Energy price declines not limited to oil

With all the focus on falling crude oil prices (chart below) as well as sharp reductions in the cost of gasoline (including retail), jet fuel, and heating oil, it's easy to miss the fact that prices of other energy products have been hit quite hard as well

Source: barchart

Here are a few examples:

1. US natural gas price declines have been spectacular.

March 2015 futures contract (source: barchart)

Natural gas valuations are of course responding to the correction in oil. But other factors include strong US gas production and the normalization of gas inventories in storage after the harsh 2013-14 winter.

2. Coal prices have fallen sharply as well, particularly for Appalachian coal (see chart). Coal traded in Asia (chart below) has also been under pressure.

Source: barchart

3. Price declines have not been limited to fossil fuels. Even uranium futures have been selling off in spite of rising Japanese demand, as nuclear reactors go back online - see chart.

4. Expectations of weakening profitability for alternative energy sources, including wind and solar, are showing up in the significant share underperformance against the broader markets (which started with declines in crude prices).

          Red = solar shares; Blue = S&P500

           Red = wind energy shares, Blue = S&P500

Source: StockCharts.com

5. With major sources for power generation becoming cheaper, electricity prices (chart below) have declined as well.

January-2015 PJM Monthly On Peak (source: barchart)

As discussed before (see post), this is quite positive for the US (and global) economy. However a number of industries involved with products discussed above will be severely disrupted in 2015, resulting in debt restructuring, consolidation and some job losses.

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At current prices Bakken and Permian Basin are in the red

Although OPEC's decision to maintain current crude production quotas was not entirely unexpected (see post), the market reaction was violent. WTI crude fell by 10% over the last two days of the week.

At $66 per barrel North American producers have real problems on their hands. While Eagle Ford is still profitable, both Bakken and Permian Basin are in now the red.

Scotiabank: - Based upon an analysis of more than 50 oil plays across Canada and the United States, we estimate that ‘mid-cycle breakeven costs’ in the North Dakota Bakken (1.05 mb/d) are roughly US$69 per barrel and in the Permian Basin in Texas (1.63 mb/d) about US$68. While some producers have hedged forward at higher prices, if WTI oil remains around US$70 for more than six months, it appears likely that drilling activity will slow in more marginal areas of these plays as 2015 unfolds. Funding for independent oil producers will also tighten. However, the ‘liquids-rich’ Eagle Ford (1.45 mb/d) will be little impacted, with breakeven costs averaging only US$50.

That's why we've had such an extreme sell-off in US oil & gas shares on Friday (see chart) and Canadian shares underperformed (see chart). If prices persist at current levels for months to come, the Saudis will achieve their objective of dealing a blow to North American oil production. Current expectations of the US outpacing Saudi Arabia as the number one oil producer (see chart) will be shelved for some time. And the only thing the US government could do at this point to support the domestic oil industry is to begin increasing the Strategic Petroleum Reserve. Of course such a measure would be temporary and if global demand does not improve, prices will begin falling again.


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Lower crude oil price in the US does not imply oversupply

Social media has been circulating this chart on US crude oil, that seems to indicate that the US is sitting on excessive inventories. That's simply not true. In fact US crude oil availability in storage, as measured in days of supply, is tighter than it was last year.

Source: EIA

The same holds true for gasoline.

Source: EIA

Furthermore, the WTI futures curve is in backwardation, indicating that the demand for physical crude in the US remains robust (this is not the case for Brent).

Sharply lower crude oil prices is a global phenomenon and is by no means an indication of slack demand or excessive inventories in the US.

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Update on crude oil markets

Crude prices came under pressure again today. According to Reuters (from last week), the Saudis “will accept oil prices below $90 per barrel, and perhaps down to $80, for as long as a year or two”. Their goal is to shake out some of the high-cost competition (such as the US). The Saudis also do not want to choke off the economies of their customers by cutting production. Current production levels are likely to stay unchanged unless there is a significant price move to the downside from here. Spot crude is now holding right in the middle of the Saudis’ preferred range at around $85/bbl. Both OPEC and non-OPEC producers are not particularly happy with Saudi Arabia right now (particularly Russia, Iran and Venezuela) – these countries all want to see production cuts.

