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 Biden administration is clearly upset. The president traveled to Riyadh earlier this year to attempt to improve relations.  Clearly, that didn’t work.  Biden did not have kind things to say about Crown Prince Salman during the U.S. elections, and so relations between the U.S. and the KSA had cooled.  In the aftermath of the OPEC+ decision, the administration has accused the KSA of aligning with Russia and has warned of other measures to counteract the loss of production from the cartel.  The alignment with Russia isn’t just rhetoric.  We note the president of the UAE is visiting St. Petersburg to speak with President Putin.  There are also reports that the U.S. has asked the KSA to delay the announcement for a month (ostensibly to avoid prices increasing heading into the midterms); Riyadh pressed ahead  The White House is indicating that the U.S. will “re-evaluate” relations with the kingdom.
  • The KSA has denied the allegations that it is in league with Russia.
  • Some members of Congress have called for the removal of U.S. military contractors and troops from the region. There have also been discussions of halting arms sales.
  • Additional SPR sales have been announced.
  • NOPEC legislation has been resurrected. This legislation would give the U.S. Attorney General the right to enforce U.S. antitrust laws on foreign national oil companies.  Although it is not clear how that would work exactly, it’s conceivable that it would make it impossible for the affected OPEC+ nations to sell directly to the U.S.  We doubt this legislation will pass as it often returns when the U.S. isn’t happy with the cartel’s behavior.  However, we may be reaching a point where divisions between the U.S. and various cartel members have become strained enough that momentum may build for the bill’s passage.
  • Another measure would build a case to take OPEC+ to the WTO on restraint-of-trade charges.
  • What has not been mentioned yet is some sort of action against Saudi investments in the U.S.
  • Clearly relations are cooling.
• We should note that all of these actions have a clear potential for adverse consequences. Withdrawing troops from the KSA and UAE may create conditions where Iran could undermine these governments, leading to potentially catastrophic outcomes for the West.  Complicating matters is the U.S. political environment.  Currently, a significant element of the electorate believes that if the other party is in power, civilization as we know it is at risk.  Such attitudes lead those in power to take extreme measures to stay in power.  The aggressive SPR sale has elements of maintaining political power at the risk of not having the reserve if a broader crisis emerges.  Some of the discussion of attacking OPEC+ is shaded by seeing the KSA as supporting the GOP.  At the same time, Riyadh should note that attitudes toward the KSA are hardening in a bilateral fashion.
• Finally, it should be remembered that the EU embargo on Russia crude goes into effect on December 5. It may not make sense to punish OPEC+ when the world will need to offset the potential loss of Russian oil.
• At the same time, the administration has been ignoring the effects of some of its actions on the concerns of the Gulf producers. The aggressive draining of the SPR was seen as a clear threat.  The talk of price caps isn’t welcome either.
• One item to keep in mind is that the actual level of cuts will not approach 2.0 mbpd, because the cuts are coming from allocations, not actual production. The actual cuts will likely be closer to 0.8 mbpd, as the Gulf states, who are meeting their production quotas, cut back output.

• The IEA is warning that the OPEC+ cuts could plunge the global economy into recession.
• In addition to expressing anger about the KSA, the U.S. continues to negotiate indirectly with Iran for the latter’s return to the JCPOA. In theory, this could add one to two million barrels per day of oil to world markets, although we have our doubts that there is this much oil available.  The sanctions regime has weakened and thus the available supplies would likely be modest.  However, the “unsavory tradeoffs” include Iran’s human rights problems, and, perhaps more worrisome, it is in the midst of a crackdown on expanding unrest.  The optics of cozying up to Tehran at this particular moment are troublesome as it is estimated that at least 185 people have died, including 19 children.  This is especially the case since the protests appear to be widening with anecdotal evidence that security forces may be joining the rioters.  Energy sector workers are also going on strike in sympathy.  The longer these protests persist, the greater the threat to the regime.  The government seems to have little fear of using force against young protestors but appears to be reluctant to attack oil workers.  We also note that we are seeing some level of dissent from the clerical class.
  • Although we don’t expect the government to fall, we do note that authoritarian regimes tend to collapse without warning. At least initially, an overthrow would be bullish for oil because it isn’t obvious if the lack of government would affect the oil infrastructure.  If a Western-friendly government were to take power, however, we would expect the West to rapidly take steps to support that government, which would almost certainly include lifting sanctions.
• There have been reports that the administration may ease sanctions on Venezuela in a bid to increase oil supplies, although we note they have been denied. The Maduro regime has also been repressive against opponents, and, again, the optics are not good.
• Perhaps the most important point that has been lost in all the controversy is that the world has dramatically underinvested in oil production. As we have noted for months, ESG concerns continue to weigh on non-OPEC supply, but even OPEC+ is underinvested.  The fact that OPEC+ now talks about “production targets” instead of “quotas” shows how much conditions have changed.  As long as investment remains depressed, oil prices will remain elevated and could conceivably move much higher.

