We Don't Care What We Signed

Jim Brown
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Iran's Oil Minister said we will export oil regardless of current restrictions in the nuclear deal.

Iran's oil minister, Bijan Zanganeh said "Iran will export oil at the maximum level possible, regardless of restrictions" imposed in an interim deal that offered the country some relief from nuclear sanctions. It is a strange strategy for him to say that just as the P5+1 nations are sitting down again in Vienna to try and forge a permanent nuclear agreement.

Of course Iran has not been much more logical than North Korea when it comes to statements made on the world stage. For them image is everything. They can say whatever they want in the press to appear to be standing up to the Western nations but then do something completely different.

In those nations the headlines in the news rarely equal the actions in the government. Under the current agreement Iran is supposed to limit oil exports to 1.0 million barrels per day. In the first three months of the year they averaged 1.37 mbpd.

So how does Iran account for this discrepancy and violation of the rules? "We don't accept any figure or number that is told to us in terms of a measure for our own exports," Zanganeh told reporters. "Iran will set Iran's export level, and we will export to the maximum level possible." Basically Iran will export as much as possible and then claim they only exported the maximum of one million barrels. They could export 3.0 mbpd and still claim 1.0 mbpd. Truth is a rare commodity in Iran. Don't tell us your facts, we will tell you the facts as we interpret them.

At the same time Zanganeh was making those claims the deputy oil minister, Ali Majedi, said he expects Iran's exports to average about 1.0 mbpd for the six months covered by the interim deal. Since the average for the first three months has been 1.37 mbpd and rising apparently Majedi is also on board with the "these are my facts don't confuse me with yours" program. Iran actually produced 2.84 mbpd in April, down from 3.5 mbpd in January 2012 before the sanctions were stiffened.

It has to make you wonder how the P5+1 nations could ever feel like they are going to get a permanent nuclear agreement. Iran can simply say "we are only enriching to 5% to make fuel for our reactors" while actually enriching to 20% or higher to produce fuel for a bomb. I know the IAEA is supposed to monitor Iran's nuclear facilities but Iran has become very adept at the nuclear shell game. Who knows how many nuclear facilities they actually have? At one point a couple years ago president Ahmadinejad said they were starting construction on a dozen enrichment facilities all over Iran so the West would never know where they all were and could not bomb them.

Russia is taking the opportunity to negotiate multiple technology and energy trade agreements because they don't care about the sanctions. Russia and China continue to expand trade with Iran so blocking everyone else out with sanctions is counterproductive.

The interim agreement expired July 20th and with the recent hostile comments by others in objection to a new deal it may be very difficult to find agreement. However, there is no Plan B for the West. Everyone on the Western side of the table wants a deal so they can put this thing to rest. The constant wrangling year after year is not producing any material gains. Nearly everyone understands that Iran is going to do what Iran wants to do and they will eventually get a bomb. Meanwhile the leaders of the six western nations just want to the problem to go away. If they can get a permanent agreement signed they can go home with a victory. When Iran eventually breaks the agreement it will be for the next set of leaders to worry about it. The current leaders can check the box "Iranian problem solved" and go home. President Obama will be out of office in two years and the bomb will be the next president's problem.

Oil Inventories

Oil inventories actually fell slightly last week by -1.8 million barrels to 397.6 million. That came after a record high of 399.4 million the prior week. Analysts had expected a +1.2 million barrel build. Analysts said fog in the Houston ship channel may have slowed the deliveries because imports declined -590,000 bpd or roughly 4 million barrels. That is the equivalent of about three tankers being delayed from unloading.

Inventories at the futures delivery point at Cushing Oklahoma declined to 24.0 million and the lowest level since 2008. Analysts warned that at the current rate of decline Cushing was only weeks from being offline. The storage facility and pipeline terminal has to maintain a certain quantity of oil to remain operational. There has to be a constant flow of oil into the pipelines leaving Cushing or the low volume would impact the pumps and flows.

Oil storage tanks have floating roofs that rest on the oil. This prevents an empty space that can collect explosive vapors. When tank volumes decline significantly there are legs that support the roof when it nears the bottom. When the legs touchdown the outflows must stop even though there is still oil in the tank. Output valves must remain submerged and that requires a minimum level of oil in the tank. Analysts believe the minimum operational level is 10-20% of a tank's capacity.

