Oil Prices Still Rising on Violence

Jim Brown
 
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Crude oil prices continued to rise despite a new calm settling in over Egypt. The country has cut the nighttime curfew from 11 to 9 hours and the demonstrations are weakening. However, as one crisis cools another one is growing.

Syria took the headlines away from Egypt after a nerve gas attack killed between 400-1000 people. The exact numbers are unknown because the hospitals are not taking any more bodies and families are handling their own dead.

Numerous aid groups like Doctors Without Borders confirmed the deaths were due to poison gas of some sort that was delivered by rockets to an area that the rebels had recently occupied. The UN has not issued a determination because Syrian authorities would not let inspectors into the area.

The U.S., France and Britain appear to be debating a way to punish Assad for using weapons of mass destruction by launching a missile strike to degrade his military capability. Russia, Iran and Syria have warned against anyone interfering in Syria. I guess it is ok for Russia and Iran to send planeloads of weapons to Syria over the last six months but nobody else can "interfere."

I fear this could turn into a much larger conflict if Russia decides to take action against our forces in the Mediterranean. Let's hope calmer heads prevail.

If Syria is attacked by a coalition of forces they can't retaliate against the U.S. because of our military supremacy in the area. They can however strike oil facilities in neighboring countries as payback for our interference.

WTI prices are up 50 cents to $107 on Sunday evening. Brent is flat at $111.

WTI Chart

The constant headline pressure on crude oil from the violence and outages in the Middle East and Northern Africa may have short circuited the normal August-September decline. Production outages overseas have removed 2.7 mbpd from global production but some of that is already coming back online.

Libya said ports shut by strikes were reopening. Brega is expected to reopen and add 90,000 bpd to exports which have rebounded to 500,000 bpd last week. The largest ports of Ras Lanuf, Zueitina and the oil port of Hariga have not yet reopened. Libya was producing 1.6 mbpd of light crude before the civil war that ended Qaddafi'a reign. Production had resumed and returned slowly to 1.2 mbpd before the strikes. Officials claim the remaining strikers have dwindled to a "couple hundred" and they expect the situation to be resolved in the coming weeks.

Crude prices also rose because of the continued decline in jobless claims suggesting employment was improving and the drop in new home sales. The data was contradictory but both reports helped push prices higher.

The sharp decline in new home sales for July and downward revision to the prior three months makes the potential for a continuation of QE a lot greater. Numerous chain stores reported declines in sales for Q2 and early Q3 and when coupled with the decline in new home sales it suggests the economy is slowing not progressing. The GDP revision for Q2 coming up this week could also show that growth is slowing and that would guarantee continued QE.

A stronger than expected PMI for Germany came in at 52.0 for August up from 50.7 in July. China's PMI from HSBC rose unexpectedly from 47.7 to 50.1 and exceeding all 16 estimates compiled by Bloomberg. These reports helped to build a stronger case for future demand increases.

The drop in new home sales also pushed gold prices higher on the bet stimulus would continue. Gold rose to $1,400 with the rise fueled by the drop in the dollar and the return of the Armageddon trade. With much of the Middle East in flames and the potential for an even bigger conflict the flight to the safety of gold accelerated. Whenever Russia and the U.S. are in danger of a conflict the easily panicked traders rush to gold. The rebound was also the result of short covering with much of the hedge fund community short over the last six months. There is a rumor JP Morgan has quietly amassed over 10,000 futures contracts over the last couple of months and that is scaring bearish traders. Also retail gold demand in Asia is up between 70% to 85% for coins, bullion and jewelry.

Silver outshone gold because it was also heavily shorted but mainly because of the German and Chinese economic numbers. Silver is an industrial metal and rising economic trends will produce more demand. We currently consume more silver annually than is mined and we are depleting existing inventories at a rate that will leave us with zero within seven years. There is no downside to investing in silver for the long term.

Silver futures are $24.15 late Sunday and gold is $1405.

Silver Chart

Gold Chart

UBS shook up the deepwater drilling sector last week when they downgraded the sector. Deepwater drilling has seen a huge surge in demand once the industry got past the impact of the Deepwater Horizon disaster. Last week the Gulf of Mexico saw four new rigs begin work bringing the active total to 59 and the highest level since Feb 2009. You would think the continued surge in drilling would be a positive for the sector. However, the UBS analyst said the wave of new rigs to hit the market over the next couple years could cause dayrates to weaken.

In 2013 there were 20 new rigs scheduled to be completed and enter service. That will increase the number of global rigs by +16%. In 2014 another 21 rigs are due to be completed followed by another 13 in 2015. In total that is the addition of 54 rigs for a 43% increase in offshore rigs.