A significant difference remains in the demand profile between the international crude markets and those in the US. While both of the futures curves shifted sharply lower, the WTI curve, unlike Brent, remains in backwardation. It means that US crude oil market participants have an incentive to take oil out of storage rather than storing it. This indicates a more robust US spot crude demand than exists globally.

Source: Deutsche Bank

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From our sponsor:

The good, the bad and the ugly of falling energy prices

The recent correction in the price of crude oil should have an immediate positive impact on the US consumer as well as on a number of business sectors. However there also may be a significant economic downside to this adjustment. Here are some facts to consider.

1. The good:

The US consumer is not only about to benefit from materially lower gasoline prices (see chart), but also from cheaper heating oil.

Source: barchart

With wages suppressed, the savings could be quite impactful, particularly for families with incomes below $50K per year.

Merrill Lynch: - ... consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.

Source: Merrill Lynch

Furthermore, with gasoline prices lower, it is unlikely that consumers will be buying significantly more of it than they have been. Historically when oil prices fell, gasoline consumption in dollar terms also fell. Dollars saved on fuel will be redirected elsewhere in the economy.

Source: Scotiabank

Moreover, suppressed oil prices will, at least in the near-term, keep inflation expectations lower. That means lower short-term rates for longer (see chart) and therefore lower home equity and adjustable rate mortgage monthly payments. It also means lower longer-term rates and cheaper fixed rate mortgages (see chart). We may even see some new refi activity.

Other benefits include cheaper transport (potentially lower travel costs) and shipping costs (lower UPS/Fedex surcharges), as well as cheaper PVC, nylon, polyester, foam, etc. - all of which should benefit the consumer.

2. The bad:

The US has become a major energy producer, with the sector partially responsible for improving economic growth and lower unemployment in recent years. As an example here is the GDP of Texas as a percentage of the US GDP. This trend is driven in part by the recent energy boom in the state.

Source: @M_McDonough

If oil prices remain under pressure, this boom could soon be in jeopardy. While large US energy companies are sitting on a great deal of cash, at some point they will begin to cut portions of the higher cost development and production. And private investment into energy and oil services firms, which has been brisk lately, is likely to moderate. For example, here is the private debt and equity capital flowing into various states last month.

Source: CAZ Investments

While, only a portion of the funds going to Texas is directly energy related, various other Texas firms funded by PE (including some real estate, manufacturing and financial companies) have been benefiting from the energy boom. Soon that flow of private capital may slow dramatically.

To put this into perspective, here are the jobs directly generated from Texas oil and gas extraction in recent years. And this does not include the thousands of jobs that support this industry. Such trend is unlikely to continue if oil prices remain at current levels or fall further.

In fact, while the overall industrial production growth in the US has been strong recently (see chart), a big portion of the gains are energy driven (see chart from Lee Adler). A slowdown in that sector will be quite visible across the US.

3. The ugly:

A significant number of middle market energy firms in the US - many funded via private capital (above) - are highly leveraged. The leveraged finance markets are becoming quite concerned about the situation - even for larger firms with traded debt. Here is the yield spread between the energy sector loans in the Credit Suisse Leveraged Loan Index and the index as a whole.

Source: Credit Suisse

Rumors have been circulating of a number of energy (and related services) firms getting ready to "restructure". There are also stories that some large funds are gearing up to scoop up distressed debt of levered energy firms. However, in spite of the ample liquidity out there, bets on companies with significant commodity exposure will be limited going forward - at least until stability returns to the oil markets. Defaults, layoffs, and cancelled projects in the energy space may be in store in the near-term. And that is sure to have a negative impact on the US labor markets and the economy as a whole.

