Oil Had a Good Week

Jim Brown
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It was a good week for energy stocks with Wednesday's big drop in crude prices erased less than 24 hours later. The jobs surprise boosted expectations for demand and prices for WTI are back near their recent highs.

April was a wild ride for crude prices with the high at $96 on April 1st and the low at $85.90 on April 18th. Friday's rally took it back to $96 and the $10 round trip was complete. The key now will be holding the gains if the economics continue to weaken. We are headed into the summer demand cycle so we could easily see prices back in the $100 range if China were to say something positive.

China's demand has been growing by about 7% per year. If that were to continue through 2020 it would be unsustainable since production growth is not keeping pace. Current import demand is in the range of 6.2 mbpd. By 2020 that will be closer to 10.5 mbpd and the crude projects currently identified are not going to add that much oil by 2020 when allowing for depletion in existing fields.

Chinese Import Expectations

Since China's oil demand is expected to accelerate in this decade as they become the largest manufacturer of cars and the biggest consumer of new cars the outlook is clear. Plans to build more than 50,000 miles of new roads and highways will allow them to use those cars. Now they just have to find a place to park them.

I sat through a seminar by ASPO last week on the shrinking Land Export Model. I have written about this in these pages in the past but not in the last six months. The Land Export Model (LEM) was first documented by geologist Jeffery Brown, no relation, about three years ago.

The concept is easy to understand. Historically countries that produce oil in quantity and export it typically increase consumption at a faster rate than countries that import oil. The reason is simple. Oil produced in country is local and cheap. Imported oil is a hassle to import and it is never cheap. Therefore consumption of cheap oil increases at a faster rate than consumption of expensive imported oil.

Secondly, when exporting countries expand consumption they have less to export.

Let's try an example. Let's call our fictitious country Brownsville. Assume Brownsville produces 2.0 mbpd and exports 1.0 mbpd to start. Depletion globally runs about 8% a year but let's say Brownsville is drilling new wells so they keep it at a 5% level. It makes the math easier. Let's assume consumption is rising 5% per year because of their surplus of oil. China's consumption is rising from 7% to 9% per year and they are importers.

In year one Brownsville exports 1.0 mbpd. Allow for depletion and consumption in year two and oil available for export declined by -10% or -100,000 bpd.

In year two Brownsville exports 0.9 mbpd. Allow for depletion and consumption in year three and oil available for export declined by -10% or -90,000 bpd.

In year three Brownsville exports 0.81 mbpd. Allow for depletion and consumption in year four and oil available for export declined by -10% or -81,000 bpd.

I think you get the picture. The numbers are just an example but the theory is sound and has been proven by historical research over the last decade.

I apologize for the chart below. I can't make it any bigger or it won't fit in the email. This is the export rate of change for the top 33 net exporters from 2005 through 2011. Note that those increasing exports were a lot smaller than those decreasing exports.

Top 33 Exporters

Currently there is roughly 2.5 mbpd of excess global production capacity. Because this capacity exists there is no rush by OPEC countries to create more. Adding capacity costs billions of dollars and 5-7 years of effort. With the global economy lagging today there is no reason to spend the money when it can be used at home for social programs to keep the population under control. Most of the countries with the potential for increased exploration and production there is the constant risk of a flare up of the Arab spring movement.

Excess capacity has not increased materially in the last five years. New production has been offset by depletion in existing fields in most countries.

While we are in no danger from peak oil today, thanks to the weak global economy, the risk still exists and once the global economy finds some traction the acceleration of demand could easily equate to +2.0 mbpd per year for the first two years. That will suck up the excess capacity and immediately put the globe on crisis footing once again as EP companies race to find and develop new oil.

Crude prices in 2013 are not likely to move much over $100 but we should note that $100 is becoming the new normal and global production is not increasing materially. When demand increases the future normal for prices is going to be painful for consumers.

As prices move back to the $120 range and above an entirely new wave of demand destruction will begin and we will repeat the decades old process again. High oil prices depress the global economy and depress demand. A recession appears. Once consumers get used to paying higher prices the process repeats with a rush to explore and produce.

The only guarantee is that prices will continue to rise longer term until they rise so much the global economy is forced to find other alternatives.

In this scenario those that take long term positions in oil producers will be rewarded for their foresight.

Gas producers are operating in a different reality. Baker Hughes said active rigs rose by +10 last week to 1,764. Oil rigs rose by +22 to 1403. Gas rigs fell by -12 to 353 and a new 18 year low not seen since June 1995. The peak was 936 in 2011. The total rig count for the same period in 2012 was 1,965.

The associated gas produced from more profitable shale oil and shale gas liquids wells has kept dry gas flowing at a brisk rate. The U.S. Energy Information Administration expects marketed gas production to edge up slightly in 2013 to its third straight yearly record.

Gas injections into storage totaled 43 Bcf last week for the third consecutive week of increases. In the chart below the pattern of injections started several weeks later than normal but they remain very close to the five-year average. Gas in storage of 1,777 Bcf is only 118 Bcf below the five-year average of 1,895 Bcf.

Working Gas in Storage

Despite the spike in prices and the weekly late winter storms the pattern of gas injection is right on track. Given the massive switching from gas to coal over the last month we should see stronger than normal injections over the next few weeks as demand by power companies fades. Once prices decline into the $3.50-$3.75 range again the demand will increase. Prices over $4 make it more economical to burn coal. Under $3.75 and coal will again fall out of favor.

The EIA said the associated gas being produced with the shale liquids was maintaining production volumes even though gas only rigs were declining. Oil wells produce gas with the oil. Shale wells targeting natural gas liquids or NGLs produce gas with the liquids.

With 1,764 rigs drilling wells that average 18 days per well that means we are adding wells at the rate of more than 2,000 per month and almost every well produces some gas. New pipelines are being completed weekly that connect entire fields to the mainline with the turn of a valve. Well over 1200 northeastern gas wells remain unconnected and waiting on pipelines and processing stations.

Gas prices fell sharply last week as the realization of these facts hit traders who had capitalized on the long winter. Gas is holding at $4 but one more week of strong injections should end that $4 handle.

Gas Chart


Next week is the last material week for earnings reports in the energy sector. Apache, Anadarko, Marathon and EOG are the last four names that most investors would know.

Earnings Report Dates - Green is this week


Friday's payroll report was painful for the shorts. After the ADP Employment report missed estimates on Wednesday and the ISM Manufacturing employment component almost fell into contraction at 50.2 the bearish outlook for nonfarm payrolls was complete. When the report surprised to the upside the shorts were crushed.

However, volume was mediocre at 6.3 billion shares and there was no follow through. All the gains were made at the open and the indexes faded slightly the rest of the day.

We could see a lack of follow through on Monday but as long as the S&P remains over 1600 the dip buyers should remain in the market. There is a serious lack of catalysts next week with a weak economic calendar and the end of the Q1 earnings cycle. Eventually investors will have to decide if they want to tough it out over the summer doldrums or move to the sidelines for the summer.

Very rarely do we have a year where the lows are not made in the summer months. An improving economy could negate that historical cycle but one report is not a trend. More than 30 economic reports over the last month missed estimates. Only a couple beat estimates. Remain long but cautious.

Jim Brown

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