOE is continuing to reduce the SPR.

(Source:  DOE, CIM)

This action is a bearish factor for prices, but the gradual nature of the sale has not had much of an effect thus far.  We expect another 7.0 mb of sales to occur this year.

Market news:

• This week’s big news is the ransomware disruption of the Colonial pipeline.  The line, which runs from Houston to New England, is a critical element of U.S. energy infrastructure.  Although we expect flows to begin by the weekend, it will likely take at least a week to 10 days for conditions to normalize.  Meanwhile, refineries are reducing operations because the product has nowhere to go.  Restarting will also take time.  As this picture shows, drivers are scrambling to find gasoline.

(Source:  AP)

Local gasoline prices are rising rapidly.  Meanwhile, government officials are trying other forms of transportation to move the product to markets facing shortages.  This situation will affect the energy data for the rest of May.

• Michigan is threatening to close a pipeline that runs from Canada to the U.S.  A portion of the pipeline passes across the Great Lakes, and there are fears a rupture could be catastrophic.  At the same time, the lines have run for over 70 years without incident.  The threat is raising tensions between the U.S. and Canada.  Trade is conducted through the USMCA, and thus, Ottawa may have legal remedies to halt the closure.  Meanwhile, Michigan Gov. Whitmer is threatening to seize profits from Enbridge (ENB, USD, 40.12), the pipeline operator, for continuing to operate the pipeline.  If this situation leads to a disruption, the timing could not be worse, given the turmoil caused by the Colonial pipeline situation.
• We continue to see news on the Texas freeze-out.  During the crisis, state regulators implemented a program that pays industrial users to reduce their natural gas consumption.  Paradoxically, this led to the curtailment of natural gas as firms involved in the natural gas infrastructure were taken offline.

Geopolitical news:

• Crosscurrents in Iranian/U.S. relations continue.  Negotiators from the Biden administration are in discussions with Iran, and there are optimistic reports that the two sides may come to an agreement on restoring the 2015 Nuclear Agreement in a matter of weeks.  However, it is also evident that there is a high degree of ambiguity in what both sides want; in reality, it is unlikely that a full return to the original deal is possible.  Meanwhile, low-level skirmishes between the U.S. Navy and the Iranian Revolutionary Guard Corps continue in the Persian Gulf.  The fact these continue suggests wide divisions still exist.
• Iran has confirmed that talks between Tehran and Riyadh are underway, but not much else is known.  The fact that the two sides are talking does suggest the KSA expects the U.S. to withdraw from the region, thus forcing Iran and the KSA to make some sort of agreement.

Alternative energy/policy news:

• The EU carbon price is rising rapidly, hitting a new record of €50 per tonne.
• There are increasing worries that rapidly rising base metals prices will slow the conversion to electric transportation.  There is also a growing realization that the mining required to acquire these metals is far from green.
• The IEA reports that wind and solar power rose last year.  The U.S. has approved the first offshore wind farm.

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

Tightening supplies have lifted crude oil prices toward the top of the recent trading range.

(Source: Barchart.com)

Crude oil inventories declined 8.0 mb compared to the 2.0 mb draw expected.  The SPR fell 1.0 mb, meaning without the addition from the reserve, commercial inventories would have declined 9.0 mb.

In the details, U.S. crude oil production was steady at 10.9 mbpd.  Exports rose 1.5 mbpd while imports fell 1.2 mbpd.  Refining activity rose 1.1 mbpd.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are through the peak of the winter/early spring build season.  In the second half of June, stockpiles usually decline.  Note that stocks are already below the usual seasonal trough seen in early September.  Our seasonal deficit is 53.0 mb.

Based on our oil inventory/price model, fair value is $46.25; using the euro/price model, fair value is $66.02.  The combined model, a broader analysis of the oil price, generates a fair value of $55.09.

