Geopolitical Tensions Rise

Jim Brown
 
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Oil prices are getting a boost from events around the world that don't seem serious individually but are adding up to some major sentiment worries.

The payroll report helped boost the price of oil to a two-week high but that was also fueled by increasing concerns over Syria and the potential spread of violence through the Middle East. Also lifting prices was news of an outage at Nexen's 200,000 bpd Buzzard field in the North Sea. In the U.S. BP's 405,000 bpd Whiting, Indiana refinery is on schedule to restart by the end of June after a $4 billion remodeling effort.

Syria said its oil production has fallen from 380,000 bpd to 20,000 bpd because of the civil war. The rebels have captured the fields in northern and eastern Syria where most of the production is located.

The Syrian violence is spreading into neighboring countries and potentially involving some much larger players. Russia is stepping up arms sales to Syria including high technology weapons systems. Iran is sending weapons and personnel in an effort to boost efforts by Assad to take back land lost to the rebels.

Israel continues to warn they will not allow chemical weapons to leave Syria for Lebanon and they vow to eliminate the long distance missile threats when possible.

Russia continues to ratchet up their diplomatic warnings about third parties interfering in Syria and threaten to defend Syria against "hot heads" from around the world.

Sudan has halted oil shipments from South Sudan over backing for rebel groups in the north. In March the two countries had formalized nine agreements to end the two years of bickering after South Sudan became an independent country ending 22 years of civil war. South Sudan has the oil fields but Sudan has the ports. South Sudan had restarted production after the agreements were reached in March. Production had increased to 200,000 bpd and rising compared to 300,000 bpd before the initial dispute. Some six million barrels had been produced since the agreements were signed. If Sudan halts the pipeline it will cause backups in the fields and force another costly restart when it is eventually reopened. The majority of the South Sudan oil is sold to China, India and Malaysian refiners. Sudan says the pipeline will be closed within 60 days. That gives South Sudan time to ease back on production and not damage the fields.

Egypt is still in meltdown mode but not getting much press these days. Turkey is suffering from the most violent anti-government protests in years and adding yet another layer to the energy security risks in the Middle East. Turkey does not produce much oil but the 360,000 bpd pipeline from Iraq could be damaged in the protests. The Turkish Straits see about 3.0 mbpd of oil from Russia. While nobody expects shipments to be disrupted there is always the risk. Turkey shares borders with Syria, Iran and Iraq. The Turkish stock exchange fell -10.5% on Wednesday as riots increased.

Iran is about to hold presidential elections and although there are 8 "approved" candidates there are only two in contention. Saeed Jalili and Mohamed Qalibaf are the front runners blessed by the Supreme Leader. Both are regime loyalists and both are bent on spreading Iran's Islamic revolution around the world.

In 2009 there were riots when the people found out the votes had been rigged and their candidates lost. Several of the prior "reformist" candidates are still under house arrest. This time around the Supreme Leader simply allowed only candidates that were loyal to him and therefore it does not make any difference which wins. Both front runners will make Ahmadinejad seem friendly by comparison.

The nuclear issue is only going to get worse with Jalili the former nuclear negotiator to the IAEA and UN. He vows no compromise and to make Iran the strongest nuclear power in the region. Since Iran has always said they are only enriching uranium for electric power generation that comment suggests he has something else in mind.

Regardless of who wins the election the nuclear issue is going to erupt very soon. Israel claims there must be military action before the end of summer and the calendar is growing short. Any action by anyone against Iran will bring about retaliation against Persian Gulf neighbors and Iran has threatened to close the Strait of Hormuz where nearly 20 mbpd is shipped.

Oil prices are clearly being supported by the rising number of political events in the Middle East. Each, other than Iran, only represents a small amount of global production but taken together they represent a serious set of concerns over adequate oil production.

Brent prices have returned to resistance at the $105 level and WTI is approaching $97. With demand slated to rise by 1.5 mbpd over the summer months as a result of burning oil to generate electricity in Saudi Arabia and elsewhere the minor supply disruptions will mean inventory declines.

WTI Crude Oil Chart

Brent Crude Oil Chart

Baker Hughes said active rigs declined by -6 to 1,765. Oil rigs declined by -4 to 1406. Gas rigs were flat at 354 and slightly above the 18 year low of 350 set in early May. The peak was 936 in 2011. The total rig count for the same period in 2012 was 1,984.

The international rig count fell -18 to 1,283 in May from 1,301 in April. That is still +58 higher than in May 2012. The majority of the decline was in Canada. The offshore rig count was down -4 to 327 but still +8 over May 2012.

Barclays surveyed more than 300 companies in May regarding capital spending plans. Barclays said they were expecting 50-100 rigs to be added to the gas total because of the price of gas and the expected increase in future demand. "Demand for gas is going to grow pretty quickly and producers are going to want to support that demand." The recovery in North American drilling "has taken hold and will likely gain some momentum." Also, "There is optimism out there among the oil and gas companies and certain oil service companies are being told to prepare for additional activity."

Barclays said they expect oil and gas companies to increase E&P spending by +10% in 2013 to $578 billion. The company said Petrochina (PTR) will be the biggest spender and beating Exxon for the first time since the 1980s. "We believe the industry is in the early stages of a strong, sustained upcycle." Higher Middle East spending will offset slower growth in Latin America. Spending in North America is expected to increase by +2%.