Finally, this is terrible news for the development of alternative energy sources. At these prices, fossil fuels are becoming increasingly difficult to compete with.

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Latest dynamics in US energy markets

Here are two major trends currently underway in the US energy markets:

1. Cushing, Oklahoma inventories (the location for settlement of WTI futures) are falling to new lows. The crude backlog that existed in recent years has been resolved. Oil now moves in sufficient quantities (via Seaway and other infrastructure) to the Gulf Coast as well as to Midwest refineries to stabilize and even cut inventory in storage. Also Cushing is now often bypassed, with crude moved directly to the Gulf via rail.

2. US refineries are now pumping at record levels, as lower US crude feedstock costs contribute to refinery profitability.

Source: EIA

Oil & Gas Journal: - Refinery inputs reached a record-high of 16.8 million b/d in each of the past 2 weeks, exceeding the previous record from summer 2005, according to the US Energy Information Administration. Inputs at refineries in the Midwest and Gulf Coast have been particularly high, reflecting these refineries' access to lower-cost crude oil, expansions of refining capacity, and increases in both US demand and exports.

These dynamics are part of the reason we see outperformance in shares of firms like Tesoro for example.

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Speculative activity in WTI

Crude oil technicals are not looking great, as the speculative accounts are becoming increasingly net long WTI futures. This is “fast money” chasing a quick Iraq-driven spike. What if it doesn't happen?

While the Iraq risks are quite real, the market remains well supplied and significant price declines are quite possible.

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From our sponsor:

US oil refiners taking advantage of changing energy landscape

The US energy markets continue to adjust to rising domestic production and shifting delivery capabilities. The bottleneck of transporting oil from Cushing, Oklahoma (settlement point for WTI futures) to the US Gulf Coast has been eased via improved pipeline capacity as well as higher rail deliveries. The oversupply of crude at Cushing rapidly dissipated.

Source: EIA

Crude supplies at the Gulf Coast on the other hand rose sharply (see discussion). However as the second chart below shows, when measured in terms of "days of refinery throughput supply" (the amount of time it takes refineries to absorb all this crude) the region does not look so oversupplied.

Source: EIA

That's because as more crude was being delivered to the Gulf Coast, the refining capacity in the region continued to grow.

EIA: - Gulf Coast refineries have been running at near record levels for much of 2014. Through May, crude inputs at Gulf Coast refineries averaged 8.1 million barrels per day (b/d), an increase of 0.5 million b/d compared with the same period in 2013. Price-advantaged crude oil and natural gas feedstocks have encouraged high utilization rates at PADD 3 [Gulf Coast] refineries. Crude oil distillation capacity additions have also supported higher crude runs. All other factors equal, increased refinery crude runs increase crude inventories required for operations.

Source: EIA

Part of the reason for this rising capacity has been the improvement in refining profitability. Crack spreads (price spread between gasoline or heating oil and crude) have risen substantially this year.

Source: Barchart

As a result, independent refinery shares have substantially outperformed the overall equity market.

Source: Ycharts

Some analysts believe that the conflict in Iraq (see discussion) could benefit US refineries further. With supply disruption risks widening the Brent-WTI spread these companies' margins would improve.

Barron's: - As rebels seize control in Iraq and threaten the flow of crude, shares of some U.S. oil refiners are well-positioned to hit new highs. With extremist Sunni militant incursions threatening Shiite control in Iraq, the international Brent oil benchmark price, on which U.S. gasoline prices are based, is up more than 4% in June to $114.99 per barrel. The U.S. benchmark is up 3% to $106.11 per barrel.

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From our sponsor:

Shifting bottlenecks in US energy markets

With the startup of TransCanada's Cushing Marketlink pipeline and increased rail shipping of crude directly to the US Gulf Coast (bypassing Cushing, Oklahoma), a new dynamic in the US energy markets is taking shape. The glut of crude at Cushing (see post form 2012) that used to put downward pressure on WTI is over.