Market news:

• Exxon (XOM, USD, 60.99) is facing increasing investor pressure to change its direction from a fossil fuel company to something else.  This is a theme we think has legs; essentially, regarding the previous point, transportation is shifting from drilling to mining.  The company isn’t the only energy firm coming under scrutiny.
• Michigan is threatening to close a pipeline that runs from Canada to the U.S.  A portion of the pipeline passes across the Great Lakes, and there are fears a rupture could be catastrophic.  At the same time, the lines have run for over 70 years without incident.  The threat is raising tensions between the U.S. and Canada.  Trade is conducted through the USMCA, and thus, Ottawa may have legal remedies to halt the closure.

Geopolitical news:

• The situation between the U.S. and Iran continues to be fluid.  There are rumors circulating that the U.S. was willing to release some frozen funds to Iran in return for Iran releasing prisoners.  This rumor was denied, but the comments may either signal that something is going on, or it was offered as a trial balloon.  At the same time, American and Iranian vessels are engaging in close encounters in the Persian Gulf.  Such close calls raise the possibility of an accident that would raise tensions.
• Saudi Aramco (2222, SAR, 35.65) and India’s Reliance Industries (RELIANCE, INR, 1921.50) are in talks; the former is considering a minority stake in the Indian company.  In a first, Saudi Aramco is discussing using stock to fund the purchase.
• The EU is facing pressure from the industry to implement a carbon equalization tax.  This tax would raise tariffs on imported goods that don’t apply the same low carbon standards as Europe employs.

Alternative energy/policy news:

• The Senate has voted to restore methane control rules for the oil and gas industry.  They were suspended by the previous administration, and there are expectations that even tougher rules may be in the offing.  To some extent, this swing in policy is a growing problem; political polarization is leading to conditions where policy swings violently between governments, hampering long-term planning.
• China is rapidly becoming the dominant producer of electric vehicles.  Interestingly enough, a sizeable portion of the new capacity is coming from startups.  The U.S. is planning to keep pace, but China’s large domestic market and its ability to streamline approval will tend to give them an advantage.
• Cobalt prices are up 40% this year.  It is a key component of batteries, with most of the metal coming from the Congo.  Acquiring important metals is a significant issue surrounding the shift to electric vehicles.
• One of the overlooked issues surrounding the transition from fossil fuels is the amount of land required to “green” the economy.  In the end, there is a strong case for nuclear and carbon-captured natural gas, simply because it will be hard to expand the footprint for wind and solar to meet the nation’s demand for electricity.
• We have been watching the solid-state battery industry development for some time.  Here is a new entrant.  Solid-state batteries hold great promise because they would hold more energy and recharge much faster.
• Data from NOAA show that temperatures have turned warmer.
• Despite promises, it doesn’t appear that the change from fossil fuels to green energy will lead to no loss of blue-collar jobs. Instead, there is a higher likelihood of job losses which will make selling the policy difficult politically.

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

After the recent rally in prices, the market is consolidating recent gains and establishing a larger trading range between $68 to $58 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 0.1 mb compared to the 1.0 mb draw expected.  The SPR fell 1.4 mb, meaning without the addition from the reserve, commercial inventories would have declined 1.3 mb.

In the details, U.S. crude oil production declined 0.1 mbpd to 10.9 mbpd.  Exports were also unchanged while imports rose 1.4 mbpd.  Refining activity rose 0.4 mbpd.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are now at the peak of the winter/early spring build season.  Until the Texas freeze, we were seeing a counterseasonal decline.  This week, stockpiles were mostly steady.  We are currently at a seasonal deficit of 40.6 mb.

Based on our oil inventory/price model, fair value is $43.72; using the euro/price model, fair value is $65.91.  The combined model, a broader analysis of the oil price, generates a fair value of $53.66.

(Sources:  DOE, CIM)

One of the factors that led to last year’s price collapse was the fear the market would run out of storage capacity.  To prevent that outcome, the U.S. purchased around 20 mb of crude oil from late April into early July.  Since peaking at 656.1 mb, the government reduced the SPR to 637.8 mb in February.  It held stocks at that level until three weeks ago when the government began to reduce the SPR again.  We note that current SPR levels are below the level where the pandemic affected the market.  In fact, this week’s reading is the lowest SPR level since 2003.