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.

• Refinery workers in France have gone on strike and there are numerous reports of spot shortages and tensions at filling stations. The Macron government is trying to force workers back to the refineries but is struggling to enforce its will.  There is talk of wider protests against inflation.
• The Permian Basin has been responsible for nearly all the production growth this year. However, to continue to expand, associated natural gas that comes from drilling must be processed.  Flaring, which could be one way to address this issue, has become untenable.  While there is still some natural gas processing capacity available, without additional investment, production growth could stall.
• Although OPEC+ has called on production cuts, we note that the KSA has signaled a reduction in supplies to Asia. It appears supplies will be met by drawing down inventories.
• Munich Re (MURGY, $24.40), the world’s largest reinsurer, announced restrictions on issuing policies on oil and gas projects. Financing constraints have been a factor in restricting oil and gas production.
• Venture Global (1557028.MC, €10.16) announced a deal to send U.S. LNG to Germany.

Geopolitical News:

• Germany’s unilateral energy price support package continues to raise hackles across the EU. In response, Germany is proposing to support unified EU debt to broaden subsidy support.  Increasingly, the EU and Eurozone have been creating bonds as opposed to member nation debt instruments.
• Sweden’s investigation of the recent Nord Stream pipeline attacks strongly suggests sabotage.
• Last week, we noted that Lebanon and Israel were nearing a deal on production sharing for offshore natural gas development. A deal has been tentatively agreed upon but will need ratification by both governments.  We expect it to pass as Israel wants energy security without the distraction of tensions with Lebanon, and Lebanon desperately needs the revenue from natural gas sales.  The U.S. cheered the arrangement, which may ease tensions between Israel and Hezbollah, which dominates the Lebanese government.
• Iran has been an observer of the Shanghai Cooperation Organization (SCO) since 2005. It has wanted to join the group, but the leadership was uncomfortable admitting a member under sanctions, fearing that the SCO would face scrutiny from the West.  However, now that Russia, a long-time member of the SCO, is under sanctions, there is a higher likelihood that Iran will be admitted. If so, the SCO will probably become an anti-U.S. organization.
  • In Iran, state television was hacked during a news bulletin.
  • The IAEA reports that Iran is aggressively moving to expand uranium enrichment at its underground facility at Natanz. This news will raise questions about the wisdom of returning to the JCPOA.
• The U.S. energy industry is warning against implementing product export constraints.

 Alternative Energy/Policy News:

• Florida’s electrical grid has reportedly recovered rather quickly in light of the hurricane devastation. The grid was strengthened by using concrete and steel power poles and burying power lines underground. Areas that built solar capacity have mostly emerged unscathed.
• One problem with EVs is their high cost. Ford (F, $12.16) has announced a second price increase of the F-150 Lightning since summer.  The base model now costs over $50k.
• The recently passed Inflation Reduction Act has provisions that provide large subsidies for EVs if the vehicle is mostly made in the U.S. with American components. The EU is crying foul, suggesting this is protectionism.
• Copper is critical to EVs, and the West is short on copper supplies.
• Austria is challenging the EU ruling that nuclear power and natural gas are “green” fuels. This suit joins others from environmental groups.  If the challenges are successful, ESG guidelines will restrict investment in these two sources of energy.
• General Motors (GM, $32.65) has decided to expand its battery production to include electricity storage for home and commercial use. For homeowners, this possibility will be tied to an EV.
• Researchers have developed a prototype lithium battery with 40% more capacity.
• A new cobalt mine, the only one of its kind in the U.S., recently opened.
• The EU wind industry is contracting due to rising input costs.
• New Zealand is applying taxes on livestock to curtail methane emissions.
• The uranium miner Cameco (CCJ, $21.95) announced an investment in the nuclear power division of Westinghouse, which is owned by Brookfield Partners (BBU, $19.48). Cameco’s investment looks like a bid to vertically integrate.

