Geopolitical Risk Rising

Jim Brown
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Hot spots all over the world are raising the geopolitical risks to oil production. The constant headlines are helping to offset weakening demand expectation from China and Asia.

It would be hard to name a country in the Middle East and Northern Africa that is not having some internal problems. Syria is the biggest danger with a strong risk that the sectarian violence is going to spread to other countries. The Syrian conflict has attracted numerous outside players including Lebanon, Jordan, Israel, Iran the U.S. and Russia. With promises from Iran, Russia and the USA to provide increasing amounts of military assistance the conflict has a good chance of blossoming into something much larger.

The Egyptian military said this weekend it is prepared to intervene to stop the political crisis from spiraling out of control. This statement came a week before a planned nationwide rally against President Mursi. Egypt's defense minister said the armed forces "won't remain silent as the country slides into a civil war that is difficult to control. There is a state of division in society and its continuation is a danger to the Egyptian state." The comments were a warning to Mursi more than a warning to protestors. The military is independent and Morsi and the Muslim Brotherhood have lost favor with the people and the military. Mursi has been trying to consolidate the power of his Islamist backers rather than address the economic turmoil affecting the country. A large number of the population wants to throw him out of office. The riots and increasingly larger protests are becoming a threat to Egypt and the country's credit risk has risen to the highest level since 2008. Sectarian violence is increasing. On Sunday four Shiites in a village west of Cairo were beaten to death by a crowd of Sunnis.

Sunnis are the majority across the Islamic world. In the Middle East, Shiites have strong majorities in Iran, Iraq and Bahrain, with significant communities in Lebanon, Yemen, Syria, Saudi Arabia, Kuwait and other parts of the Gulf.

Libya has fallen back into a tribal state where fighting between the 100+ tribes is becoming a daily occurrence. The country has been deemed too dangerous for major oil companies to send workers to repair facilities and expand oil production.

Nigerian producers have to declare force majeure almost monthly because of damage done by MEND rebels. Currently Total's Usan grade of Nigerian crude is restricted. Shell's Bonny Light and ENI's Brass river crude are all restricted. Nigerian LNG also declared force majeure on LNG exports after a Shell pipeline was blown up. The rebels recently vowed to attack anyone anywhere that is related to the oil industry. Theft is also a big problem. Thieves hack into the pipelines and steal the oil for sale elsewhere. This is a major problem because it damages the pipelines. Nigeria said oil theft in May was between 150,000-180,000 bpd. That is a lot of oil.

Sudan and South Sudan have turned hostile against each other again. No violence yet but Sudan's president Omar Hassan al-Bashir threatened on Friday to halt all oil flows from South Sudan. This is the second time in two weeks he has made that threat. All of South Sudan's oil crosses Sudan through pipelines. South Sudan exports 400,000 bpd through the pipelines.

It is not just the Middle East. In Brazil more than 500,000 people in more than 80 cities protested high inflation and government corruption. Rio de Janerio saw police attack a crowd of more than 300,000 with tear gas, concussion grenades and water cannons. Brazil is a large oil producer but currently most of their development efforts are offshore and are separated from the demonstrations. However, if the country continues to spiral downward it will be hard to prevent contagion.

Sectarian violence in Iraq is increasing and major oil companies are scaling back their presence. China is the opposite and is increasing their footprint and control of Iraqi oil fields. Iraq is never more than 3-4 weeks from destabilizing so it is a weekly worry as the bombings increase.

Iran is about to be hit with another round of sanctions despite the election of a new president who takes office in August. The U.S. and allies are attempting to push Iranian exports down to a trickle of only 500,000 bpd and they are starting to focus on refined products as well. Iraq should have been multiple countries. The centuries old battles between the Kurds in the north and Arabs in the south are legendary. The Sunni/Shiite division in the south is a daily conflict. One analyst said the number of Iraqis killed every day is greater than deaths in some wars. Iraqi borders were arbitrarily drawn by the British decades ago without any consideration for the various populations and rivalries.

The Iranian nuclear problem is not going away and Israel has warned a military decision must be reached before the end of summer. With Israel somewhat involved in the Syrian conflict the focus has softened towards Iran but it should heat up in the next 4-6 weeks. The new president has expressed a desire to end the sanctions but Iranian talk is cheap and he really has no control over the nuclear program.

Turkey has seen daily riots for several weeks over internal problems and at the same time they have received six Patriot missile batteries to protect themselves from Syria. Turkey does not produce much oil but pipelines from Iran and port areas are in danger.

Saudi Arabia has so far avoided the Sunni / Shiite confrontations now occurring elsewhere but the governing family is Sunni and the majority of the population is Shiite. As long as the King continues to pledge billions of dollars in housing and jobs the ruling family will probably stay in power. However, if the sectarian violence spreads to Saudi Arabia it would be very bad for future oil production.