Congress has mandated a sale of 10 mb this year; so far, they have sold 3.6 mb of that mandate.  We have been a bit surprised at the speed of the sale.  However, it does appear that the plan is to move quickly to meet the mandate.  Longer-term, the SPR poses a problem.  If the U.S. holds on to the oil, and the world moves away from it, the reserve could become a stranded asset, similar to an oil company’s oil reserves when oil isn’t used.  This issue would suggest the government should sell the reserve down before it loses its value.  At the same time, the economy still consumes a significant amount of oil, and having the reserve in place protects the economy from a supply shock.  It is possible that environmentalists would protest the sale of the oil to prevent its consumption from lifting carbon emissions.  Another use could be to contain oil prices if the lack of investment by oil companies curtails supply and lifts the price.  The SPR will bear watching in the coming months; although another 7.4 mb will be sold, what the administration does after that could be important.

Market news:

• The shipping industry is being forced to move from high sulfur bunker fuels to less polluting ones.  Although lower sulfur diesel is the likely alternative, hydrogen is also a potential replacement.
• Exxon (XOM, USD, 56.96) is facing an activist revolt.  The company’s management has been resolute in maintaining its fossil fuel production in the face of climate change regulation.  A group of stock activists is pushing the company to reconsider, offering a slate of new directors.
• Although U.S. production has rebounded from the pandemic lows, it remains well below the previous peak.  Returning to that peak will likely require shale firms to attract funding, which remains a serious challenge.

Geopolitical news:

• The KSA is planning to sell off additional parts of Saudi Aramco (2222, SAR, 35.80).  Ascertaining the motive for steadily selling off what used to be a strategic asset by the kingdom is not exactly clear.  It could be that CP Salman simply needs the money.  We suspect the KSA realizes the age of oil is coming to a close and, thus, monetizing the country’s biggest asset while it still has value makes sense.
• CP Salman indicated that he wants to improve ties with Iran.  We have been watching the two nations take tentative steps to reduce tensions.  On the one hand, the KSA and Iran have aspirations to be the dominant regional power.  On the other, as the U.S. begins to back away from the region, these nations will need to figure out how to cope with the resulting power vacuum and may conclude that they will need some degree of cooperation to prevent chaos.
• Total (TOT, USD, 44.92) declared force majeure on a $20 billion LNG project in Mozambique.  The project and the country have been under attack from Islamic insurgents.  This project is Africa’s largest private investment, and the declaration is a clear setback for the company and the region.
• A leaked tape in Iran confirms what we have suspected for some time—the Iranian Revolutionary Guard Corps (IRCG) is the real power in the country.  We continue to watch to see if, when Ayatollah Khomeini dies, if the IRGC continues the fiction of the rule by clerics or simply takes power.
• The U.S. is signaling to Iran that it will consider removing some sanctions to facilitate a return to the Obama-era nuclear deal.  It is unclear if this will be enough to entice Iran to reduce uranium enrichment.
  • At the same time, the U.S. Navy and Coast Guard and elements of the IRGC have been engaging in skirmishes in the Persian Gulf.  It is unclear why the hostilities have emerged.  It is possible Iran is probing the Biden administration to gauge a response.  Tehran could be using the tensions to improve its bargaining position.  Nevertheless, anything there is a confrontation, the risk of an escalation is possible.

Alternative energy/policy news:

