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

A note to readers: The Weekly Energy Update will go on holiday hiatus following today’s report and will return on January 7, 2021.  From all of us at Confluence Investment Management, we want to wish you a Merry Christmas and Happy New Year!  See you in 2021!

Here is an updated crude oil price chart.  Prices are taking another leg higher on hopes of stronger demand.

Commercial crude oil inventories fell 3.1 mb, in line with the 3.0 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 fell 0.1 mbpd to 11.0 mbpd.  Exports rose 0.8 mbpd, while imports declined 1.1 mbpd.  Refining activity fell 0.8%.

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data showed a decline in crude oil stockpiles, which is normal.  Inventories usually decline into year-end.

Based on our oil inventory/price model, fair value is $40.30; using the euro/price model, fair value is $69.70.  The combined model, a broader analysis of the oil price, generates a fair value of $53.42.  The wide divergence continues between the EUR and oil inventory models.  This week’s jump in oil inventories led to a large decline in the oil model forecast, while the weaker dollar boosted the EUR model forecast.  Overall, the dollar probably has a greater impact on oil prices and thus should keep the market elevated despite high levels of supply.

The IEA report for December continued to paint a bleak outlook for oil as demand remains weak.  For 2021, the group projects demand at 96.9 mbpd, still below the 100.1 mbpd seen pre-pandemic.  At the same time, supply is creeping higher as U.S. production recovers, Libya comes back on-line, and OPEC begins retaking market share.  Still, as we note above, the weaker dollar is a strong catalyst for higher prices and may overcome otherwise soft fundamentals.

Natural gas producers are becoming increasingly adept at adjusting production to market conditions.  If this practice becomes widespread, it could lead to stable natural gas prices.  Simply put, instead of prices adjusting, supply adjusts.

In geopolitical news:

• There was an attack on an oil tanker in the Red Sea near the port Jiddah. It is suspected that a vessel controlled by Yemeni Houthis was likely behind the attack.  A drone boat probably was deployed by the rebels.  The U.S. added additional sanctions on Iran for the abduction and likely death of former FBI agent Robert Levinson.  He was abducted in 2007 but this is the first formal action against Iran for the event.
• Iran has been exporting more oil despite sanctions, with most of the oil going to China.  Iran’s exports remain well below normal levels due to American sanctions.
• Meanwhile, as Arab states normalize relations with Israel (likely creating a potent coalition to oppose Iran), Iran is moving some of its nuclear production to underground facilities to protect against attack.
• Saudi Aramco (2222, SAR, 35.60) has a long reputation for being a good work environment for expat workers. However, a recent report from the FT suggests that may no longer be the case as financial pressures rise on the company.  The report suggests the company is cutting corners on safety, likely to meet financial goals.
• The kingdom is also introducing austerity to reduce its fiscal deficit; usually, such actions are reversed due to fears of civil unrest.

Here is the roundup of climate and alternative energy news:

• Exxon (XOM, USD, 43.04) announced a series of carbon reduction measures.  The company is promising to reduce emissions intensity (carbon per unit of production) rather than a full cut.  In other words, if intensity falls but production rises, the overall output of carbon will continue to rise.  Exxon is facing growing pressure from the investor community to reduce its carbon emissions.  This is a factor affecting the energy sector; although we have seen a rise in equity values recently, it may be a mere recovery bounce.
  • This brings us to a broader issue.  How should investors treat the oil and gas sector?  A case can be made that the future for oil and gas is in peril.  Oil and gas are being hit from all sides between technology that reduces the need for travel, the electrification of transportation, the growing likelihood of a carbon tax, and investor pressure to reduce carbon.  And yet, in the here and now, it is clear that we still need oil and gas.  The last three months have seen a strong recovery; the question now is how long will this last?
  • A key point to remember is that equity markets are anticipatory markets, whereas commodity markets are not.  In other words, the value of a stock is ultimately based on future cash flows; if the future is “cloudy,” investors tend to reduce the value of cash flows into that unclear future.  On the other hand, commodities don’t really pay a future stream of cash (despite academic studies that suggest one can generate cash from futures roll yield, it can just as easily turn into a cost depending on the shape of the futures curve) and the value of commodities is (a) the value of processing it into a product, and (b) changes in price between now and the future.  In this situation, we could very easily see oil and gas equities underperform the commodity; in fact, this has been a feature of the market for the past few years.
  • Industries in decline can still be investible.  Tobacco proves that one can make money in a pariah group.  On the other hand, coal has been a destroyer of capital.  The difference is complicated, but industry concentration plays a role as does the ability to shape regulation.  Tobacco did a masterful job, e.g., eventually turning the states into supporters of smoking.  Coal did not.  If the oil and gas sector takes steps to address climate change and carbon mitigation (e.g., support a carbon tax,[1] invest heavily in carbon capture, branch into alternative energy), the sector might do fine.  If it fails to manage the situation, oil and gas could resemble the path of coal equities.
• China is promising to reduce its carbon intensity (see above) by 65% by the end of the decade.  We take these promises with a grain of salt.  China is still the world’s largest consumer of coal, a fuel with a high carbon content, and the country is continually expanding its coal-fired electricity capacity.  We view this as mostly a public relations move.
  • At the same time, as we have noted in recent Daily Comments, China has been seeing a spate of corporate defaults, especially in the SOE sector.  However, we note that the Xi government did rescue Tianqi Lithium (002466, CNY, 31.38) when it was facing a deadline on a bank loan.  The company is the world’s largest lithium producer, and this move by the state suggests it is being treated as a national champion.  The recent plunge in lithium prices has undermined the company’s ability to manage the default.
  • One of the emerging themes is that the energy world is moving from oil and gas to metals.  In other words, alternative energies and electrification of transportation will require lots more metal (e.g., lithium, cobalt, nickel, aluminum, copper) and much less oil and gas.  Since the turn of the last century, oil has been a primary factor in geopolitics.  That may not be the case in the future; instead, the pivot will be mines.
• Although electric cars are still in the forefront, fuel cell vehicles, powered by hydrogen, may end up being the winner.  Hydrogen can be produced from fossil fuels (gray), natural gas (blue), or electricity (green).  Green hydrogen comes from generating electricity from a non-fossil fuel source (hydro, solar, wind, nuclear) and splitting water to get the hydrogen.  A fuel cell takes the hydrogen, and its waste product is water.
  • This is where nuclear comes in.  Since the Three-Mile Island/Chernobyl/Fukushima disasters, nuclear power has been considered a pariah by environmentalists.  However, we are starting to see a reassessment among this group that reducing carbon emissions is probably impossible without nuclear power.  Like everything, the decision to use nuclear is a tradeoff; as the above referenced events show, nuclear power can be dangerous.  At the same time, rising levels of carbon dioxide in the atmosphere is also considered a danger.
  • The nuclear industry has been building smaller modular reactors that could be used to make green hydrogen.  Modular technology could make permitting easier (once the model is approved, it can be replicated without another permit) and established where needed.  If these reactors become commonplace, it could bring a renaissance to the nuclear industry.