[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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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 fell 1.4 mb compared to a 2.1 mb build forecast.  The SPR declined 6.2 mb, meaning the net draw was 7.6 mb.

In the details, U.S. crude oil production was steady at 12.0 mbpd.  Exports fell 0.1 mbpd, while imports fell 0.5 mbpd.  Refining activity rose 0.7% to 91.3% of capacity.  We are in the usual period for 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 at 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 could be 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 $108.71.

Market News:

• This week’s big news is that OPEC+ has agreed to a production cut to bolster prices. A reduction of two million barrels per day has been confirmed.  This news offers a number of insights into the thinking of the cartel.  First, such action would have to be considered an affront to the Biden administration who has taken great pains to reduce oil prices to improve consumer confidence.  A rise in oil prices will eventually lead to higher product prices, thwarting that goal.  In fact, Washington is raising diplomatic pressure on the Gulf states to try and prevent such actions.  Second, the news suggests that prices under $80 are not making producers happy.  Third, worries about global recession are likely leading producers to try to prop up revenues, even though higher oil prices will also tend to hurt global growth.  Finally, the KSA may be trying to reduce output to build a capacity buffer.  It appears that OPEC+ is close to being out of capacity, and the fact that most nations can’t meet their quotas suggests that the cartel may not be able to lift output during an emergency.  By cutting production, the KSA could create some excess supply,  but it is unmistakable that the KSA/U.S. alliance that has existed since the end of WWII is fraying badly.
  • Although the U.S. could continue SPR withdrawals in response to an OPEC+ cut, there is growing risk that the reserve is being depleted with little chance of rebuilding.
  • The administration is considering a ban on product exports to keep gasoline and diesel prices low in the U.S. Such talk smacks of desperation.  Europe will likely shift to oil from natural gas if the latter becomes too scarce to maintain electricity production, and it will need U.S. diesel to do so.  Cutting off exports would show a profound lack of leadership from Washington and undermine support for the Ukraine war effort among Europeans.  The fact this is even being considered shows a cost of political polarization as once both parties believe that the other being in power will lead to catastrophic outcomes, any action appears justified.  Cutting off product exports, however, could have profound geopolitical effects and may, in the end, not even lower prices in the U.S.  It is not hard to imagine that refining activity would decline if refining margins narrow.
• The Dallas Fed’s survey of oil and gas activity in its district paints a picture of deteriorating conditions for energy firms. Most participants expect oil market supplies to tighten into 2024.  The industry is bracing for a recession.
• The head of Saudi Aramco (2222, SAR, 35.95) is warning that the world lacks adequate productive capacity for oil and natural gas, mostly because of the lack of investment in production. Oil and natural gas are depleting assets and without constant investment, production will decline.  Although recession will likely reduce demand, once growth resumes, oil and gas prices could move higher.
• The rise in EU natural gas inventories suggests that the region has been trying to prepare for winter. Unfortunately, we still don’t know if the plan demand and supply actions will be sufficient.  Germany’s energy regulator warns that consumption is still too high, raising concerns about a crisis this winter.  Complicating matters is that Germany, like other nations in Europe, is planning subsidies to shield consumers from higher prices.  Although understandable, preventing consumers from feeling higher prices will simply add to demand.
  • One way the EU will likely try to address natural gas shortages is through fuel switching. Unfortunately, diesel inventories are also tight.
  • Germany is building new LNG terminals to replace lost Russian production. There were no Russian natural gas imports to Germany in September.
  • Europeans have opposed fracking, which has denied them potential energy supplies.
  • A new gas pipeline to Poland from Norway has recently opened.
  • Russia has shut off natural gas flows to Austria.
  • China has been rerouting U.S. LNG to Europe since China’s economy has been sluggish, which frees up this resource for resale. The sale has been profitable for Beijing.
• The Inflation Reduction Act has measures designed to reduce methane emissions. This report offers a primer on the impact.
• The following chart shows how coal has lost market share for U.S. electricity generation.