• Economists generally accept the notion that controlling carbon emissions will be best served by an appropriate carbon price.  Once a price on carbon emissions is put into place, the powerful market mechanism will be triggered, which will lead to society better balancing the need for energy against the adjusted environmental cost.  The market mechanism is efficient in securing outcomes, but its efficiency can be brutal.  One key problem is that the market pays little attention to who bears the burden of the cost, and it is often applied to those least able to handle it.  We note that President Biden’s climate policy says nothing about carbon pricing.  We doubt this isn’t due to economists around him not suggesting it should be part of it; instead, this is likely a political calculation.  So, despite the industry calling for carbon pricing, the president’s plan relies on less efficient mandates.
  • The oil industry is facing an increasingly hostile regulatory and tax environment.
• Although improving the power grid in the U.S. is peripherally associated with addressing climate change, the administration has allocated $8.0 billion in its climate package to this goal.  The U.S. electrical grid is substandard.  The Texas experience last winter made that evident.  There has been underinvestment in the grid for years.  If wind power is going to expand, a better grid will be necessary to bring that power from the rural areas where the wind blows to the urban areas where the power needs are the greatest.
  • The administration is also pushing for an expansion of offshore wind projects.  These have a certain allure; if they are over the horizon, no one on land sees them.  Yet, these projects face state regulations and other hurdles.  The administration has been arguing that green projects will spawn high-paying jobs, but that remains to be seen.  In fact, if high labor costs are part of the process, it may reduce the expansion of green energy.
• The U.S. is considering a European plan to mandate climate risk exposures.  Although disclosures can be a powerful tool, it is also notable that annual reports are full of footnotes that often investors overlook.  It is quite possible that the goal of disclosures is a form of “greenwashing,” which will do little more than admit that there is a climate impact to a company’s activity but little more.
• A U.N. study is calling for better management of methane leaks from oil and gas projects.  If the industry cannot control such leaks more effectively, it runs the risk of curtailing natural gas production, which, although not completely green, has much lower carbon emissions than other fossil fuels.  This is especially true in China.  Substituting natural gas for coal would have a marked effect on reducing greenhouse gas emissions.  It will need to get that gas from abroad, and if regulation due to methane reduces that supply, we may end up with the continued use of coal.
• One problem with reducing the use of fossil fuels is that we are moving from dense to less-dense energy sources.  Although efficiency gains in consumption may offset some of this problem, the fact remains that much of the industrial revolution was built on getting more energy out of smaller sources.  One way to overcome this problem would be to apply the world’s most dense energy source, uranium.  We note that the industry has been enjoying a bit of a renaissance as environmentalists rediscover the benefits of nuclear power.

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

After the recent rally in prices, the market is consolidating recent gains and establishing a larger trading range between $68 to $58 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 0.6 mb compared to the 3.4 mb draw expected.  The SPR fell 0.7 mb, meaning without the addition from the reserve, commercial inventories would have declined 0.1 mb.

In the details, U.S. crude oil production was unchanged at 11.0 mbpd.  Exports were also unchanged while imports fell 0.4 mbpd.  Refining activity was steady.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are about two weeks to the end of the winter/early spring build season.  Until the Texas freeze, we were seeing a counterseasonal decline.  This week, stockpiles were mostly steady.  We are currently at a seasonal deficit of 34.9 mb.

Based on our oil inventory/price model, fair value is $43.72; using the euro/price model, fair value is $65.05.  The combined model, a broader analysis of the oil price, generates a fair value of $53.19.

Gasoline consumption is now above the five-year average.

So is distillate demand.

It is also notable that demand is well above last year when the lockdowns were implemented.

Market news:

• The primary forecasters for the oil markets have updated their forecasts.

For the most part, demand is expected to rise compared to last year.

• One of the themes we have applied to our Asset Allocation has been that the oil and gas industry would be starved for capital due to ESG issues.  And so, the better place to invest isn’t in the industry but in the commodity itself.  Although energy stocks have done well this year, they have not done as well as the commodity overall.  We have further evidence that ESG concerns are affecting capital to the industry.  First, private equity, a source of funding for the industry, is drying up.  Second, the industry faces the problem that changes in demand and regulation could lead to stranded assets.  Therefore, a company with a development project runs the risk that by the time the fields start producing, the demand for that oil may not exist.  Large firms are starting to sell off these projects; smaller firms are taking the chance that the drop in demand may not materialize as soon as expected and are buying up these projects.

