Energy Markets in Decline

Jim Brown
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Brent crude declined -$3.50 and WTI -$2.34 after economic numbers from China and Europe showed a dramatic decline in activity. Bad economics coupled with a sharp spike in the dollar crushed all commodities including oil, precious metals, copper, aluminum and steel.

Dragging the markets lower was a flurry of bad data from overseas. The official Purchasing Managers Index (PMI) for China came in at 50.1 for February. That was down from 50.4 in January. It was the weakest reading in five-months. The HSBC-Markit Economics PMI fell from 52.3 to 50.4 and a four-month low. Readings above 50 represent expansion and below 50 represent economic contraction.

The rebound in the Chinese economy appears to be failing. New orders, an indication of expected conditions in the months ahead, fell to 50.1 and a five-month low while export orders contracted for the second month. China lives on exports and two months of contraction is a bad sign.

In the U.K. the PMI declined dramatically from 50.5 to 47.9. This put the index well into contraction territory and sent the pound to a 2.5 year low and the dollar to a new six-month high. Copper fell -1.4% to the lowest level since November as a result of the Chinese PMI. Aluminum prices dropped for the 10th consecutive day and the longest streak of declines since June.

The British pound declined to a two year low, the Euro to a two month low and the dollar rose to a six month high.

British Pound Chart

Euro Chart

Dollar Index Chart

The S&P GSCI commodity index fell -4% to the lowest level of the year and its fourth weekly decline. That is the longest losing streak since June. Commodity fund investors withdrew a weekly record of $4.23 billion for the week ended Feb 27th. Outflows for the prior week totaled only $829 million. To say there was a dramatic change in sentiment would be an understatement.

Much of the withdrawals came early in the prior week on concerns the Fed would ease up on QE. After the Bernanke testimony to the House and Senate those fears were quashed. The Commitment of Traders (COT) report showed that commodity net long positions declined to the lowest level since March 2009. The strong dollar and declining economics in China and Europe are simply too much of a headwind for commodity traders. With the equity markets moving higher there is a strong incentive to abandon commodities and move to stocks. That strategy could end up being a mistake but time will tell.

Keystone Pipeline

The long-awaited environmental assessment of the new route for the Keystone XL pipeline was released last week. The State Dept draft, makes no recommendation on whether the pipeline should be built but it said the pipeline would not worsen the risks of global warming or endanger the aquifer in Nebraska.

President Obama blocked the original pipeline application ahead of the elections in order to pacify his environmentalist backers. Now that he has been reelected he has said he would approve the pipeline assuming there were no challenges in the assessment. That approval is expected by September. A crowd of 35,000 protested against the pipeline in late February in Washington.

TransCanada (TRP) has already begun construction of the lower U.S. part of the pipeline because it does not need State Dept approval. With the rising production levels in the Midwest and central states the pipeline south from the middle of the country will be fully utilized.

The pipeline is expected to carry 830,000 bpd south from Alberta Canada and additional input points along its route. The State Dept said the pipeline would not worsen climate conditions because the Alberta oil sands would be developed regardless of the pipeline. If the oil does not come to the USA it will simply be piped to a coast and shipped to China. The project will replace oil imported from unstable countries including Venezuela and the Middle East. Approving the pipeline increases the fuel security of the USA.

Gasoline Prices

Prices at the pump have increased by 49 cents since December according to AAA. The auto club said continued refinery outages for upgrades and maintenance would push prices higher in the weeks ahead. The average pump price in the U.S. was $3.782 on Friday and the highest ever for this time of year. It is 10 cents higher than the prior record. The 2012 price hit a high of $3.936 on April 4th.

Refiners boosted utilization by more than 2% last week as some temporary outages ended. The decline in crude prices last week should mean refiners will accelerate purchases of crude while the prices are low. Crude inventories are only about 10 million barrels below a 22 year high of 387.2 million barrels.

Crude prices in the U.S. declined to a low of $90.04 on Friday. That is a two month low and a windfall for refiners able to access WTI crude from the shale fields in the Midwest. It means the gasoline prices will not see as much upward pressure even though the maintenance issues are ongoing. Brent crude declined to $110 and that helps the refiners on the coasts.

Saudi Arabia, OPEC's biggest producer, pumped 9.0 mbpd in February. That was -100,000 bpd below January and -900,000 below May when production was the highest since January 1989.

Ironically net longs in the week ended Feb 15th reached their highest level since March 2012. Crude prices plummeted the two weeks following that high.