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[1] And the level of the tax.

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

Here is an updated crude oil price chart.  Prices are consolidating after the late November rally.

Commercial crude oil inventories unexpectedly jumped 15.2 mb when a 1.0 mb draw was expected.  The SPR fell 0.1 mb; 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 11.1 mbpd.  Exports fell 1.6 mbpd, while imports rose 1.1 mbpd.  Refining activity rose 1.7%.  The unusual build appears to be a combination of rising imports and falling exports.

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data shows the large rise in crude oil stockpiles, which is clearly contraseasonal.  Inventories are past their second seasonal peak and usually decline into year’s end.

Based on our oil inventory/price model, fair value is $39.28; using the euro/price model, fair value is $69.41.  The combined model, a broader analysis of the oil price, generates a fair value of $52.68.  The wide divergence continues between the EUR and oil inventory models.  This week’s jump in oil inventories led to a large decline in the oil model forecast, while the weaker dollar boosted the EUR model forecast.  Overall, the dollar probably has a greater impact on oil prices and thus should keep the market elevated despite the increase in supply.

The above chart shows refinery utilization.  Although run rates rose, they remain nearly 15 percentage points below average, reflecting weak demand.

In case you missed it, check out this interactive chart of U.S. energy consumption.  Starting in 1800, it shows the shift from biomass to fossil fuels.  It’s a chart you will want to keep.  And, here is a primer on Cushing, OK, the delivery point for the NYMEX oil futures contract, a little town in Oklahoma that is a web of pipelines and a sea of storage facilities.

In Middle East news, two Iraqi oil wells in the Khabbaz field in Kirkuk were set ablaze by explosions carried out by Islamic State.  Although the attack had only a modest effect on prices, Islamic State has been intensifying its efforts in this area, reflecting the lack of security in Iraq.   Although Kuwait has an ample sovereign wealth fund, the emirate is facing a cash crunch as weak oil prices have reduced revenue and the economic slowdown has increased spending.  Moody’s downgraded Kuwait’s debt in September over these concerns.

We have been documenting the decline in product demand due to the pandemic.  Although recessions tend to be bearish for energy demand in general, this one has led to a sharp decline in mobility and has crimped gasoline demand.  We are starting to see a ripple effect through the refining industry.  Refiners have struggled with margins for years and the drop in demand has led to the closure of some refining operations.  These closures have been especially pronounced in the West, where many of the facilities are small and old and thus more costly to operate.  In Asia, there has been an increase in refining capacity and it is likely that, in the future, the West will be importing product from Asia.

On the alternative energy front:

• A potential battery breakthrough could have a significant impact on the electrification of vehicles.  Although all are familiar with lithium batteries, the actual amount of lithium in these batteries is small because the metal is unstable.  In practical terms, it has a tendency to catch fire if charged too quickly.  This is why airlines are uncomfortable with lithium batteries in cargo holds.  Specifically, lithium creates spikes called dendrites.  Over time, these dendrites form on the anodes of a battery and can cause it to short circuit.  A company called QuantumScape (QS, USD, 70.47) claims to have solved the problem by creating a solid state lithium battery.  If true, it would dramatically shorten recharging times (it can reach an 80% recharge in 15 minutes), with more density and longer-lasting.  If this battery works as advertised and is affordable, it would be a significant leap and likely improve adoption of EVs.
• Oil majors are facing increasing pressure to decarbonize.  Shell (RDS.A USD, 37.46) had several clean energy executives leave over a disagreement on the pace of change at the company.  The company says it wants to be at “net zero” by 2050.  Meanwhile, Exxon (XOM, USD, 43.35) is facing pressure to replace board members with ones more amenable to climate mitigation.  We also note the company has been slow to roll out its carbon capture program.
• Tom Vilsack has been chosen for Ag secretary.  He has had that role before; one thing we will be watching for is growing interest among farmers to participate in carbon sequester.  It may be possible for CO₂ to be captured by cover crops, which would bring additional revenue to farmers.  We will be watching to see if Vilsack becomes a proponent of this idea.
• Toyota (TM, USD, 140.70) is planning a new set of EVs.  It is also offering its second generation of fuel cell vehicles.

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