(Source:  EIA)

Geopolitical News:

• We continue to monitor the Nord Stream 1 and 2 situation. The EU and NATO have both declared the act to be sabotage.  Although Russia is suspected to be behind the attacks, it is still uncertain who actually attacked the pipelines.  The gas that was leaking was mostly for line pressure, and Danish officials have noted that it appears that most of the gas that was in the line has dissipated.  Both Sweden and Demark claim that the pipeline leaks were caused by “several hundred kilos” of explosives, increasing the likelihood that a state actor was involved.  NATO may not have the wherewithal to protect Europe’s energy infrastructure.
• The EU is expanding its sanctions against Russia. The current package includes an oil price cap along with other measures.  A price cap on natural gas hasn’t been agreed upon quite yet.  We are starting to see protests against high energy prices in Europe, and if the winter turns out to be cold, such unrest could spread and undermine support for Ukraine.  Meanwhile, the U.S. appears to be calling for a phased implementation, likely to reduce the potential for price spikes.
• Germany caused a firestorm in the EU by unveiling a support package for its industrial sector that would likely harm smaller nations in the EU. The “go it alone” approach is coming under strong criticism as other countries fear that Germany’s subsidy program would lift German demand for natural gas and reduce supplies available to other areas of Europe.
  • Adding to concerns about the fracturing of the EU are reports that Germany may cut electricity exports to keep the lights on at home.
• Iran is continuing to shell Kurdish areas of Iraq which Tehran suspects are supporting the unrest in Iran. The U.S. shot down an Iranian drone that was threatening a U.S. installation.  Unrest continues for the third week.  Rioting has moved to universities where security officials are responding harshly.  Officials are warning against further protests, with both the parliamentary speaker and Ayatollah Khamenei calling for calm.  There are reports that shopkeepers are joining the protests, and there is greater risk to the regime if participation widens.  History is generally on the side of the regime.  Although it has faced unrest before, harsh reprisals have tended to turn back protests.  However, authoritarian regimes can unexpectedly fall, and with Ayatollah Khamenei suffering from cancer and being elderly, it is possible that the clerics could lose control of the government to a coup.
  • In a related note, Tehran may be reconsidering its position with regard to the nuclear talks in light of the protests. Accepting a deal may be attractive if it would boost the economy.  However, given the protests, it might be hard for the Biden administration to offer any concessions.
• As we noted last week, Israel and Lebanon were close to an agreement to share offshore natural gas fields. The deal has now been made.

 Alternative Energy/Policy News:

• There is increasing interest in placing nuclear power plants on the sites of existing and closed coal utilities. Since the sites are already brownfields, there is less likely to be opposition and the coal plants are already connected to the grid.
• High prices for lithium are spurring interest in other materials for batteries. The search for alternatives is a risk to lithium investment.  One battery design that might work for stationary requirements (like utilities) would be a flow battery.
• The world’s largest CO₂ removal plant will begin operations soon in Wyoming.
• Energy storage other than batteries is another area of interest. Stored hydropower, where water is pumped to an elevated reservoir during periods of lower power demand to flow down through turbines during periods of high power demand, has been around for years.  China is working on a project that uses compressed air to accomplish the same outcome.
• One of the great ironies of the clean energy industry is that it relies heavily on rare earths, which require large amounts of energy to mine and refine. So, as oil and gas prices have increased, production of these metals is starting to decline.

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

Crude oil prices remain under pressure due to recession fears.

(Source: Barchart.com)

Crude oil inventories fell 0.2 mb compared to a 2.0 mb build forecast.  The SPR declined 4.6 mb, meaning the net draw was 4.8 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.0 mbpd.  Exports rose 1.1 mbpd, while imports fell 0.5 mbpd.  Refining activity plunged 3.0% to 90.6% of capacity.  We are in the usual period for 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 at 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 could be 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 $107.52.

Market News:

• Hurricane Ian is bearing down on the gulf side of Florida. There isn’t a lot of oil and gas production in the path of the storm, but delays are an issue as the U.S. is exporting a record level of energy products to the world. Hopefully, the delays shouldn’t last long.
• As the G-7 looks to try to sell the world on a price cap for Russian oil (see this report for a primer on how it might work), India appears to be sharply curtailing its purchases. This change in buying pattern doesn’t appear to have anything to do with its attitude toward Russia, but rather it has more to do with higher shipping rates.  As rates have risen due to the global scramble to secure oil supplies, it’s now cheaper to buy African crude oil once shipping costs have been taken into account.
• There is a growing consensus that OPEC+ is considering a $100 per barrel target for oil prices.
• One element of the Inflation Reduction Act was a measure that would have sped up permitting, but in its final version it was removed to be considered as a standalone bill. Environmentalists have been using various delaying tactics to prevent pipeline construction or drilling from occurring, even after companies have complied with regulatory requirements.  Clean energy has faced similar constraints.  Solar and wind power could expand if it were easier to build long distance transmission; however, these structures can also face local opposition.  Manchin (D-WV) tried to lead a bipartisan effort to streamline permitting, but that bill has failed.  Democratic progressives loathe the permitting of pipelines and other infrastructure for fossil fuels.  The GOP didn’t want to give the Democrats a win and likely opposed streamlining permitting for clean energy projects.  Sadly, by looking for the perfect, the good was sacrificed.  The fact that a compromise couldn’t be reached suggests that both wings of the political spectrum believe they can get exactly what they want.  Until that is proven false, we will continue with this world where energy infrastructure is not being built.
  • We note that this isn’t just a U.S. problem as Australia is seeing similar issues.
  • For U.S. LNG to expand (and help wean Europe from Russia), pipelines will need to be built.
• Natural gas prices in Europe are starting to have ripple effects. With U.S. prices significantly less, EU companies are shifting industrial activities that rely on natural gas production to the U.S.  Basics such as bathroom tissue are being affected.  There is growing speculation that the EU will expand gas to crude oil fuel switching, which may lift crude oil demand later this year.  Germany has secured an LNG deal with the UAE as part of its effort to diversify its natural gas supply chain.
• Even as hedging costs rise, EU regulators are resisting calls for support from the energy industry.
• U.S. utilities are starting to warn customers that home-heating costs this winter are poised to rise due to elevated natural gas prices. Overall prices are expected to increase over 17% from last year.
• Norway’s oil production rebounded in August.

 Geopolitical News:

• The Nord Stream 1 and 2 pipelines have been sabotaged. It is unclear who did this, but there is evidence of a gas leak in the Baltic Sea.  Although the Nord Stream pipelines were not sending gas to Europe, the lines were pressurized, and the gas that is leaking was in those pipelines.  The CIA has warned that pipeline infrastructure in Europe is vulnerable.  The leak could mean that no gas from Russia will be available to Germany even if relations were to improve.  Speculation is rife that Russia attacked the pipes (the broad scale of the attacks mostly rules out an accident), although no party has been officially blamed.  Scandinavian seismic stations reported explosions around the pipelines before the leak was discovered.
  • This attack is ominous because it could signal a new element of this war— targeting critical infrastructure. Russian submarines have been noted prowling around undersea cables.  Russia has already been accused of severing fiber optic cables between Svalbard and Norway that are key communication links for NATO.  If Russia decides that attacking energy and communications infrastructure is necessary to win the war in Ukraine, a new risk element will be introduced.  The EU has vowed to protect its energy infrastructure, but given the miles of pipelines involved, no government can guarantee it will protect everything.
• A key reason for the creation of the EU was to manage competition within Europe. After all, the continent suffered two world wars due to unresolved competition, and thus avoiding another one was important.  The EU has expanded and grown to include influence on economic matters.  So far, Brussels has tried to manage the scramble for energy resources.  However, the IEA is warning that if more isn’t done, competition to secure oil and natural gas could lead to chaos and spiraling prices.
  • As we have noted earlier, EU demand has cut supplies of fuel to the emerging world.
• Last week, we noted the unrest that followed the death of a feminist in Iran who was accused of improper head covering. The unrest has continued to spiral, with now over 75 deaths being attributed to the protests.  Even conservative women are joining the protests, which suggests a broadening threat to the regime.  There are reports suggesting that some cities in Iran are no longer controlled by the government.  Historically, the regime tends to react harshly to protests.  As we noted last week, the government has interfered with the internet to undermine the protestors’ ability to coordinate their actions.  Those efforts have expanded, and in response, the U.S. has relaxed rules on tech firms so they can provide services to Iran to help the protestors.  The Starlink system, a satellite internet service built by Elon Musk that has blanketed space with small satellites, is said to be operative and giving protestors internet access.  Although we doubt the regime is at risk, it should be noted that Ayatollah Khamenei is said to be gravely ill, but the most recent reports suggest he may have recovered to some extent.  It bears watching to see if some sort of change in government emerges from Tehran.
  • Protests against Iran have spread to the West.
  • Iran has also launched attacks against Kurdish groups in Iraq. Tehran is accusing various groups of supporting the protests in Iran.  Attacking groups on foreign territory highlights how little sovereignty Iraq has over Iran.
  • Iran has withdrawn its “morality police” that were responsible for the death of Mahsa Amini from public view. We doubt this is permanent, but for now, it looks like Iran is trying to placate the protestors.
  • In related news, the Biden administration says it will continue to engage in talks to return to the JCPOA. Given the protests, making an agreement with Iran looks like a long shot, but the fact that the White House hasn’t broken off talks looks politically risky.
• Although the G-7 continues its plan to introduce a price cap on Russian oil, and the EU is moving toward an embargo and an insurance ban, the U.S. has ruled out secondary sanctions for now. Secondary sanctions would penalize nations and firms that buy Russian oil and gas in violation of sanctions.  The fact that secondary sanctions have not been implemented suggests the West isn’t really serious about inflicting damage on the Russian economy.  Most likely, leaders in the G-7 realize that seriously reducing Russian oil supplies would subject the world economy to crippling increases in oil prices.
• Sanctions on Russian oil shipments are preventing local ship captains from controlling oil tankers from Russia that are traversing the Danish straits. Without the local captains, the likelihood of an oil spill is increased.
• The U.S. has been mediating a natural gas sharing arrangement between Israel and Lebanon. The two nations have both claimed offshore natural gas fields.  Although a deal hasn’t been struck yet, reports suggest they are “close.”