Faulty Bolts A Growing Problem

Several weeks ago GE Oil and Gas notified the BSEE and offshore drillers of the potential for a bolt failure on the H-4 connector that attaches the blow out preventers to the wellhead. These bolts are used on multiple models of blow out preventers (BOP) and every driller around the world will now have to pull their BOPs to the surface and inspect and possibly replace the bolts.

The notice came after a leak was reported from one defective bolt. After the warning and subsequent undersea inspections drillers have found leaks on three additional wells. These are minor leaks of drilling fluids (mud) but for the BSEE there is a no tolerance policy after the Deepwater Horizon disaster.

There are 83 active rigs in the Gulf of Mexico. GE said 23 of these rigs were immediately affected and several have already been cleared to return to work.

The BSEE has told the rig operators to suspend operations and bring the BOPs to the surface for a check. If the bolts are found to be defective they have to find replacement bolts, install them and then find a third party to certify the job was completed and within specifications. For shallow to medium water rigs this is a 4-7 day process assuming there is no replacement needed. For deepwater drillers this can take up to two weeks to withdraw all the pipe, close the wellhead, disconnect the BOP, lift the 100 ton device to the surface, inspect, replace and then reverse the procedure to put it back on the wellhead and restart drilling. With dayrates of $500,000 to $600,000 per day this is an expensive proposition.

The secondary challenge is acquiring the replacement bolts. As you can imagine there is a sudden shortage of the bolts since every driller immediately placed an order as soon as the notice came out.

Ensco (ESV) has indicated it has already inspected the majority of its fleet and replaced the bolts where necessary and has scheduled the inspection on its deepwater fleet at the next available opportunity. They also said they have additional bolts on hand and they could probably sell them for a small fortune once they inspect the remainder of their fleet. How much is a bolt worth if your $600,000 a day rig is not drilling until a replacement bolt can be found?

It remains to be seen if GE will suffer some damages from supplying the defective bolts. They did not actually make the bolt but their name is on it.

GE H-4 Connector Module

BP Trial Not Going Well

The daily headlines out of the BP trial in Houston don't paint a good picture for BP. The government witnesses are listing a growing number of complaints and problems that BP either failed to act on or deliberately ignored. If the judge believes BP acted with gross negligence it ould cost BP an additional $16 billion in fines.

A Transocean employee said BP hampered efforts to stop the resulting gusher of oil by misleading government officials about how many barrels were flowing from the damaged well. The well spewed oil and gas for 87 days before it was effectively shutdown.

In April and May of 2012 BP continually told regulators, decision makers and the public the oil flow was about 5,000 barrels per day. "BP intentionally withheld documents, analysis and estimates that would have allowed investigators outside BP to realize the estimates were misleading and fraudulent." Transocean said the leak could have been stopped two months earlier had BP not withheld important documents and analysis.

Transocean said federal officials attempted to stop the flow of oil using the "top kill" method but it was destined to fail because oil was flowing at a rate far greater than BP would admit. BP was aware the well was flowing at a far greater rate of 70,000 to 100,000 bpd.

Transocean said knowing the accurate volume of oil would have precluded things like the top kill and the failed funnel device that still sits on the ocean floor. Each of those efforts took time to prepare and implement and oil was gushing for weeks surrounding the efforts.

Transocean's filing was in a motion attempting to limit their liability for the oil spilled because of misleading and fraudulent information from BP.

Meanwhile BP executive Mark Bly testified BP did not explore management's role in causing the disaster because the investigative team did not have access to employee records. Bly said the team did not have access to the records needed to do a "systemic evaluation" of what led to the failure of the well. Instead the report published by Bly concentrated on mistakes by rig workers leading up to the disaster. Reportedly, CEO Tony Hayward, requested and got an exemption from the board to NOT follow the standard BP policy that required accident investigators to look into systemic failures within the systems. Obviously it was convenient to NOT have that data in the report that would be dissected by every party to the trial.

The focus on the trial so far has been on the effort by BP to cut costs. The well was weeks behind and well over budget and BP management told the workers on the rig to get it done and move on. The intense pressure to move to the next well was cited as the cause for ignoring basic pressure tests and erratic readings that were indicating a problem.

BP continues to try and implicate Transocean and Halliburton in the liability for the disaster. However, emails to Halliburton praising them for their work on the well are creating a challenge for BP. It is tough to claim Halliburton was deficient when they have emails before the accident claiming otherwise.

Jim Brown

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