With the transport backlog to the Gulf Coast diminishing, crude supplies at Cushing (the delivery point for WTI futures) fell significantly, once again contributing to tighter Brent-WTI spread. Lower supplies at Cushing raised WTI prices while Libya resuming crude exports lowered Brent prices.

Brent-WTI spread (source: Ycharts)

This development however created another bottleneck. The oversupply of crude has shifted from Oklahoma to the US Gulf Coast.

Source: EIA

Bloomberg: - Houston and the rest of the U.S. Gulf Coast have more crude oil than the region can handle. Stockpiles in the region centered on Houston and stretching to New Mexico in the west and Alabama in the east rose to 202 million barrels in the week ended April 4, the most on record, Energy Information Administration data released yesterday show.

One of the key issues is the US crude oil export restriction. Back in the 70s, the US Congress made it illegal to export domestically produced crude oil without a permit. And permits are tough to get these days, given how unpopular the notion of US oil exports seems to be. The Jones Act which restricts shipping among US ports is also adding to the bottleneck. 

Bloomberg: - Storage tanks are filling as new pipelines carry light, sweet oil found in shale formations to the coast and U.S. law keeps companies from moving it out. Most crude exports are banned and the 13 ships that can legally move oil between U.S. ports are booked solid. The federal Jones Act restricts domestic seaborne trade to vessels owned, flagged and built in the U.S. and crewed by citizens.

Now it's the refineries who will need to clear this inventory and ultimately export the excess product. And that's exactly what is taking place currently, as idle US refining capacity hits a multi-year low.

Source: EIA

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From our sponsor:

US refineries' production hits a record; reasons for the increase misunderstood

During the month of December large money managers have been once again beefing up their long bets on crude oil.

This chart shows only the "large spec" net positions for WTI futures

Bloomberg: - Hedge funds increased bullish bets on crude oil to the highest level in three months as stockpiles dropped and the U.S. economy expanded more than forecast.

Money managers raised net-long positions, or wagers on rising prices for West Texas Intermediate crude, by 4.4 percent in the week ended Dec. 24, U.S. Commodity Futures Trading Commission data show. It was the fourth consecutive increase, the longest streak since July.

What's driving this push into crude? The media focus has been on the recent sharp decline in supplies, which some have attributed to improving economic conditions in the US.

Source: EIA

While the US economy is certainly showing signs of improvement, there is more to this story than the domestic demand for energy. This drawdown in crude was the result of US refineries firing on all cylinders, particularly in the Gulf Coast states. In fact refinery inputs have hit a new record.

Source: EIA

As discussed earlier (see post), US energy firms can export gasoline and jet fuel abroad but are restricted from easily exporting US crude. With domestic crude production at recent record levels (see Twitter chart), refining and selling abroad is the name of the game. And that is benefiting the US refinery sector. Just take a look at the outperformance of Valero Energy Corporation (VLO).

Blue = VLO, Red = S&P500

The mass media is looking for simple answers for these rising long bets and stronger prices on crude oil.

The Columbus Dispatch: - Oil finished the year with a gain of 7 percent with much of the gain coming this month on signs that an improving U.S. economy is leading to greater demand for gasoline and diesel fuel.

But the "US growth" explanation is not accurate. Over the past several years, US exports of refined products have tripled, going from about a million barrels per day to over 3 million. And bets on WTI crude are more about increased refinery capacity in the US and the resulting growth in exports.

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From our sponsor:

Brent-WTI spread widens again as the discount shifts to the Gulf for the first time

The spread between crude oil traded in the international markets and the US benchmark, the so-called Brent-WTI spread has blown out once again. It's now approaching levels not seen since February.

What's going on? What happened to the Goldman's forecast of convergence between the two indices, as more US crude is pumped from the Midwest toward the Gulf of Mexico (see post)? In the past the bottleneck was in moving growing US supplies from Cushing, Oklahoma (where WTI settles) to the Gulf. While that problem has been at least partially solved, the oversupply of crude now simply shifted from Oklahoma to Louisiana.