Geopolitical news:

• Talks with Iran on restarting the nuclear deal have begun.  Although there is optimism surrounding the talks (the fact they occurred at all is notable), Iran’s decision to enrich uranium to the 60% level presents a serious problem for negotiations.
  • A complicating issue for these talks is that Iran has national elections in June, and parties within Iran are using the talks for political gain.  Hardliners in Iran are expecting strong gains in the elections, as the country has navigated the U.S. crackdown and survived.  Entertainment media is said to be undermining the current foreign minister who might be a candidate for president.  In Iran, Mohammad Zarif is a moderate; a thinly veiled serial makes him out to be a fool.
  • At the same time, the leadership is trying to deal with a series of attacks thought to be sponsored by Israel.  The pace of events suggests that Israel has built a network of spies.
  • An Israeli delegation is traveling to Washington to discuss the Iran nuclear deal.
• The U.S. has generally acted to maintain order in the Middle East; before WWII, the U.K. played the role of regional hegemon.  As the U.S. withdrawals from the region, the fear is that without an outside power maintaining order, the region will spiral into persistent conflict.  Although China and Russia have made moves to increase their influence in the region, there are doubts that either nation has enough naval power to project order into the area.  However, it is also possible that regional powers could maintain order themselves.  We note that Saudi and Iranian officials met in Baghdad recently to discuss relations.  Although the two powers vie for regional hegemony, both have reasons to talk.  The KSA would like to wind down the conflict in Yemen and needs Iran to cooperate to contain the Houthis.  Iran would like to see oil export restrictions lifted and needs investment.  Both nations have denied talks occurred (which we view as a good sign that the negotiations have substance).  Although we have doubts that the parties can get along, at present, both need “space” to recover, and that alone might be enough for at least a temporary improvement in relations.  Eventually, Iran and KSA may be able to define spheres of influence that could stabilize the region…assuming Turkey agrees.
• The KSA and Greece signed an agreement that would lead the European nation to install a Patriot missile system in the kingdom.
• China has become the dominant supplier of solar panels.  This fact presents dissonant objectives to U.S. climate policy and foreign policy.  On the one hand, increasing solar power capacity is part of reducing carbon emissions from electricity.  On the other hand, there is evidence that some solar panel components come from Xinjiang, likely from incarcerated labor.  As the Biden administration gathers world leaders for a climate summit, it is unclear how this dilemma will be resolved.
  • China has agreed to join the climate summit.

Alternative energy/policy news:

• Exxon (XOM, USD, 55.29) is proposing a $100 billion project to capture carbon among facilities in the Houston area.  Overall, environmental groups tend to oppose these measures, fearing that (a) they won’t work and (b) they encourage hope that society can continue to use fossil fuels and rely on carbon capture.  Despite these concerns, carbon capture technology will likely continue to be studied because it has political potency, and we may need it to control carbon that is removed from the atmosphere.
• The administration is pushing a “clean jobs initiative” as part of its infrastructure package.
• After carbon emissions fell last year due to the pandemic closures, emissions are rising rapidly as the economy reopens.  Emissions are set to rise 4.8% this year, the fastest growth since 2010.
• Although lumber prices have been on a tear, trees have a competing use in absorbing and capturing carbon dioxide.  Carbon markets are offering tree growers an option to cutting down their forests, and some are using the carbon markets to postpone harvesting.  This situation, if it continues, could exacerbate lumber supplies.
• One of the roles in oil and gas development is the “landman,” a person who scours county records to see who owns the mineral rights to land and then pitching the owner for the right to develop the asset.  Like many jobs in the commodity business, it is “boom and bust.”  When development is rapid, landmen could make an impressive living.  When the inevitable downturn occurred, they usually just scraped by.  But, one saving grace was that oil and gas was a depleting asset; as long as there was oil and gas drilling, there was the need for their services.  As the long-term outlook for oil and gas demand darkens, the landmen have moved to selling the wind and solar rights to land.  The problem is that these sources of energy are renewable, meaning the rights, once sold, probably won’t be needed again.  As the industry evolves, the occupations tied to it will adjust as well.
• The EU continues to delay a decision on whether natural gas is “green” or not.  Although natural gas isn’t without emissions, it is much cleaner than coal or oil.  The delays are hampering the industry’s ability to adapt to policy changes.

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

After consolidating for a month, prices are starting to move higher.

