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

The report was delayed due to the Martin Luther King Jr. holiday.  Here is an updated crude oil price chart.

Commercial crude oil inventories unexpectedly rose 4.4 mb, when a decline of 1.3 mb was forecast.

In the details, U.S. crude oil production was unchanged at 11.0 mbpd.  Exports fell 0.8 mbpd, while imports declined 0.2 mbpd.  Refining activity rose 0.5%.

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s rise is normal (although it seemed to surprise most analysts).  If we follow the seasonal pattern, inventories will rise about 10% into mid-April.  That situation should be factored into the current price but the anticipated rise in stockpiles isn’t a positive for the market.

Based on our oil inventory/price model, fair value is $44.83; using the euro/price model, fair value is $70.97.  The combined model, a broader analysis of the oil price, generates a fair value of $56.43.  The wide divergence continues between the EUR and oil inventory models.

In geopolitics, we continue to watch with great interest the situation with Iran.  The U.S. withdrawal from the JCPOA led Iran to violate its restrictions on enriching uranium.  It has also moved further toward acquiring a domestic nuclear weapon.  The incoming Biden administration has signaled it would like Iran to return to the constraints of the JCPOA; we have doubts Iran will accept this program, fearing that a future administration will withdraw again.  We note the U.S. has shifted Israel from the European command to Central command.  For years, the U.S. put Israel under the supervision of the European command to avoid upsetting the Arab states.  From an operational standpoint, it makes more sense for Israel to be in Central command and now that several of its Arab neighbors have normalized relations with Israel, the emerging alliance structure in the region should benefit from the switch.

• Islamic State is returning.  It claimed responsibility for two suicide bombings in Baghdad.  This group has shown remarkable resilience.  Although the U.S. and other allies seemingly eliminated the group a couple of years ago, if efforts are not maintained, it has the habit of re-emerging.
• Venezuelan oil is under sanction by the U.S.  China is putting additives in Venezuelan oil to mask its origin and transferring cargos at sea to avoid sanctions and acquire Venezuelan crude, “laundering” the shipping documents through Swiss shipping companies.  According to reports, Venezuela accounts for 50% of China’s oil imports.

On the policy front, we are seeing the following developments:

• The OCC has ruled that banks cannot exclude the Energy sector as a class without offering specific reasons why services won’t be provided.  This won’t preclude a bank from refusing to lend to an oil company if the risk is considered too excessive, but it means the bank cannot refuse to make the loan just because it’s an energy company.
  • Although this is the current ruling, we expect the incoming administration to provide cover for financial services to reduce lending and other services to the sector under the aegis of combating climate change.
• The French oil company Total (TOT, USD, 45.06) has ended its membership with the American Petroleum Institute, the oil lobbying group.  The decision highlights the differences between U.S. and European supermajors.
• Last week, we discussed how environmentalists were focusing on constraining pipeline growth as a way to restrict the expansion of fossil fuels.  This tactic looks like it will find support from the incoming Biden administration as one of his initial executive orders was to cancel the XL pipeline.  The state of Michigan has ordered the closure of the Great Lakes Pipeline, a line that carries oil and natural gas liquids from Alberta to U.S. and Canadian refineries.  Part of the line runs on the lakebed from the Upper Peninsula to Michigan and environmentalists argue that a rupture would create catastrophic conditions.  Rising oil imports from Canada are straining the existing pipeline infrastructure and the inability to build more capacity will create bottlenecks and price distortions.  We expect this trend to continue under the new administration.
• The state of New York is planning to build miles of new power lines to tap electricity from wind and solar farms that are usually situated in rural areas.  This plan will pit environmentalists and landowners against each other.
• Courts have struck down a Trump era regulation that allowed for greater coal use by electric utilities.  Despite this action, higher natural gas prices will likely boost coal demand this year and create a problem for the new administration.  Adding to this pressure are signs that the new administration will crack down on methane emissions from natural gas wells and pipelines.  We also note that Vale (VALE, USD, 17.03) is divesting itself from its coal mining operations in Mozambique.
• As countries begin to use carbon taxes to address climate change, the prospect for using carbon pricing tariffs to prevent free-riding carbon emissions will become a bigger issue.  Trade officials have taken a dim view of such regulations in the past, fearing they could be used as an excuse for protectionism.  Look for ideas like a “carbon border tax” to start circulating.  We also note that the U.S. Chamber of Commerce appears to be supporting the idea of a carbon tax instead of regulation.  And, a recent executive order recreates the Obama era working group on establishing carbon prices.  The entire backbone of carbon reduction will need a workable carbon price so markets can be created to allocate carbon more efficiently.
• The Senate under Democratic Party control may allow for more climate legislation.
• The U.K. is considering a ban on new gasoline and diesel vehicles by 2030.  If this plan is adopted on a more widespread basis, the oil and gas industry is in serious trouble as it will clearly show peak demand is on the horizon.