China is expected to reap the most benefits from the oil boom in Iraq. China currently buys 1.5 mbpd from Iraq, nearly half of their production and they are bidding to buy up all the available drilling contracts in Iraq. They are currently bidding to acquire a huge stake owned by Exxon in one of Iraq's largest fields. Exxon wants out because of the extremely tough contract terms and the minimal returns from those fields. Some of the new contracts only award the drillers with 50 cents to $2 a barrel for any oil they produce. They also have major penalty clauses for failing to increase production by stated amounts within a certain period of time. With oil facilities under constant attack and security issues for personnel it is not worth the risk for Exxon and others.

China does not seem to mind. China is building an airport on the border to make it easy for workers to reach the southern Iraq oil fields. They have plans to begin direct flights to Baghdad from Beijing and Shanghai in the coming months. Chinese oil executives were forced to learn not just Arabic but Iraqi-accented Arabic to seem less "foreign" to Iraqi officials.

Since Chinese oil firms are state owned and don't have to make profits for shareholders they are being pressed to take a more active role in monopolizing the development activities in Iraq. With China's oil demand rising and China taking a larger role in increasing Iraqi production they are actually helping themselves. The oil they produce will be sold to China and actually insulate the global markets from the increasing production.

There are more than 500 reactors either under construction or in the planning stages around the world compared to 453 currently in operation. In the U.S. we are seeing reactors being permanently closed. Southern California Edison announced last week it was closing the San Onofre nuclear plant permanently. This plant supplied power to 1.4 million homes. It was shutdown in 2009 when excess corrosion was found in the pipes. A $670 million upgrade was undertaken and then failed. Edison has more than $500 million in outstanding bills and environmentalist objections at every turn.

The first reactor went online in 1968 at San Onofre with two others added in the 1980. After renovating the plant in 2009-2010 a small radiation leak was discovered in January 2012. The leak led to a discovery of unusual damage to hundreds of tubes that carry radioactive water to the plants new steam generators. After spending millions of dollars and getting no closer to the possibility of a restart Edison decided to close the facility. It will take years and millions of dollars in additional expenses but the headache will finally be over.

The San Onofre plant has 8 million people living within 50 miles. Edison probably calculated the potential for disaster using the Japanese problem as a measuring stick and decided to cut the losses now rather than find some new problem 2-3 years down the road. In California there is always the risk of earthquake and after Japan that threat is considered more serious.

The Trojan plant near Portland Oregon was closed in 1993 after finding the same cracks in the steam tubes. Duke Energy closed the Crystal River plan in Florida after the containment building cracked during an upgrade and efforts to fix it in 2011 only made it worse. Dominion Resources said it was closing the Kewaunee Power Station in Wisconsin after it was unable to find a buyer. The Shoreham plant on Long Island NY was completed in 1984 at the cost of $6 billion but never opened because of community opposition after the Three Mile Island meltdown in 1979 soured sentiment for nuclear power.

There are new plants waiting approvals in the USA. These are several generations newer than the ones discussed above and significantly safer. The nuclear energy business has suffered through a three decade blackout in the U.S. after Three Mile Island but it is coming back. The problems are the extreme expense of building a plant and the decade it takes to get environmental and engineering approvals. The benefits are very cheap energy, relatively speaking, for decades thereafter. Things like hurricanes, flood plains, earthquake zones and population centers are much more in focus than they were when the San Onofre plant was built in the 1960s. The number of active plants in the world is expected to double by 2025.

The coal sector was downgraded by Raymond James last week. The company said coal prices are still falling. Other brokers disagreed. Peabody has said repeatedly that Q1 would be the trough for coal prices in 2013.

Peabody said current inventories of 172 million tons equaled 74 days of demand. That limited inventory should lead to higher prices later this year. That would be especially true if inventories fell into the 50 day range. In the U.S. there are roughly 200 mines being shut down or idled, mostly private producers. That would lower net U.S. exports by 25 million tons roughly divided between thermal and met coal.

The cheap coal prices are limiting the gains in natural gas prices with $4 gas the level where coal becomes cheaper. Gas prices finally imploded last week to close at $3.81 after a larger than expected injection into storage of 111 Bcf. Now that the $4 price point has been broken again we could see the decline we have been expecting for several weeks. We could see gas decline to $3.40 if the spring weather remains mild. Producers have opened up the valves and several new pipelines have been connected in the Northeast.

Natural Gas Chart

Market

Dip buyers appeared on schedule when the S&P hit the 50-day average on Thursday at 1604. There was a decent rebound on Thursday but shorts were still active. The better than expected payroll report caused a strong gap open and shorts panicked again. The Dow had its second best day of 2013.

The major indexes rebounded to stop exactly at downtrend resistance. The Nikkei futures are suggesting the Japanese markets are going to rebound as well and that should lead to a positive open for the USA. Unless there is a lot more buying volume on Monday the markets could have a tough time moving higher. There are several resistance levels created on the decline and each will have to be overcome. The economic calendar is weak and lacking any material market moving reports.

We are going to be heading into the summer doldrums where traders are absent from the market and spending time with their families. Be patient because we will use any declines as a buying opportunity.

Jim Brown

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