FT: - Surging shale oil production along with severe restrictions on exports has led the US oil market to diverge from the global market in recent years. This week US benchmark West Texas Intermediate crude fell to a five month low of $91.77 per barrel, almost $20 per barrel less than the global marker Brent.

But until recent months infrastructure constraints have made it costly to move oil from inland shale formations to the country’s main refining hubs in Texas and Louisiana, limiting the benefits of low prices to the wider US economy. With more oil now able to flow through pipelines, the Gulf Coast market is also diverging from Brent. On Thursday, Louisiana Light Sweet, the Gulf Coast benchmark, hit a low for the year of $95.30 per barrel. Its discount of $16.01 per barrel to Brent, was easily the highest on record in Reuters data going back twenty years. Traditionally LLS has traded at a premium to Brent, reflecting its superior quality and the cost of shipping to the US.

Source: EIA

Surely at these spreads it is worth shipping US crude from Louisiana to Europe to sell at Brent spot prices. After all, US crude is of the quality that Europe needs (vs. the heavy Saudi crude). It's not so simple however. Back in the 70s, the US Congress made it illegal to export domestically produced crude oil without a permit. And permits are tough to get these days, given how unpopular the notion of US oil export seems to be. So much for the concept of "free trade". Instead US crude oil inventory continues to grow, widening Brent-WTI spread, as domestic production expands.

Source: EIA

And while there is a restriction on crude exports out of the US, selling refined products such as jet fuel and gasoline abroad is allowed.

FT: - The low prices are a boon to Gulf Coast refiners, which can pick up crudes at low local prices and then sell refined, products such as gasoline and diesel, which can be exported from the US freely, into the international market at high prices.

At about 3m barrels a day, exports of finished petroleum products from the US are running at three times the rate of eight years ago, according to US government data.

These changing dynamics in the US energy markets are having two major effects:

1. US refineries are loving this. The government is holding down domestic crude prices by limiting exports, while allowing refiners to sell as much gasoline abroad as they want. Refined products abroad are generally priced based on Brent, allowing the refineries to capture the spread. In effect the US government is subsidizing the refining business at the expense of crude oil producers. And here is how the stock market is reacting to these recent price changes.

TSO = Tesoro Corporation, a major refiner; XLE = diversified energy index ETF

2. This is putting pressure on nations who traditionally sell crude to the US. While in the past they were able to sell their crude close to international prices, they now get paid much less due to Louisiana Light Sweet becoming significantly cheaper than Brent.

FT: - Imports to the Gulf Coast tend to be priced off local benchmarks including LLS and the Argus sour crude index, a basket of four heavier Gulf Coast crudes. With Gulf Coast prices falling, exporters such as Saudi Arabia and Venezuela are receiving less revenue for their sales into the US.

The discounts of US crude show no sign of ebbing with oil inventories continuing to rise as production grows, and many refineries remaining closed for maintenance.

Needless to say, these nations are not happy with the US as they now have to find alternate buyers in order to get the full price for their product. And many in the US are quite happy with this outcome.

When Louisiana crude was trading at a premium to Brent, analysts thought that by improving the transport system from Oklahoma to the Gulf will eliminate the Brent-WTI spread. Instead it simply shifted the discount further "downstream". And with that came other unintended consequences that often result from uneven regulation.

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From our sponsor:

Crude oil leading commodities slump

As discussed earlier (see post), crude oil (particularly WTI) remains under pressure. As US economic activity slowed (see post), so did the demand for crude. This pushed up inventories to 5-year highs for this time of year.

Source: EIA

The rise in crude inventories can be explained by the fact that US oil production is now 15% higher than it was a year ago, while refinery demand has declined to levels that are similar to last year's. One can see the impact of the government shutdown in the chart below, as refineries cut production.

Source: EIA

Moreover, with the Fed's "taper" looming and the dollar seemingly stable, traders have sent crude prices lower. The weakness in the energy complex has spread to other sectors, pressuring the overall global commodity indices. For example, the CRB BLS Index (described here) is at this year's lows.