In alternative energy, we continue to see investment flows and batteries dominating the news.

• Hydropower has also been a mixed bag for environmentalists.  On the positive side, the facilities create reliable electric power with no carbon emissions.  On the negative side, dams change the environmental characteristics of the rivers where dams are built.  Some dams were built long ago for flood control or navigation.  Investors are looking at these old, smaller dams as offering the potential for hydropower, installing generators and using the existing facilities to create clean power.
• Batteries remain the key bottleneck in expanding alternative energy.  Wind and solar, by their very nature, create intermittent flows of electricity.  Electricity is difficult to store; conventional flow management usually relies on flexible excess capacity (peaking power) fueled by natural gas or stored water systems.  This report offers some parameters on how cheap battery storage would have to be to replace conventional energy sources.  To fully replace conventional, storage would need to cost $20 kWh.  Current storage is around $175 kWh.  However, if the target is 95%, the report suggests $150 kWh will suffice.
• Meanwhile, the race to build a better battery for EVs continues.  The concept of a solid state battery that would allow for multiple recharges, longer range, and rapid recharging is the current rage.
• Of course, the mini nuclear reactor remains an interesting alternative.  Researchers in the U.K. are making the case that fossil fuel use will continue without an expansion of nuclear power. (An aside: a smart lobbyist for the oil and gas industry would fund anti-nuclear groups.)
• Clean-tech firms’ equities continue to outpace oil and gas stocks.

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

Here is an updated crude oil price chart.  Prices are continuing to march higher.

Commercial crude oil inventories fell 3.2 mb, in line with industry forecasts.

In the details, U.S. crude oil production was unchanged at 11.0 mbpd.  Exports fell 0.6 mbpd, while imports rose 0.9 mbpd.  Refining activity rose 1.3%.

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s decline was typical, but we are about to embark on a period of rapid seasonal increases.  If we follow the seasonal pattern, inventories will rise about 10% into mid-April.  That situation should be factored into the current price but the anticipated rise in stockpiles isn’t a positive for the market.

Based on our oil inventory/price model, fair value is $46.25; using the euro/price model, fair value is $71.97.  The combined model, a broader analysis of the oil price, generates a fair value of $57.68.  The wide divergence continues between the EUR and oil inventory models.

The DOE has released its Short-Term Energy Outlook.  For the most part, the government is looking for mostly steady prices this year.  The most uncertain element of their forecast is U.S. production.  Their forecast calls for 11.0 mbpd; we have doubts that this level will be achieved due to environmental/policy issues we discuss below.

One energy theme we are watching with great interest is the divergence between the price of energy commodities and their underlying equities.

This chart shows a model of the S&P Energy Sector Index relative to WTI and the S&P 500.  For the past 18 months, energy equities have underperformed relative to not just overall equity values but to oil prices as well.  Although the index has shown signs of recovery, note that it is still not outperforming overall equities and oil prices.

It is normal for the underlying equities to exhibit at least some degree of sensitivity to commodity prices.  Changes in commodity prices send signals to companies in the industry; for example, rising prices let producers know that conditions are favorable to increase output.  Obviously, falling prices indicate the opposite.  However, the decision to change production levels is affected by more than just the price of the commodity.  It is also affected by interest rates, regulation, the availability of capital, infrastructure, and expectations of the future.  To some extent, the last item may be the most important.  If companies see a rise in prices as being mostly temporary, they may not react.

