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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Here is an updated crude oil price chart.  Prices are moving higher on dollar weakness and the recent OPEC+ decision, discussed below.

Commercial crude oil inventories fell 8.0 mb, well below the -1.5 mb draw forecast.  The SPR was unchanged; there is still 3.1 mb of storage in excess of the 635.0 mb that existed before the pandemic.

In the details, U.S. crude oil production was unchanged at 11.0 mbpd.  Exports and imports were also unchanged.  Refining activity rose 1.3%.

The above chart shows the annual seasonal pattern for crude oil inventories.  Since this is the first reporting week of the year, the data overlaps.  But it is important to note that inventories usually rise about 10% into mid-April.

Based on our oil inventory/price model, fair value is $45.18; using the euro/price model, fair value is $75.75.  The combined model, a broader analysis of the oil price, generates a fair value of $57.32.  The wide divergence continues between the EUR and oil inventory models.  Although the inventory issue is a concern, as we note below, if the Saudis are going to play the role of swing producer then the dollar is probably a more important variable.

In geopolitical news, OPEC was in deep negotiations on output policy.  The Russians wanted to increase output, while most of the rest of the cartel, including Saudi Arabia, want to hold production steady.  Although the group has been able to manage output changes without roiling the market, the underlying problem is that Russia has less production flexibility than the Middle East producers.  There are seasonal shut-ins that Russia can execute but closing production in other areas will lead to permanent loss of output.  The Saudis resolved the issue, virtually single-handedly, by agreeing to a unilateral cut of 1.0 mbpd.  We don’t expect the cartel reduction to be this size as other nations (Russia, Kazakhstan) will fill some of the gap.  But, this does show that the Kingdom of Saudi Arabia (KSA) is committed to maintaining price levels at the cost of market share.  This action is very bullish, at least for now.  At some point, however, the KSA will want its market share back.  In effect, the KSA is acting as swing producer as it did from 1973 to 1985.  In December 1985, the KSA signaled it was no longer willing to cede market share to prop up prices.  The end result was a 66% plunge in oil prices.  We doubt the Saudis intend to return to the swing producer role on a permanent basis, but their actions create a precedent that will be hard to undo.  One other interesting fact—for the first time in 35 years, the U.S. didn’t import any crude oil from Saudi Arabia.

In other geopolitical news:

• Tensions with Iran remain elevated. The U.S. initially moved the U.S.S. Nimitz out of the region then sent it back; B-52s have been located into the area.  Iran announced it will increase uranium enrichment, which will complicate the incoming Biden administration’s attempt to return to the Obama-era nuclear deal.  It will complicate regional tensions as well.
• Iraq has announced that China is prepaying a year’s worth of imports. This will relieve fiscal pressure on Baghdad and, at the same time, enhance China’s influence in the Middle East.
• Qatar and Saudi Arabia are ending their feud that led to the border being sealed. Although we don’t think the issues have been fully resolved, it appears that the Saudis have concluded it isn’t in their interest to maintain hostile relations.  The blockade simply allowed Turkey to increase its influence in the region and thus has to be seen as a foreign policy error.
• Venezuelan President Maduro has solidified his power in the country by regaining control of the legislature. Although not a pressing problem, the regime in Caracas remains an unresolved problem.  The UAE, usually an ally of the U.S., has become a key link in Venezuela’s sanction avoidance.
• The World Bank reduced its GDP growth forecast for 2021; weaker growth is a negative factor for oil demand, and if the expected rebound fails to materialize this year then oil prices will face bearish pressure.

Here is what we are following in alternative energy news:

• Carbon sequester has been part of climate policy for some time.  There are two primary areas; the first is through biological methods, e.g., planting trees and carbon-absorbing crops.  The second uses physical methods to pull carbon dioxide out of the air.  On the former, we are seeing a surge in interest from the farm sector.  In Europe, planting grasses in peat bogs is being considered.  Peat tends to hold large amounts of CO₂; drying it out tends to release it into the atmosphere.  Farmers are considering rewetting dried out peat bogs and planting new grasses for harvest.  In the U.S., paying farmers to change practices to capture carbon is being discussed.  Providing money to farmers for changes in agricultural practices will be politically popular and thus we would expect policy momentum to develop on this issue.
  • Carbon capture was part of the omnibus government funding bill.
• For the first time since 1885, the U.S. consumed more green energy last year than coal.
• We continue to monitor developments on the hydrogen front.
  • Geopolitically, the end of oil could be disastrous for Middle East oil producers. However, that is only true if they fail to adapt.  There are discussions in the region about using solar energy to produce hydrogen and convert it to ammonia for cheap shipping.
  • Using hydrogen for a shipping fuel is being investigated.
  • Although hydrogen, by itself, is quite green, making it can be anything but environmentally friendly.  Using coal-fired electricity to make hydrogen is hardly worth the effort.  But, as we have discussed recently, turning to nuclear power for making hydrogen could create a fuel free of fossil fuels.  Instead of the large reactors used for electricity, the industry is moving toward modular reactors than can be mass produced and moved to production areas.  Improving the efficiency of catalysts to extract hydrogen from water is also being researched.
  • Oil majors are starting to make larger investments in this area.  Expanding scale is important to achieve the goal of lower cost.
• On auto-electrification, the next “new thing” is the solid-state battery.  Such a device would make the cars safer and allow for rapid recharging.  Here is an update.  Another area to watch is recycling.  As more electric cars are produced, the need to recycle old batteries will become more important.  If the recycling industry expands, it should reduce the need for metals mining.

Here is what we are following in energy policy:

• As President Biden slowly moves toward the Oval Office, the energy industry braces for policy changes.  Clearly, there will be more focus on reducing carbon emissions, which is not good news for the oil and gas industry.  At the same time, Biden is a centrist and lacks the power to make sweeping changes to the industry.  We would expect less direct intervention from the president compared to the Trump administration, but there will be changes that will likely help alternative energy and larger oil companies.
• Another area we are watching is the impact of central banks on climate change policy.  Although we are not seeing anything direct, it is clearly on the radar screen.  One area where we could see intervention is in central bank buying of “green bonds.”

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