Source: CRB

And the DJ UBS Commodities Index is now at the lowest point since the summer of 2010.

Dow Jones-UBS Commodity Index 

While energy remains the largest factor pushing commodity indices lower, demand weakness combined with strong production seems to be pressuring a number of other commodities sectors as well.

Bloomberg: - West Texas Intermediate fell below $95 a barrel for the first time since June. Gold reached a two-week low. Hog futures capped the longest slump in three months, and cotton slumped to the lowest since January.

Production is poised to top demand for everything from coffee to zinc as ample rains this year boosted global crops and demand waned for metals, grains and energy. U.S. crude inventories climbed to the highest since June, data from the Energy Information Administration showed Oct. 30. Commodity returns will be “mostly flat” in the next 12 months, and there are “significant downside opportunities” in gold, copper and soybeans, Goldman Sachs Group Inc. said Oct. 18.

Finally, adding to the softer valuations are some major commodities trading businesses going up for sale.

CNBC: - Facing lingering questions about the oversight and profitability of their businesses, Morgan Stanley and JPMorgan Chase have taken steps to sell their commodity divisions, say people familiar with the matter.

The firms are holding discussions with a range of offshore buyers who wouldn't be subject to relatively stringent U.S. banking rules.

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From our sponsor:

Reasons behind the sell-off in crude oil

WTI crude oil has undergone a substantial correction in the last few days. What's going on?

Source: Barchart

A few reasons for this price adjustment come to mind:

1. Iran seems to be getting ready to enter the market as it prepares for sanctions to be lifted.

Reuters: - Iran is reaching out to its old oil buyers and is ready to cut prices if Western sanctions against it are eased, promising a battle for market share in a world less hungry for oil than when sanctions were imposed.

New Iranian President Hassam Rouhani's "charm offensive" at the United Nations last month, coupled with a historic phone call with U.S. President Barak Obama, revived market hopes that Iranian barrels could return with a vengeance if the diplomatic mood music translates into a breakthrough in the stand-off over Tehran's disputed nuclear programme.

The Islamic republic's crude exports more than halved after the European Union and United States, which accuse Tehran of seeking nuclear weapons, tightened sanctions in mid-2012, cutting its budget revenues by at least $35 billion a year.

"The Iranians are calling around already saying let's talk ... You have to be careful, of course, but there is no law against talking," said a high-level oil trader, whose company is among many that stopped buying Iran's oil because of sanctions.

2. Yesterday's employment report points to weak economic growth, tapering demand expectations for crude. In particular, private payrolls growth came in way below expectations.

Source: Econoday

3. Related to the slower growth expectations for the US as well as to the recent government shutdown is the buildup of crude oil inventories.

ABC: - The U.S. Energy Department will release crude stockpile figures for last week later Wednesday and a 3 million barrel increase is expected.

The supply report for the week ended Oct. 11 was released Monday after being delayed five days due to the government shutdown. It showed crude supplies up by 4 million barrels.

That expectation of 3 million barrels increase was too low. The actual number this morning was 5.2 million, as inventories continue to build.

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From our sponsor:

Equity markets are discounting the rally in crude oil

Energy shares have underperformed the broader market starting in April when crude oil prices touched the lows for the year. Stock valuations clearly responded to the downside. On the up-side however, in spite of the recent sharp rally in crude (see discussion), energy shares continue to lag.

Source: Ycharts

Equity markets are not convinced by the recent spike in oil prices and view it as temporary. The US government economists seem to agree. The recent projection of average cash prices for 2014 puts Brent forecast 9% below the current level while WTI is predicted to be almost 15% below where it currently trades.

Source: EIA

The general consensus seems to be that unless we have further unrest in the Middle East or an unlikely event of materially improving economic fundamentals globally, prices should decline. Of course the question remains: How long should oil prices stay elevated relative to forecasts before energy shares begin to outperform?

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