  Alternative Energy/Policy News:

• As urbanization continues, people are being separated from the basic notion that producing any commodity has an impact on the earth. Drilling, mining, farming, and ranching all disturb something.  This op-ed, lamenting the cutting down of forests for a solar farm, is an example.  Solar power is a low-density source of electricity.  To generate it at scale requires great amounts of space.  Clean energy may disturb things less than other forms of energy (or not), but make no mistake, changes will be necessary.
• China is aggressively moving to become a world leader in nuclear power. It has built 39 reactors over the past decade, which is a bit more than 57% of the global total.  The process of building reactors increases the country’s expertise in construction and engineering and provides its economy with electricity that would be hard to disrupt by an outside power.  While the West continues to impede the development of nuclear power, it runs the risk of falling behind China.
• The DOE is providing funding for building green hydrogen infrastructure, setting off a scramble to secure the needed resources.
• Firewood and wood pellet prices are up 20% in France as demand rises.
• One of the problems with forecasting is that models all use past history and relationships to predict the future. Accounting for changes in technology requires guesswork that is highly unreliable.  We note that agriculture researchers are using AI to figure out how to make plants drought-resistant.
• According to the IEA, clean energy progress is lagging.
• As the EV industry grows, recycling the traction batteries from cars will become more important. South Korea has been taking the lead in this industry.
• The scramble for rare earths is heating up.  The world is currently heavily dependent on China for this resource.

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

Crude oil prices remain under pressure on recession fears.

(Source: Barchart.com)

Crude oil inventories rose 1.1 mb compared to a 1.9 mb build forecast.  The SPR declined 6.9 mb, meaning the net draw was 5.8 mb.

In the details, U.S. crude oil production was steady at 12.1 mbpd.  Exports were unchanged while imports rose 1.2 mbpd.  Refining activity rose 2.0% to 93.6% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  The rise in stockpiles over the past two weeks is contra-seasonal.  As the chart shows, we are nearing 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 could be 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 $106.98.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization.  The inventory/EUR model suggests oil prices should be around $66 per barrel, so we are seeing about $20 of risk premium in the market.

The SPR

In our weekly reporting above, we have been updating total U.S. oil inventories, both commercial and the SPR.  For years, analysts have tended to treat the two as different entities as commercial inventories are what is available and the SPR was only deployed in emergencies.  Price modeling, therefore, tended to focus on commercial storage.  The separation of commercial and strategic stocks made sense.  However, as our above analysis suggests, we have stopped treating the SPR as an emergency reserve and have begun considering it a buffer stock.

