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

Here is an updated crude oil price chart.  Prices broke out of their recent trading range and are now well above $55 per barrel.

Commercial crude oil inventories unexpectedly fell 1.0 mb when a build of 3.0 mb was forecast.

In the details, U.S. crude oil production was unchanged at 10.9 mbpd.  Exports rose 0.1 mbpd, while imports increased by 1.4 mbpd.  Refining activity rose 0.50%.

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s decline, though small, is contraseasonal.  The usual seasonal pattern occurs due to refinery maintenance; in the past, the U.S. oil industry had limited ability to export, which contributed to the seasonal pattern.  With the potential for higher exports, the expected seasonal build may not occur, which would be bullish for prices.  If we were following the normal seasonal pattern, oil inventories would be 22.4 mb higher.

Based on our oil inventory/price model, fair value is $48.37; using the euro/price model, fair value is $70.79.  The combined model, a broader analysis of the oil price, generates a fair value of $58.32.  The wide divergence continues between the EUR and oil inventory models.

Geopolitical news:

• The Biden administration has reportedly offered the EU its terms for allowing the Nord Stream 2 project to be completed.  First, the U.S. wants the EU (read: Germany) to renegotiate its gas transit contract with Ukraine.  Second, it wants to build in a shutdown mechanism on the pipeline so that if Russia cuts off natural gas flows through Ukraine, the Nord Stream 2 flows would also be suspended.  It’s hard to see why the EU would accept these terms.  The whole point of the pipeline is to avoid the bottleneck through Ukraine, which holds the EU hostage to Russian/Ukrainian relations.  But, Germany and the EU may want to show they want to work with the incoming Biden administration and agree.
• Israel is warning that it has new plans to attack Iran’s nuclear program.  Given that relations with the Arab states have improved through the Abraham Accords, the logistics of an Israeli attack have improved.  We doubt Israel will act but it is a warning to the new administration that the situation in the Middle East is fluid and may become a problem.
  • Although the Biden administration says it would like to return to the Iran nuclear deal signed under the Obama administration, it is unlikely that Iran would return under the previous agreement.  This situation makes returning to the deal difficult.  Compounding the problem is Iran’s continued development of missile technology, which was generally excluded from the original agreement.
• At the same time, the Biden administration is suspending arms sales to the UAE and the KSA.  This decision includes the sales of F-35s to the former, which was made in return for its recognition of Israel; we do expect the sale to be completed at some point.

Energy industry news:

• Although hope is rising for energy shares, it is still unclear if the industry, especially shale, can woo investors back.  As we note below, the future isn’t bright.  Although the world will be using oil and gas for the next couple of decades, it’s likely that consumption will decline over time.
  • Adding to pressure is that pipeline projects are becoming much more difficult to complete.  It may be that major projects have become impossible.
  • Worries about a shrinking industry led two of the supermajors, Exxon (XOM, USD, 45.63) and Chevron (CVX, USD, 87.06), to discuss a merger in early 2020.  As industry growth slows, and eventually contracts, cost-saving through mergers will likely become more common.
  • The earnings for oil companies in 2020 were “brutal” as the pandemic and regulation weighed on the sector.  This year will be better, but not stellar.
• It is important to note that commodities are priced based upon current supply and demand fundamentals with less regard for future market conditions.  In other words, the price of oil a decade from now doesn’t have a major impact on current crude prices.  But it does affect energy equities, which discount the future.  Thus, the outlook for future oil demand is bearish for energy equities, but paradoxically it is actually supportive for oil prices because less investment means supplies will fall, likely faster than demand contracts.
• The only commercial carbon capture program closed, oddly, due to low oil prices.  The program sold the carbon dioxide it pulled from burning coal to oil producers to enhance oil production (CO₂ injection is one method to enhance oil output).  When oil prices fell, it was no longer economical to operate the plant.  Carbon capture has been one hope the fossil fuel industry has to maintain the industry in a low carbon world.  Unfortunately, thus far, the programs have failed to deliver.

Alternative energy/policy news:

