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

Oil prices have moved into the upper end of the trading range.

(Source: Barchart.com)

Commercial crude oil inventories fell 0.6 mb, less than the 2.0 mb draw forecast.  The SPR was unchanged.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.2 mbpd.  Exports rose 0.8 mbpd, while imports declined 0.8 mbpd.  Refining activity fell 0.9% to 93.4% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Current inventories are falling but at a slower-than-normal pace.  If we follow the seasonal pattern, stockpiles should continue to fall into mid-September.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $60.14.  Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

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 2002.  Using total stocks since 2015, fair value is $93.10.

Market News:

• The Biden administration is projecting it will make a modest purchase of SPR oil this year, around 12 mb. Obviously, this amount pales in comparison to the sales over the past 18 months.  Part of the reason for the slow injection is that the infrastructure may not be able to handle aggressive injections, but the bigger reason is that there is simply a lack of urgency to refill the reserve.  Some of the reluctance is due to cost; like dieting, saving isn’t fun.  Another reason is that the shale revolution means there is less vulnerability to world events, and if the world reduces its use of oil, the SPR could become stranded.  Still, the SPR does act as a supply buffer, not just for the U.S. but the world.  China has been doing the opposite of the U.S., which is building its reserve.  Of course, cheap Russian oil has created this opportunity for Beijing.
• As India industrializes, its energy demand is rising. The country is becoming an important source of incremental oil demand.
• Argentina is expanding its natural gas exports.
• Due to falling water levels, Kyrgyzstan has declared an energy emergency.

 Geopolitical News:

• Although U.S. foreign policy has clearly signaled a desire to reduce its focus on the Middle East, Washington has decided to expand its military capability in the region in response to ship seizures by Iran. Iran’s behavior is clearly an irritant and distraction, but it also shows that no other military is able to fill this stabilizing role in the near term.
  • The U.S. is considering placing air defense systems in Iraqi Kurdistan due to threats from Iran.
  • Iran is equipping its navy with long-range cruise missiles.
  • In recent reports, we have been documenting this summer’s heat across the Northern Hemisphere. Iran is dealing with extreme levels of heat this year, which is leading to water problems.
• Iran has become closely allied with Russia and China, but apparently there are limits to that alliance. Iran announced that its deal to buy Su-35 fighters from Russia has fallen through.  Although no official reason was given, it appears that Russia was uncomfortable giving Iran its best military technology.  Iran is also suggesting it has an indigenous substitute.
• The net effect of the Western sanctions against Russia has not been a reduction in oil supplies, but rather a massive restructuring of the global oil market. One way the market has changed is that the former dominant oil trading firms have shied away from Russian trade, opening up opportunities for smaller firms to fill the gap created by sanctions.
  • We are also seeing new buyers for U.S. crude oil as shipping patterns adjust. Asian buyers are purchasing U.S. crude oil in the face of rising Middle Eastern prices.
  • Iraq has been a conduit for Iran to evade sanctions. The U.S. has taken steps to crack down on the illicit dollar trade between Iraq and Iran by banning 14 Iraqi banks from the dollar network.
• China is taking steps to reduce its dependence on foreign energy supplies. Recently, it has been drilling ultra-deep onshore wells in search of natural gas.  Given the costs, this investment is probably only justifiable on national security concerns.  China is currently the fourth largest producer of natural gas.  Although official data is lacking, there is a high likelihood that China is boosting imports to fill its SPR.
• Afghanistan has struggled since the early part of the century. It harbored al Qaeda after 9/11, leading the U.S. to invade the country to oust the Taliban.  The U.S. occupation continued until 2021, when the Biden administration engineered a chaotic exit.  The Taliban returned to power, but to some extent, it was a Pyrrhic victory.  Few nations wanted to deal with the regime, and it has faced its own internal unrest.  However, one bright spot for the Taliban is that Afghanistan holds rich lithium deposits.  China is making inroads into Afghanistan, hoping to exploit this resource.
• The Kingdom of Saudi Arabia and China continue to deepen their economic ties. Saudi Aramco (2222, SAR, 32.25) recently completed a deal to take a 10% stake in China’s petrochemical industry.
• In Sweden, demonstrators have allegedly been burning Qurans; in response, the Swedish embassy in Baghdad was stormed by protestors.
• Oil and gas deposits in the eastern Mediterranean are becoming an important source of hydrocarbons for the Middle East and Europe. The West is dominating this development, acting as a counterweight to other Middle Eastern producers.