Buffer stocks are sometimes used in commodity markets to dampen price volatility.  When prices rise to a level considered “too high,” the buffer stock manager releases inventory, and when prices are “too low” the commodity is purchased.  In the 1970s, several commodities had buffer stocks, which were managed by producers.  All of them eventually failed because producers set a price well above the market clearing one.  Eventually, the buffer stock became too large, and the manager was forced to “dump” the stocks on the market, leading to a price collapse.  A buffer stock operated by a consumer would likely have the opposite problem since it would want to set a price well below the market clearing one.

Recently, the Biden administration floated an idea that if WTI fell to $80 per barrel or less, the SPR would buy oil to refill it.  We still harbor doubts that oil will ever be purchased by this administration, but this recent “trial balloon” is intriguing.  If this idea becomes policy, it will confirm that the SPR has become a buffer stock and the government is comfortable with an $80 per barrel oil price.  That is probably a high enough price to maintain current output, but if prices remain steady, the inflationary impact (inflation is a rate of change concept) would diminish over time.  In theory, the $80 per barrel becomes a floor, and it is unclear what price would trigger selling (the ceiling price), although one could imagine that a round number like $100 per barrel would be reasonable.  There remain numerous uncertainties about this concept, but we will continue to monitor developments.

Here’s the key point to all this:  from the late 1970s until recently, there was great faith placed on markets to solve problems.  Government intervention into the economy was normalized during the Great Depression and WWII but the inflation of the 1970s undermined the idea that the government could manage the economy.  The infamous gas lines of the 1970s occurred, in part, due to price caps on product.  When it became unprofitable to refine gasoline at the cap price, shortages developed.  Markets do work, but they are focused on efficiency, not equality.  In other words, high gasoline prices did increase available supply and eased demand, but the burden of the policy fell more heavily on lower income households.  The government using the SPR as a buffer stock could suggest a return to the pre-Reagan/Thatcher era.

Market News:

• We want to issue a correction to last week’s report; we implied that the permitting element of the Inflation Reduction Act had already been passed. It was not.  This part was peeled from the bill to be passed separately.  Talks on permitting are currently underway.
• The government has accepted about $190 million of bids for offshore oil development.
• The G-7 price cap idea remains untested, but the IEA notes that when the EU implements its embargo next February, Russian oil demand will fall by 1.9 mbpd.
• As winter approaches, U.S. oil producers warn they will not be able to meet shortfalls as demand rises. Surging LNG exports are pushing U.S. electricity prices higher.
• For reference, this site updates EU natural gas storage.
• One of the factors that has cooled oil prices has been weaker Chinese economic growth. If Beijing becomes serious about stimulating the economy, oil prices will likely rise.
• Over the past several months, we have noted that the data for miles driven by Americans shows a clear reaction to higher gasoline prices. For years, it was a “truism” that driving demand was price insensitive.  However, work from home and the expansion of social media appear to have caused gasoline consumption to become more sensitive to price.
• As energy prices rise in the EU, manufacturing firms are being forced to curtail production.
• Smaller U.S. oil firms have been aggressively expanding oil and gas production, but reports suggest that they have exhausted their most promising fields, which may lead to falling output.
• As energy prices rise in Europe, governments are trying to address this issue. There are two policy paths.  The first is to increase supply, and although that is the preferred solution, it is hard to execute in the short run because it often takes investment and time to lift production.  The other path is to ease the negative impact on consumers by either fixing the price and then allocating the “pain” to either producers or the government, or by subsidizing consumers.  The problem is, once this path has been taken, it becomes a political decision about who will bear the cost.  The U.K. is a good example of what not to do as the support program is likely too broad, offers too much support, and will be funded by government borrowing.  The steady decline in the GBP is evidence that the markets, to quote Queen Victoria, “are not amused.”
  • Due to price turmoil, the German government has nationalized the natural gas distributor Uniper (UNPRF, $2.90). Soaring natural gas and oil prices are making it difficult for firms to hedge their exposure, which could either lead to a supply crisis or a financial market crisis.
• The lack of investment in oil and gas production is a key element to the recent rise in prices. A good example of this lack of investment is Nigeria, where oil production is  about 1.2 mbpd, down from 2.6 mbpd in 2012.  Economic mismanagement and corruption have weakened the incentives to investment, and since oil and gas are depleting assets, the lack of investment means falling output.  This investment issue isn’t just a Nigerian problem as OPEC+ now speaks of “production targets” as opposed to “production quotas,” reflecting the lack of productive capacity.
• The recent heatwave in China has spurred coal demand and has lifted imports of coal from Russia and Indonesia.
  • Strong coal demand has started to trigger investment in mines that can be tapped quickly.
• As we head into another “La Niña” season, Japan is bracing for a cold winter. If the temperatures stay true to form, it will lift LNG demand.