UBS believes all these rigs will find contracts since the new rigs are more technologically advanced with higher specifications and most are able to drill in deeper water to greater depths. Some of the new rigs are high specification jackups and midwater rigs so all the new inventory is not going to the deepwater sector where demand is so great.

The UBS analyst believes there will be a weakening in the dayrates for older existing rigs. Drillers are aware of the new inventory coming to market and they have been actively selling off older rigs to upgrade their fleet ages and raise cash to pay for the new rigs.

The ocean is a big place and there are a lot of leases that remain undrilled. One analyst estimated there are more than 3,500 known drilling locations where reserves are already known or at least highly probable. The discovery of extremely large gas fields off the coast of Africa, in the Mediterranean, and surrounding Australia could put all the new rigs to work for a decade or longer. There is no shortage of drilling locations. The only shortage is drilling capital and experienced personnel. With each of the new rigs requiring 100-150 or more experienced personnel there is a shortage of people. Drillers like Transocean will continue to train and advance new personnel.

Transocean (RIG) released its monthly fleet status update last week. Over the last 20 days they added $2.5 billion in new and extended contracts. They are showing no signs of dayrate weakness or a slacking in demand. It will be interesting to see if the UBS warning comes to pass.

Onshore the pace of drilling in the shale fields is still holding at a rapid rate. Oil production in the Eagle Ford shale formation rose +60% in June from June 2012. Production rose to 617,884 bpd compared to 386,763 bpd in the year ago period. Output for May was revised upward from 581,923 bpd to 625,833 bpd. Eagle Ford light crude was selling for $100.25 a barrel last week compared to $103.85 for WTI. The discount is due to transportation costs. The entire state of Texas produced 2.53 mbpd in May and the highest rate since April 1982.

The EIA expects natural gas injection in to storage to accelerate over the coming weeks and push gas in storage to total more than 3,800 Bcf by October 31st. That is the normal end of the gas in injection season as the weather begins to turn cold and demand increases. The maximum storage capacity is 4,265 Bcf.

The 2013 injection period should see near record injection because inventories at the start of the season on April 1st were 31% below normal. This was the result of the very long winter that extended well into the typical spring season.

This is completely different from the 2011-2012 winter which was the warmest winter in 60 years and left gas inventories at record highs. This prompted the lowest gas prices in 10 years and boosted the demand for natural gas.

The higher prices for natural gas this summer have caused a sharp drop in gas as a fuel for electric power generation. Gas demand declined -20% in Q2 and the EIA believes the Q3 demand will fall -12%. This has been confirmed by coal producer Peabody Energy saying thermal coal volume has risen dramatically.

Active rigs drilling for gas hit an 18 year low in June at 349. That has increased some to 388 but that may not be enough to prevent the decline in production as the thousands of wells drilled over the last five years approach peak decline rates. I have written about this numerous times illustrating the 60% to 75% production decline rates in the first 12-24 months make only the best wells commercially successful. The low gas prices and temporary gas glut has pushed drillers to the various shale oil fields to explore for oil instead of gas. Eventually the cycle will repeat and slowing gas production will boost prices and drilling for gas will increase. The industry can't seem to reach a happy medium where supply and demand are equal and drillers can make a reasonable profit without chasing the current hot spots all across the country.

Hurricane Update

Tropical depression six turned into tropical storm Fernand late Sunday. Fernand is in the Gulf of Mexico but it is headed west over Mexico and assuming there are no sudden direction changes it will be over Mexico on Monday and disintegrate into winds and heavy rains by Monday night. There should be no danger to the U.S. Gulf but Mexican offshore installations are going to be deluged by heavy rains. Winds are only 40-45 mph so no significant damage capability.

On the Pacific side of Mexico tropical storm Ivo is falling apart but it has produced significant rains over Mexico. There is another tropical depression forming offshore southern Mexico with a 40% chance of becoming a tropical storm over the next 48 hours and 90 chance over the next five days. This low pressure area in southern Mexico appears to be dragging Fernand in that direction

Atlantic Storm Map

Pacific Storm Map

Market

The market rebounded over the last two days on what appeared to be an oversold bounce. The drop in home sales turned off the taper talk and some analysts are now expecting it could be January before the taper begins. That means four more months of market friendly QE.

It remains to be seen and as the Fed has recently stated they don't want the market to start assuming the direction of QE or "unwanted reactions" could result. You can translate that into "another bubble could form or the market crash." After Friday's economics and flurry of Fed speak that seemed to enforce "data dependent" QE decisions the market rallied to resistance. I would expect Fedspeak this week to attempt to correct that bounce. The Fed wants the market to be based on uncertainty rather than blatantly directed by the Fed.

We need to get past the September debt ceiling battle and the FOMC meeting on the 18th before we start adding positions for a potential end of year rally.

Jim Brown

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