All of these hot spots are going to continue to support the price of oil even though demand expectations are falling. China's HSBC flash PMI fell to a nine-month low last week at 48.3 and well into contraction territory. Some analysts believe China's GDP is going to fall dramatically below the 7.5% target and could decline to 4.5% over the next several years.

There is a serious problem in the Chinese banking system and Fitch Ratings warned the potential collapse could be worse than the 2008 financial crisis. The shadow banking system is thought to have as much as $2 trillion in loans with many in the nonperforming category. Banks sell loans to corporations, trusts and wealth management firms in order to get the loans off their books and remain in compliance with regulations. Many retain a partial liability in those offloaded loans. Leverage in some Chinese banks is thought to be as much as 100:1 and way over the 30-40:1 for U.S. banks like Lehman and Bear Stearns prior to the financial crisis. Furthermore the Chinese regulatory system is very lax so there is no real way to know how bad the situation really is. Fitch is warning of a global meltdown of historic proportions if the government does not take control and fix the problem soon.

With China's economy slowing and potentially on the verge of a crisis the expectations for oil demand growth are slowing. Today the security issues for oil are supporting prices but should the conditions in China worsen we could see a return to the recent lows.

WTI prices have firmed recently as more Bakken and Eagle Ford producers ship their oil via railroad to the refiners on the east and west coasts. This has relieved some of the congestion at Cushing and allows the producers to get more for their oil.

North Dakota's oil production rose to 793,250 bpd in April. That is a +33% increase over April 2012. Of this total 75% was shipped by rail. EOG was the first producer to ship its crude by rail. EOG now shipe 100% of its ND production by rail to coastal refineries. Continental Resources, the largest Bakken producer, ships 80% of production by rail. The refiner rail fleet has grown to more than 20,000 cars. They realize they can buy land locked crude cheaper and then ship it themselves to their locations.

The huge ramp of rail shipping to the east and west coasts has reduced the amount of water borne crude that coastal refiners need to buy. This has reduced Brent prices and provided a lift to WTI prices. The spread between the two has shrunk to $7 compared to highs around $20 over the last several years. Once the additional pipelines are completed from Cushing to the coast the prices should return to trade in tandem like they did before the glut of land locked crude.

Oil production in the nine fields that make up the Eagle Ford rose to 530,689 bpd in April. That was a +54% increase from the same period in 2012. The entire state of Texas produced 2.37 mbpd and the highest monthly output since February 1986 according to the EIA. Because of rail shipping and pipeline availability the price of Eagle Ford light crude was $94.75 on Friday compared to a WTI close at $98.24. Producers should be happy with that minimal discount but once the pipelines currently under construction are completed they should be able to get closer to Brent prices.

The coal sector is under attack. President Obama is set to announce strict new emission regulations for existing power plants including coal and gas. He warned before he was elected the first time that he was going to put the coal sector out of business. With his administration under fire for multiple scandals and his foreign policy initiatives in shambles it must be time to circle the wagons and launch a new offensive to distract from the problems.

He made global warming a major part of his inauguration speech and this is the first major step. He will propose tough new standards for existing plants and even tougher standards for future plants. The announcement will be on Tuesday. He will promise to take action by executive order if Congress does not act on his plan. White House spokesman Jay Carney, said the president has directed his cabinet to come up with executive actions to reduce power plant pollution and speed the transition to more sustainable sources of energy. His speech will include new energy efficiency standards for appliances and call for clean energy production on public lands from wind and solar.

While any actual regulations from this attack on the coal sector will take years to pass, enact and enforce, I believe the coal sector is going to take a sentiment hit on Tuesday. Coal is still the cheapest power source but it is dirtier than natural gas. This should speed the switchover to natural gas and potentially force dual fuel plants to shift solely to gas to get under the new emission rules. It will take months if not years to pass, enact and enforce any new rules but be advised it is coming. Obviously the president can't issue an executive order that requires plants to have a specific level of emissions without allowing time for them to make the necessary modifications to comply with the order. With lawmakers cool to the global warming concept in recent years it may be difficult to get any serious legislation passed. The president may also be limited to what he can actually do by executive order.


The S&P crashed through the support of the 50-day average at 1618 to test the 100-day at 1577. That is a major departure from where it was trading just ahead of the Fed meeting at just over 1650.

Futures have been all over the place late Sunday and down over -5 points to up +3 points. Europe and Asia are setting up to be mixed at their opens and sentiment is negative.

Historically the week in June after the triple witch expiration is negative. That is followed by the Russell Index rebalance on June 28th and then the first week in July is typically bullish. After that the historical trends tend to fade until August when the dog days of summer see the indexes begin to fade after the Q2 earnings reports.

S&P-500 Chart

The energy sector is declining as I expected and we should see further declines in the July-August period. Be patient and we will use any weakness this summer as a buying opportunity.

Jim Brown

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