Alternative Energy/Policy News:

• When China restricted Japan’s access to rare earth minerals in 2010, it highlighted China’s dominance in this market. In reality, rare earths are not all that rare.  What allowed China to dominate the market was that the mining and processing of these minerals tend to be disruptive.  China was simply willing to suffer the environmental costs.  But as other nations realized the vulnerability they faced from Beijing’s whims, we have seen a concerted effort to build mining capacity outside of China.  This report on Sweden’s mining activity is an example.
• The Inflation Reduction Act (IRA) provides subsidies to firms building clean energy facilities in the U.S. Foreign firms have been aggressively taking advantage of the opportunity.  This outcome suggests foreign firms are participating in the reindustrialization of the U.S.
  • The IRA is also fostering the EV battery recycling industry. As EVs become more prevalent, scrapping the vehicles after their useful life expires creates new problems.  Recycling the batteries reduces the problems of dealing with old EVs.
  • In fact, recycling may be part of the solution in meeting the demand for EV metals.
  • The U.K. is also subsidizing battery production.
• One of the favorable factors of markets is that prices signal to both consumers and producers to adjust their behavior. The decentralized characteristic of markets creates efficiencies that central planning, to date, hasn’t been able to duplicate.  The EV revolution will increase demand for copper, and as copper prices have increased, producers are looking for ways to use less copper.  Most of the adjustments, so far, have been in modest engineering changes.  We still expect copper demand to be strong in the coming years, but the simple extrapolation of demand from current use is probably overestimating future consumption.
  • Another example of the evolution of the EV industry is the solid state battery. Toyota (TM, $165.40) claims to have a battery with a 745 mile range.
• The Greens in Germany are part of the currency ruling coalition. Ostensibly an environmental party, it has moderated its positions over the years to increase its political power.  However, true to its roots, it has supported an aggressive policy stance of replacing boilers in German homes with heat pumps.  The plan has turned out to be very unpopular and may undermine the current coalition.
• EVs are fair weather vehicles, as it turns out. It’s well known that extreme cold weather reduces battery range.  Evidently, hot weather has an even greater negative effect.
• The environmental movement is plagued by a purity constraint as virtually every technical solution to an environmental problem will create an adverse impact on some part of the ecosystem. A recent lawsuit against the EPA argues that biofuels likely violate the endangered species act.

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

On Monday, oil prices spiked on reports that the Kingdom of Saudi Arabia (KSA) was going to extend its voluntary production cuts until year’s end.  The report was incorrect but does show the power that the news has on the oil markets.

(Source: Barchart.com)

Commercial crude oil inventories fell 0.7 mb, less than the 2.5 mb draw forecast.  The SPR was unchanged.

In the details, U.S. crude oil production was steady at 12.3 mbpd.  Exports rose 1.7 mbpd, while imports increased 1.3 mbpd.  Refining activity rose 0.6% to 94.3% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  After accumulating oil inventory at a rapid pace in the first quarter, stockpiles have moved into a pattern consistent with the seasonal.  Current inventories are in line with seasonal levels.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $59.94.  Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

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 2002.  Using total stocks since 2015, fair value is $92.96.

About the Heat:  We have been commenting on the unusually warm temperatures currently in the Northern hemisphere.  Europe, unaccustomed to such heat, is having a very difficult time adjusting.  In the U.S. the southern tier of states has experienced extreme heat, especially in the Southwest.  China is seeing hot weather as well.  Temperature reporting is now front and center in the media.  Although climate change is being blamed for much of it, our experience with climate is that it’s complicated.  There are two complications that are important to mention:

• Sunspot cycles: The sun plays a major role in the earth’s climate.  Sunspots are the result of magnetic activity on the sun that causes flares and ejections from the sun’s surface.  The scientific community is divided on the impact of sunspots on climate.  Some argue that it is an important factor, others dismiss the activity as negligible.  We are not climate scientists but interested observers.  Our take is that the cycles likely amplify the normal variation.  That means that sunspot cycles probably don’t drive climate by themselves but do play a role.
  • Sunspot cycles run 22 years, from trough to trough. The current cycle will peak in 2025.  In general, increased activity tends to lead to higher temperatures.  Thus, we are in the part of the cycle that should lift global temperatures.  The current cycle isn’t unusually amplified, but its current readings exceed the peaks observed in the last cycle.