As the “greening” of America proceeds, it is sending signals to fossil fuel energy producers and the industries that support oil and gas production.  The future isn’t rosy; transportation electrification and environmental regulations suggest future demand will likely be less than what it would have been otherwise.  Therefore, oil and gas companies are already in the process of adjusting to this changing market environment.  Here are some of the items we noted this week:

• For years, drilling in the Arctic Wildlife Refuge has been a goal of producers and an anathema to environmentalists.  The U.S. finally opened parts of the region for development and held an auction for reserves.  The bidding was mostly a bust.  The state of Alaska provided most of the bids.  Banks have little interest in financing the project and oil companies see two problems.  First, the public relations optics of drilling in the region are unfavorable.  Thus, the hurdle price of investing is likely very high.  Second, if oil demand is going to decline in the future, there is a significant risk that this investment could become stranded.  In other words, just about the time oil starts to flow, it won’t be needed.
• Financing for oil projects is becoming difficult to find.  The government is trying to force banks to fund projects, but banks are not really interested.  Some of this reluctance to invest is due to credit issues.  But this situation highlights one of the problems our divided political situation has caused—investing has become riskier because policy can vacillate broadly from administration to administration.  Thus, for a bank, funding drilling today might be acceptable only to become a violation at some point in the future.  Thus, finding financing, especially for long-term projects, has become more difficult.
• Environmentalists are focusing on pipelines.  It can be difficult to stop drilling projects as these are often intrastate so state governments can facilitate production.  And, trying to reduce consumption at the endpoint is a sure-fire way of becoming unpopular.  This is why carbon taxes, arguably the most effective way to deal with climate change, really hasn’t gained traction.  This makes pipeline policy critical.  Pipelines cross multiple jurisdictions and involve the federal government, giving activists multiple venues to prevent distribution.  For example, pipeline projects out of Appalachia are becoming difficult to complete.  Last summer, the Atlantic Coast pipeline project was abandoned due to legal hurdles.  The Mountain Valley project is due to be completed this year but is also facing litigation.  The lack of pipeline capacity effectively strands natural gas projects.
• The Biden administration is expected to tighten rules on methane emissions, which will lift the cost of oil and gas production.  Smaller companies are not planning on investments to reduce methane emissions or flaring, at least in Texas, which could reduce their production if new rules are adopted.  However, in Kansas and Oklahoma, surveys suggest some interest, although environmental investment is still not widespread.

The bottom line is that we are likely to see supply constrained in the future due to environmental regulation and changes in investing time horizons.  A similar path is emerging to what coal has seen over the past 15 years.  What this means in the short run is that we are likely to see a disconnect between oil and gas equities and the price of the underlying commodity, which favors the latter.  In other words, as economic recovery takes hold and demand improves, supply will be constrained by the factors noted above.  If our analysis is correct, this means the prices on oil and gas will rise much higher to generate a supply response.  But, in the end, the investing thesis is that owning the commodity will likely prove to be a better path than owning the associated companies.

On the alternative energy front, we are starting to see utilities invest in large-scale battery projects.  Utilities are building battery storage to solve the problem that alternative energy creates—what do you do when the sun doesn’t shine, or the wind doesn’t blow?  California is the home of a couple of large projects.

• We continue to monitor reports on modular nuclear reactors.  Although resistance to nuclear power remains elevated, achieving significant carbon reduction without nuclear energy will be difficult without serious changes in economic and social activity.  For off-grid facilities, diesel generators are the current norm.  Engineers are investigating the use of small modular nuclear reactors to replace diesel for electricity.
• Texas now generates more electricity from wind than it does from coal.
• The FT editorial page is suggesting that we are approaching a tipping point on transportation electrification.
• General Motors (GM, USD, 48.78) announced the introduction of a new electric delivery van.
• Although electrification continues to grab headlines, don’t “sleep” on hydrogen.  We note growing efforts to use wind energy to separate hydrogen from water.  Hydrogen could be used in cars through fuel cells but could be most applicable for aircraft.  Batteries are heavy, limiting their effectiveness, but fuel cell/hydrogen aircraft engines may offer nearly carbon-free flying.

In geopolitics, the controversial Nord Stream 2 pipeline appears closer to completion.  The U.S opposes this project and will likely try to use additional sanctions to prevent it from opening.  The blockade on Qatar was recently lifted by Saudi Arabia.  Interestingly enough, Qatar has indicated that it won’t change its relations with Iran.  Qatar’s Iranian ties were one of the factors behind the decision to deploy the blockade.

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