 Geopolitical news:

• Throughout history, Germany and Russia have had periods of economic integration, followed by disengagement. Recent reports that the German government has seized three Russian-owned refineries in Germany suggest disengagement is underway.
• The G-7 is preparing to implement its price cap on Russian oil. The reason for the cap is that the U.S. is afraid that when the EU’s ban on insurance for tankers goes into effect this December, Russian oil flows will slow to a trickle, leading to a spike in prices.  The U.S. has proposed the price-cap idea, where Russia could still export oil that would be granted tanker insurance but at or below a mandated price.  The trick is to establish a price high enough to encourage continued production but low enough to reduce revenues.  We remain skeptical that this plan will work, but if the EU insurance ban goes forward, we could see a drop in available oil supplies and a rise in price.
  • EU leaders are watching growing protests over the war and high energy prices.
• Meanwhile, ties between Russia and Saudi Arabia appear to be tightening.
• Protests against the beating death of a woman in Iran who refused to wear a head covering have become widespread, leading the government to reduce internet connectivity as a way to prevent organizing. According to reports, five protestors have died as security forces attempt to quell unrest.
• In recent interviews, President Raisi of Iran has made it clear that his country won’t rejoin the nuclear deal without guarantees that a future administration won’t exit it again. Since the deal is not a treaty, the Biden administration cannot bind future governments to it.  If this position is maintained, there is little chance that the U.S. will rejoin the pact.  Although the market may take this as bullish, in reality, we harbor doubts that the current sanctions are keeping Iranian oil from global markets.  Thus, the impact of failed negotiations may be minor.

 Alternative energy/policy news:

• There is an old adage in commodities that “nothing cures high prices like high prices.” The idea is that high prices lead consumers to reduce demand and suppliers to boost output.  In the current high-price environment, most of the adjustment has come from consumers.  However, one area often overlooked is increasing efficiency.  A recent report indicated that data centers, server farms that do the calculating that fosters AI and the internet, tend to generate massive levels of heat that is usually vented.  However, with prices for energy high, there are efforts to capture this energy and use it for the production of steam.
• As EVs expand, lithium, a key mineral in batteries, is in high demand. It tends to be found from two sources:  ‘hard rock’ mining and evaporating brine at high altitudes from waters containing lithium.  The latter source is mostly found in South America, primarily Chile.  The former source is distributed around the world, with several mining sites in Canada.  A major, yet undeveloped, mine exists in Quebec.  Despite high demand and high prices, the mine remains uncompleted due to various obstacles.
• Hertz (HTZ, $18.15) announced plans to purchase 175,000 EVs from General Motors (GM, $39.17) over the next five years.
• Modular nuclear reactors hold the promise of expanding nuclear power quickly to less populated regions. Despite their promise, industry expansion has been slow.  There are several reasons.  First, most of the research and development of these reactors are still in the concept and design phases.  This situation is still favorable, because is suggests this product will become increasingly available.  But for now, electricity from small modular nuclear reactors remains in the future.  Second, connecting to the grid remains an issue in some markets.  One possibility would be to site these reactors where current coal-fired plants reside, allowing for rapid connectivity.  And finally, even with modularity, nuclear power remains controversial, which tends to slow development.
• Although key metals for clean energy are found in various places around the world, processing is concentrated in China.

• A leak at a German nuclear power plant has led to its temporary closure.
• One of the benefits of offshore wind energy is that, unlike on land, offshore wind is more constant. Despite this benefit, getting projects completed has been remarkably slow.
• As the West builds out LNG infrastructure, there is a concern that these assets, which have long lives, could become stranded.
• Policies are sold. As governments try to sell clean energy to their citizens, leaders are touting the prosperity the change will bring.  Even in China, with an authoritarian government, there are concerns about whether clean energy will bring economic benefits.  A related element of this goal is that governments are taking steps to favor domestic firms to build out the clean energy industry.  Such actions will likely run afoul of WTO rules.  Our take is that the trade rules will be broken, lending additional evidence that we are ending the current phase of globalization.

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