(Source:  NOAA)

• ENSO cycles: The ENSO cycle has three phases—El Niño, La Niña, and neutral.  In recent years, we had experienced a set of La Niña events.  We are currently in an El Niño event, and current projections suggest it will be moderate to strong.  El Niño events often lead to hot North American summers, especially across the south.  It has also coincided with mild winters.

The combination of elevated sunspot activity and an El Niño ENSO cycle indicates that hot weather will continue.  In the developed world, this climate condition tends to be bullish for summertime natural gas prices, as it boosts air conditioning demand and consequently, electricity consumption.  So far, U.S. natural gas production has been robust enough to keep injections on par with seasonal norms.  This factor has kept natural gas prices low.  If winters are mild, it could be bearish for natural gas prices going forward.  There have been other effects as well:

• Hot, dry weather in parts of Europe have caused the water levels of the Rhine River to decline, forcing shippers to lighten barges by shipping less product. Mississippi River water levels are also low.

• High river temperatures are limiting nuclear power production in France.
• Hot weather in Spain has sent (olive) oil prices soaring.
• Temperature and rainfall changes have created situations where it is hard to find any part of the U.S. that is unaffected.

Market News:

• The IEA’s oil market report increased oil demand by 2.4 mbpd to 102.3 mbpd, a new record. Most of the demand will be met by non-OPEC+ suppliers.  Meanwhile, we note that the KSA is losing its spot as top oil producer within OPEC+.  In the early 1980s, something similar occurred which led the Saudis to aggressively retake market share, tanking oil prices in the mid-1980s.
  • As the KSA reduces output, Kuwait is aggressively lifting productive capacity. We doubt that the Saudis will tolerate this absorption of market share indefinitely.
• The global natural gas market is experiencing a generational adjustment in the wake of the war in Ukraine. The IEA’s recent global natural gas report details how the world market for gas has changed.
• The recovery in oil prices has lifted the Russian Urals price to the G-7 cap of $60 per barrel. The breach will begin triggering financial sanctions for traders and the financiers of these oil purchases.  We will be watching to see if Russian oil sales are affected.
• The Biden administration is planning modest injections into the SPR, but in no way is this going to replace all the oil that was sold.
• California, once a major oil producer and still the 7^th largest oil producing state, has essentially stopped new oil well approvals.
• Turkey has suspended oil flows from Iraq over a dispute over payments. So far, there has been little progress in freeing up these flows.
• One of the surprises of the past year has been the rather modest increase in U.S. oil production despite elevated prices. As we have noted in the past few months, higher costs for drilling and financing issues have stifled output.  Now, there are reports that drilling rig counts are fading, suggesting that production may decline in the coming months.

 Geopolitical News:

• India has been a major buyer of Russian crude oil, but the two nations have struggled to establish payments. India has been paying in INR, but the Russians have discovered that the usefulness of INR is limited due to the lack of deep Indian financial markets and capital controls.  And so, to facilitate further sales and avoid USD transactions, Russia and India have agreed to transact in CNY.  It’s unclear how much is being done in the Chinese currency and what India’s CNY reserve status is at the moment.  However, if this continues, then at some point India will need to run a trade surplus with China to acquire CNY.  We doubt China will support that outcome.
• Israel is working to improve relations with Azerbaijan. The Israeli defense minister has visited the country recently. At the same time, Azerbaijan is working to improve relations with Iran as well.
• Russia recently suggested that the UAE had the rightful claim to the Greater and Lesser Tunbs and Abu Musa, three islands in the Persian Gulf that are controlled by Iran. The Iranians were not pleased.  Although Iran and Russia have seen relations improve recently, there have been notable differences over the years that still affect the relationship.
• As part of the thaw in Saudi/Iranian relations, the KSA, Kuwait, and Iran may be working to jointly develop offshore natural gas in the Persian Gulf.
• In response to Iran’s interdiction of Persian Gulf shipping, the U.S. is increasing its deployment of F-16s to the region. The U.S. has also moved F-35s and a destroyer to protect shipping.  There is also talk of boosting air defense systems in Iraqi Kurdistan as Iran has also been threatening that region.
• The morality police in Iran were sidelined during last year’s headscarf protests. The police have apparently returned, along with a crackdown on women not wearing the hijab.
• Although sanctions on Russian energy sales have affected global oil supply, they haven’t really prevented Russian oil from entering the market. The sanctions have reduced the Russian revenues from oil sales (evading sanctions costs money), but the Russian economy continues to muddle through, although there is increasing evidence that economic conditions are deteriorating.  Essentially, Western nations really didn’t want to shut off the flow of Russian oil, but they just didn’t want to pay high prices due to sanctions.  The real goal was to reduce Russian revenue, and in those terms, sanctions have been generally effective.
  • Saudi Arabia is increasing its imports of Russian petroleum products. We suspect these are for reexport.  Exporting product to friendly nations is one way Russia is evading sanctions.
  • Sanctions on Russian oil have benefited Venezuela and Iran, who have both seen sanctions on their respective nations ease. Dubai has benefited by becoming the place where Russian oil deals are consummated.  The role of busting sanctions used to belong to Switzerland; that has changed.
  • Interestingly enough, the U.S. has also benefited from sanctions. The shift from coal to oil disadvantaged Europe, which had plenty of coal but lacked oil.  The U.S. has attempted to use oil as a diplomatic tool to gain European compliance to American policy goals.  Europe, obviously wanting to avoid this pressure, and against American opposition, bought Russian oil.  The U.S. was open to Europe buying oil from the Middle East as well, but Europe’s goal was diversity of sources.  The war in Ukraine has exposed the risks of being dependent on Russia, which has led to a boom in U.S. oil and gas sales to Europe.
• Schlumberger (SLB, $56.41) has finally ended sales to Russia.
• Relations between the UAE and the KSA leaders have deteriorated recently. Mostly, it appears to be driven by the goal of both leaders to project power in the region.

 Alternative Energy/Policy News:

• Solid state EV batteries could be the technology that moves transportation to electricity. The batteries promise not only to recharge in a time frame similar to filling a car with gasoline, but also to have a range that may exceed 700 miles per charge.  Nio (NIO, $10.48) announced it will start using these batteries.  The current technology is still emerging, but the more the industry moves to solid state, the quicker the transition is likely to be.
  • We continue to monitor the progress in not just solid state batteries, but cheaper materials to make batteries. Lithium prices have soared as EV production rises, so replacing such metals with cheaper alternatives would be another form of progress.
• The European heatwave, noted above, is boosting solar power output.
• The EU is trying to use trade policy to secure critical EV metals. Mercosur and the EU have been in trade negotiations for some time, but now the EV buildout is increasing European’s interest in getting a deal done.  However, for the Mercosur nations, the echoes of colonialism continue, prompting resource nationalism.
  • The U.S. Senate has approved a tax treaty with Chile, which could support lithium imports.
  • The Economist magazine notes that the process of energy conversion may not be possible without buying such products from China.
• Chinese GDP data was disappointing, but two bright spots are EVs and solar panels. China is aggressively building out battery storage which is critical to the expansion of solar power.
• According to reports, China is aggressively hacking the U.S. energy grid and could use cyberattacks on the grid in case of a war.
• One of the paradoxes of the energy transition is that environmental concerns about mining key metals is hampering the expansion of supplies needed to replace fossil fuels.
  • As the world scrambles for critical EV minerals, mining the deep sea is being considered. Concerns about environmental damage are being raised.
  • Maine has deposits of lithium, but the state prohibits commercial mining of the resource.
• Clean hydrogen offers the promise of clean energy using the existing infrastructure. However, it isn’t clear if that promise will ever materialize.
• A new deal to build and deploy small modular nuclear reactors in the Northwest shows the steady growth and interest in this new technology.
• The CFTC is drafting guidance for the eventual creation of a carbon market.  Economists hold that the fastest way to address carbon reduction is to properly price it.  Having this trading done on exchanges is one way to create a market for carbon credits.