• General Motors (GM, USD, 52.48) announced it would phase out gasoline and diesel fuel vehicles by 2035, the first major automaker to create a hard timeline to offer a fully electric line of vehicles.  It is not clear whether other automakers will follow, but if governments start to back this decision, the future of oil in transportation is facing a serious threat.
• Although the new administration is moving quickly to establish climate change regulation, the energy industry is responding, trying to slow the rollout.
  • The oil and gas industry is trying to make common cause with the farm belt.  After all, the electrification of transportation will curtail the use of ethanol and reduce the demand for corn.  Unfortunately for oil and gas, the industry has undermined the use of ethanol by supporting the EPA’s exemptions for meeting the mandate for ethanol demand.  It is expected that the Biden administration will not be as generous in granting exemptions.  When a refiner can’t use enough ethanol to meet the mandate, it must buy Renewable Identification Numbers (RINs) to fulfill the mandate.  The prices of RINs have been rising since summer.  Farm groups have been upset by the wide use of exemptions which undercut the demand for corn ethanol.
  • The Trump administration used the Commodity Credit Corporation (CCC) as a conduit for aid to farmers affected by the China trade conflict.  This use was outside of the original mandate of the CCC, which was created during the Great Depression to support commodity prices.  The Biden administration wants to continue to use this broader mandate, perhaps using the CCC funding to support a carbon bank, paying farmers for absorbing carbon by the crops they plant.
• In the waning days of the Trump administration, the OCC ruled that banks could not exclude industries from lending simply based on the industry itself.  The Biden administration has reversed this ruling, which means that banks can decide not to make loans to oil and gas firms.
  • The Fed is expected to support environmental lending as part of its regulatory mandate.
  • Fund managers are getting into the act as well.
• Although the new administration has tried to make the point that expansion of jobs in solar and wind will offset losses in fossil fuels, the numbers don’t support the claim.
• The EU is creating a body to foster the development of batteries.
  • The “hottest” area of batteries is solid state.  Solid state batteries will charge faster, have greater range, and last longer than the current arrays.  China claims it is making progress toward the commercialization of such a battery.  Despite the hopes, it will probably take years before the technology is developed and commercialized.
• A problem for “green” energy is that much of it requires rare earths in construction.  Rare earths production is mostly controlled by China, but the Pentagon is trying to support non-Chinese mining and processing by awarding contracts to firms.
• The other fuel we are watching is hydrogen.  Although most of the focus is on batteries, a competitor would be fuel cell cars fueled by hydrogen.  The process of extracting hydrogen from water offers the most promise but is still far too expensive to be practical.  However, there is continued progress on this front.

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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 consolidating between $54 to $52 dollars per barrel after a strong rally from early November into late January.

Commercial crude oil inventories unexpectedly fell 9.9 mb when a build of 1.5 mb was forecast.

In the details, U.S. crude oil production declined 0.1 mbpd to 10.9 mbpd.  Exports rose 1.1 mbpd, while imports declined 1.0 mbpd.  Refining activity fell 0.8%.

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s decline is abnormal.  The usual seasonal pattern occurs due to refinery maintenance; in the past, the U.S. oil industry had limited ability to export, which contributed to the seasonal pattern.  With the potential for higher exports, the expected seasonal build may not occur, which would be bullish for prices.  Of course, one week doesn’t constitute a trend, but the decline was notable.

Based on our oil inventory/price model, fair value is $48.05; using the euro/price model, fair value is $70.80.  The combined model, a broader analysis of the oil price, generates a fair value of $58.18.  The wide divergence continues between the EUR and oil inventory models.

Distillate consumption has returned to normal and should continue to rise on a seasonal basis.

We continue to see evidence of market and policy measures causing a divergence between oil and gas prices compared to related equities.

• The steady supply of oil relies, in part, on continued exploration and field development.  Last year, there was a notable decline in acreage acquisition by the largest oil companies in part due to low oil prices.  Because virgin oil fields require investment well before they begin producing, there is a risk that future declining demand will strand the investment.   We are already seeing declines in exploration budgets.
• We expect that pipeline growth will be further restricted.  This is bullish for oil and gas prices, and bullish for existing pipelines, but determining the impact on individual companies is hard to generalize.
• As expected, the Biden administration is restricting drilling on federal lands.  The oil industry will likely engage the courts to overturn this ruling, but, for now, it looks like this area won’t be available for production.  It represents about 9% of onshore production.
• By early in the next decade, it is estimated that 50% of new car sales will be EVs.

Here is the geopolitical news:

• In a bid to diversify its economy, the Kingdom of Saudi Arabia (KSA) is using its sovereign wealth fund to encourage health and tech companies to set up operations in the country.
• Also in the KSA, the U.S. is engaging in a quiet buildup of forces to counteract Iranian actions.
• As the Biden administration takes power, Israel is starting to saber-rattle, warning it may attack Iran.  Such comments dwindled under the last administration but were common during the Obama government.  Our take is that Israel probably won’t take unilateral action, but there is a chance that a coordinated action may be more likely as relations improve with the Arab Gulf states.
• Indonesia has detained Chinese and Iranian oil tanker crews who were engaged in illegal oil transfers in Indonesian waters.  We suspect this was done to evade sanctions.
• China is expanding its investment in green projects as part of the “belt and road” program.

On the alternative energy front, here is what we saw this week:

• Lenders are offering lower interest rates to commodity firms and traders who lower their carbon output.  This allows the banks to package these as “green” loans to investors to meet ESG goals.
• Blackrock (BLK, USD, 709.76) CEO Larry Fink warned companies that if they lag in achieving the goal of net zero emissions by 2050, the asset manager may exclude them from active portfolios.  Blackrock is using its power as a large owner of company equities to press for climate change action.
  • Exxon (XOM, USD, 46.38) has partially succumbed to activist pressure, announcing it will make changes to its board and take measures to reduce its carbon output.
• Large battery arrays are becoming more common as utilities use them to smooth out the variable flows from wind and solar power.
  • We are seeing a buildup of U.S. battery production.
• Recent studies suggest the costs of solar power will continue to decline and replace conventional energy.

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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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