(Source: Barchart.com)

Crude oil inventories fell 5.9 mb compared to the 2.4 mb draw expected.  The SPR fell 1.1 mb, meaning without the addition from the reserve, commercial inventories would have declined 7.0 mb.

In the details, U.S. crude oil production rose 0.1 mbpd to 11.0 mbpd.  Exports fell 0.9 mbpd, while imports fell 0.4 mbpd.  Refining activity rose 1.0%.

(Sources: DOE, CIM)

This chart shows the seasonal pattern for crude oil inventories.  We are about three weeks to the end of the winter/early spring build season.  Until the Texas freeze, we were seeing a counterseasonal decline.  This week, stockpiles declined more than forecast.  We are currently at a seasonal deficit of 30.3 mb.

Based on our oil inventory/price model, fair value is $43.89; using the euro/price model, fair value is $64.06.  The combined model, a broader analysis of the oil price, generates a fair value of $52.74.

For the first time since December 2019, gasoline consumption has reached the five-year average, further evidence of economic recovery.

Market news:

• The IEA is forecasting oil demand will reach 96.7 mbpd this year, up 5.7 mbpd from last year’s depressed levels.  Supply is recovering from the Texas disruption.
• In a similar vein, OPEC is also optimistic about this year’s consumption, citing stimulus programs and vaccinations.
• Saudi Aramco (2222, SAR, 35.60) has made a deal to sell a 49% stake in its pipeline business.  The company received $12.4 billion for the sale.

Geopolitical news:

• Iran’s nuclear facility at Natanz was attacked last week.  The bombing destroyed some centrifuges for enriching uranium and also disrupted electrical power.  The damage was extensive and will set back Iran’s nuclear program.  Despite the attack, Iran declared it would enrich uranium to the 60% level for the first time ever.  Although this is still below nuclear weapons strength, getting to 60% demonstrates Iran is approaching the nuclear weapons threshold.  We suspect Tehran is making this move to enhance its position in indirect negotiations with the U.S.  Iran is demanding that the U.S. remove sanctions put in place during the Trump administration.  The Biden government has indicated this isn’t going to occur without Iran pulling back from uranium enrichment.  We believe that current negotiations to return to the Obama-era nuclear agreement will likely fail; simply too much has occurred since it was established, and trust levels are too low.

Alternative energy/policy news:

• The state of New York is restricting pension investments in oil sands.  The goal of the state is to have its investments to net-zero greenhouse gas emissions by 2040.
• The Biden infrastructure package has a $16 billion provision to fund the plugging of abandoned oil wells.  These abandoned wells often emit methane, a potent greenhouse gas.  Reception for the idea is mixed.  The oil industry is mandated to plug wells when they are abandoned.  The industry has a habit of selling older wells to smaller, less capitalized firms that often can’t afford to cap the wells.  Thus, they abandon them when the wells stop producing.  The worry is that if the government pays for them, the industry will have an even greater incentive to shirk its duties.  On the other hand, the program would employ former industry workers who often lack other attractive job opportunities, and the wells probably won’t be addressed through normal channels.  We would not be surprised to see an attempt to put a user tax on oil drillers to prevent the moral hazard this proposal creates.
• There is an effort by the EU to create a law against “ecocide,” the deliberate and systemic destruction of the government.  If approved, it might create a movement to bring ecological destruction to the level of genocide, making it an international crime.
• The U.S. is moving toward the electrification of its transportation system.  Making this change will require different materials than internal combustion engine vehicles.  Many of these materials fall into the category of “rare earth” minerals.  Although the U.S. does have some capacity in this area, China remains the primary source of these goods.  It will be years before the U.S. and others can overcome China’s dominance.
  • There are increasing concerns that the mining industry might struggle to meet the demand for copper.
  • One area of interest is the development of the solid-state battery.  It would be safer than current batteries, recharge quicker, and hold a greater charge capacity.  A recent decision by South Korean battery groups to settle a legal dispute removes a potential snag in supply.
  • The CME is launching a lithium futures contract.  The creation of a contract will improve price transparency.

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