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

Falling U.S. inflation is raising hopes that the Fed’s tightening cycle is coming to an end.  That has lifted oil prices, triggering a breakout above the recent trading range.

(Source: Barchart.com)

Commercial crude oil inventories rose 5.9 mb, well above the 0.1 mb draw forecast.  The SPR fell 0.4 mb, putting the total build at 5.5 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.3 mbpd.  Exports fell 1.8 mbpd, while imports fell 1.4 mbpd.  Refining activity rose 2.6% to 93.7% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and then declined.  This week’s build is contraseasonal; current inventories are in line with seasonal levels.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $59.77.  Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

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.  With another round of SPR sales set to happen, the combined storage data will again be important.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002.  Using total stocks since 2015, fair value is $94.27.

Market News:

• China has made a concerted effort to improve energy security. Increasing its imports from Russia and making aggressive diplomatic and investment actions in the Middle East are all part of this goal.  It should be noted that domestic production is also increasing.
  • China has increased residential natural gas prices in a bid to reduce demand.
• Hot weather continues. In the U.S., 6 million Americans are in areas of extreme heat.  Phoenix is threatening to break its previous record of 18 days with 110+ F temperatures. Miami has also seen temperatures near that level and has suffered through 30 consecutive days of  heat indexes over 100 F.

 Geopolitical News:

• As sanctions erode on Iran, Tehran is boosting exports, thwarting the Kingdom of Saudi Arabia’s efforts to lift prices.
  • Iraq is becoming increasingly important in Tehran’s sanction busting.
• Venezuela has seen sanctions gradually erode as the world adjusts to the war in Ukraine. The country is using expanding oil exports to pay down debt.
• Russia tends to view Central Asia as its near abroad. We have noted that recently China has been challenging Russia for this region.  Reports suggest that the Prigozhin mutiny has led the “stans” to further distance themselves from Moscow.
• Rob Malley is a long-time diplomat that specializes in Iran. He was the Iranian envoy (the U.S. doesn’t have formal relations with Iran) for the Biden administration and was involved in the JCPOA talks.  He has been relieved of his duties as the FBI investigates his handling of classified materials.  However, there is growing speculation he may be a spy for Iran.
• Last week, we noted that the U.S. Navy had thwarted efforts by Iran to seize vessels. Apparently, this action wasn’t enough to keep Iran from trying again as the IRGC has now seized a tanker in the Persian Gulf.  Meanwhile, Indonesia has seized an Iranian tanker thought to be engaged in an illegal oil transfer.
• Iran is said to be increasing cyberattacks against Western targets.
• There is increasing evidence that Iran is trying to attack Israel directly via Hezbollah.

 Alternative Energy/Policy News:

• Although car dealers are tending to hold less inventories these days, reports suggest that EV inventories are becoming rather bloated. Current inventories are at about a 92-day supply, twice the industry average. Sales have picked up, but supply is outpacing demand with probably the biggest issue being price.  Also interesting is that hybrid inventories are only 44 days.
• Chinese automakers are targeting the U.S. Chinese EVs are a threat to the U.S. market due to their lower costs.
• Mercedes-Benz (MBGYY, $19.86) is the latest automaker to adopt the Tesla standard for charging connectors. The company joins five other firms, including General Motors (GM, $39.77) and Ford (F, $15.10), in adopting this standard.
• The IEA has released its first report on minerals critical to the energy transition. There is an expanded race to secure key metals involving governments, commodity firms, and automakers.
• The energy transition can’t occur without mining and smelting. Although such activities are generally acceptable in the abstract, they become problematic when they occur close to home.
• The IEA has published an update on the progress made toward zero emissions.
• The seabed is a controversial region for gathering these critical minerals. Island nations and China are keen to develop this source, while European nations are trying to restrict the effort.  Meetings on this issue are underway in Jamaica.
• Climate problems are becoming a challenge for insurers. The U.S. system of state regulation may not be suited to respond.
• Biofuel makers are starting to consider bamboo as a source. The plant grows rapidly and could become a reliable source for ethanol.  We note that on the West Coast biofuels are displacing distillate fuels.

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