Thirty Million Barrels

Jim Brown
 
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Over the last five weeks U.S. crude inventories have declined by -30 million barrels as refiners flushed crude through the system in order to reduce their year-end property tax bill.

Crude inventories declined by -7 million barrels in the week ended December 27th. Since there are only four days left in the year in the next report and deliveries are expected to spike starting on January 1st the report for next week could show a slight gain. The week after should show a large gain because refiners would have scheduled new imports to be delivered starting on the first and tankers were probably lined up waiting for the calendar to roll over. Historically inventories begin climbing in January and top out in June.

Inventories at Cushing declined for the third week as Transcanada continues filling the lower leg of the Keystone pipeline from Cushing to the Gulf Coast. Initial deliveries to the southern terminals are scheduled to begin next week. TransCanada said it would take four million barrels to fill the pipeline prior to the operational start.

Refiners were operating at a unusually high 92.4% utilization rate as they tried to push as much crude through the system and into refined products as possible before the tax deadline. Distillate inventories rose +5.0 million barrels but that was also due to a huge decline in distillate demand of -857,000 bpd. This is probably a blip in the reporting process rather than an actual decline in demand. However, we can expect a continued decline because of the thousands of cancelled airline flights and the massive winter storm. Trucking and traffic in general will have slowed to a crawl over the last week and that means less diesel consumed. Lastly, the holiday delivery season has ended and that will mean lower diesel consumption by truckers as well as UPS and FedEx.

Gasoline inventories rose by 800,000 barrels to offset the 600,000 barrel decline the prior week. Gasoline demand should also decline sharply now that the holidays are over and the storms kept people indoors. Refiners are planning for this drop in demand and they produced 637,000 bpd less gasoline for the week. Imports also declined -239,000 bpd.

Crude imports of 7.5 mbpd were at the second lowest level of the last eight weeks. This should rebound to more than 8.0 mbpd in the coming weeks. However, U.S. production rose to another 25 year high at 8.12 mbpd. The EIA expects production to climb to around 9.0 mbpd by the end of 2014.





We found out last week that shale oil from places like the Bakken in North Dakota burns more readily than conventional oil. The fourth train derailment and fire over the last six months caused the government to issue a warning that shale oil is more explosive than regular crude and shippers should take additional precautions.

The reason the oil is more explosive is because shale oil tends to contain more embedded gases like propane, ethane, etc. These gases are extracted at the refiner but are present during shipping. They are not present in gas form but in liquid form in the oil.

We can expect the government to eventually issue some new regulations about shipping shale oil. They are likely to demand stronger double hulled rail cars with crash plates in the front and rear to prevent the cars from being punctured in a derailment. Only about 18,000 of the 92,000 cars currently in use have those features. If the government were to issue new regulations requiring those cars for shipment it would take years and billions of dollars to replace the fleet. Currently about 800,000 bpd are shipped by rail. U.S. production rose +18% in 2013 thanks to the shale oil boom.

If that happened the current shale oil boom would crash. If producers can't get their oil to market because of a car shortage it would cause a dramatic drop in prices for oil at the field. Currently Bakken crude sells for about a $10 discount to WTI to account for the cost of shipping. If rail capacity was limited the producers would be bidding for the available space by discounting their oil to the purchasers with access to the upgraded cars. Refiners like Valero and Tesoro, which own their own cars with many of them the newer models, could almost name their price at the loading terminals.

A secondary event would be a spike in WTI prices due to a shortage of available shale oil. If shale oil availability fell -75% due to a car shortage then WTI shipped by pipeline would spike in price.

The multitude of ramifications stemming from new draconian regulations could be dramatic. Hopefully the government does not enact a series of regulations effective immediately that throws the entire shale oil industry into a state of disarray. They can enact new transportation rules but with a long lead time to allow business to continue as usual until there is time for the new cars to be constructed in volume.

The worry over potential government regulations and the impact to the energy sector were greatly responsible for the sharp decline in crude prices last week. The rise in the dollar was also to blame but the greater culprit was the fear of new shipping rules.

The rig count in the Bakken has already declined from a high of 237 to 180 as a result of the core plays having been drilled out. As drillers move farther away from the fairway area the returns begin to decline. Well costs remain the same but the amount of oil produced declines. Some companies are deciding to move to other plays rather than try to squeeze out marginal wells in areas outside the fairways. This move would accelerate if the government imposed new shipping regulations. Active rig counts could decline to 100 rigs or less.

Market

The market started off negative for 2014 and that has not happened since 2009. In theory this was simply investors selling winners in a new tax year and that is now over. The market should rise next week as fund managers return from the holiday and begin implementing their 2014 plans. Retirement contributions should be flowing into mutual funds and they will have to put that money to work. Since bonds are headed into a bear market the only place to invest those funds are commodities and equities and equities should win.

As Yogi Berra was famous for saying, "Theory never works in practice." Next week will be interesting.

Jim Brown

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