Weekly Energy Update (October 14, 2022)

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

Crude oil prices remain in a downtrend.

(Source: Barchart.com)

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

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

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  As the chart shows, we are past the seasonal trough in inventories.  The build seen in October into November is usually due to refinery maintenance.  With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2003.  Using total stocks since 2015, fair value is $105.85.

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

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

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

Market News:

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

Geopolitical News:

 Alternative Energy/Policy News:

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

[2] It wasn’t a popular speech.

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