One function of Cushing is to blend different types of crude together to produce a specific gravity of crude oil with a specific sulfur content required by downstream refiners. Basically they take in crude from all the upstream fields and then blend it to match the downstream requirements. If crude levels fall too low the blending process would have to stop. Exports would have to stop and the pipelines south would have to stop.

Some analysts believe the 24 million barrels reported last week is very close to the minimum operational level for Cushing. How this would impact prices is unclear but a Cushing shutdown would cause shortages for refiners downstream from Cushing. That would push WTI prices higher as well as Brent. Shale producers with rail capacity could potentially get a premium for their oil by shipping it south instead of to the distant coasts. However, most of that rail delivered oil is now contracted to the coastal refiners so nobody actually knows what will happen if Cushing shuts down.

Gasoline inventories rose +1.6 million barrels for the second week as refiners begin to push summer blend gasoline into the distribution channel. Gasoline production rose +369,000 bpd and imports declined -98,000 bpd.

Distillate inventories declined slightly by -400,000 barrels due mostly to a monster increase in demand of +416,000 bpd. Imports declined -50,000 bpd. Distillate production rose over 5.0 mbpd for the first time in 2014.

Despite the surge in gasoline production and distillate demand refinery utilization dipped from 91% to 90.2%.

I have serious doubts about the gasoline and distillate numbers due to the wide swings in the categories. Routinely we have temporary data glitches that are resolved from week to week as new numbers become available.

Oil exports from Libya took another hit after rebels occupying four export terminals said they could not deal with the new Prime Minister, Ahmed Maiteeq, despite an agreement with his predecessor. Libyan production is only 250,000 bpd compared to 1.4 mbpd before the civil war. There had been hopes of a restart in exports after the prior agreement but that appears to be fading.

Also, exports from Yemen dropped after militants blew up the main oil export pipeline and halting crude flows. Nigeria has this same problem almost weekly when the MEND rebels attack pipeline facilities. Getting oil from these parts of the world is a very questionable proposition.

We saw a lot of earnings from the energy sector over the last couple of weeks. Unfortunately, almost all the majors reported production declines. International oil companies like Exxon, Conoco, Shell, BP, Chevron, etc, control less than 10% of the world's proven oil and gas fields. The super-majors account for only 3% of the world's reserves but they have 20% of the production.

National oil companies or NOCs, like Saudi Aramco, comprise 17 of the top 20 production companies. OPEC members control 75% of the world's oil. The amount of oil controlled by public companies like Exxon is shrinking.

In their annual report the IEA said the current global depletion rate is now 9.1%. Without significant additional investment that number will continue to rise. As older fields begin to accelerate into decline it requires recompletions, enhanced methods, end of life procedures, etc to maintain production. This comes at a time that revenue is declining for those companies. Expenses to enhance production are often put off due to the decline in revenue. That scenario simply accelerates the production decline.

Oil producers tend to focus available funds on the fields with the lowest cost of production because that produces the most free cash flow. As those fields continue to decline they shift to higher cost fields but free cash flow shrinks and it becomes a never ending fight to delay the decline.

The IEA expects prices to decline in 2014. Falling prices only make the production algorithm worse. Oil companies need rising prices to combat falling production. The IEA said a rising price scenario would slow depletion to 6.1% but that only delays the pain for a couple more years.

Existing fields are depleting. New fields, when they are found, require billions to develop and take 5-7 years to bring online. Noted investor Jim Chanos claims several major integrated oil companies have not replaced reserves in years and several companies are actually liquidating. He said the group is spending 100% of free cash flow on capex and borrowing to pay a dividend to keep investors on the hook. "The real story at Shell and the other majors is the inability to replace produced reserves with reserves of equal quality." The cheap oil is gone and every barrel found today requires a higher price to make it commercially successful.

Exploration costs are rising because of the enhanced drilling methods used to produce the hard to get oil. Horizontal drilling has provided us with a temporary boom in production but it comes at a price with the average Eagle Ford well costing in the $9 million range.

Even more shocking is the reduction in exploration expenses despite the decline in production. Exxon is reducing exploration expenses by -6%, Chevron -5% and Shell -20%. Translation, we are making less money so we are investing less.

At the same time automobile usage is exploding. China sold 1.5 million vehicles in April. They are on track to sell more than 20 million in 2014. The U.S. is going to produce more than 16 million. Globally there will be more than 50 million vehicles added to the fleet this year. Granted there will be several million scrapped in the U.S. but in China there is no scrapping yet. Used cars just go one more level down the economic ladder so the total fleet will rise by almost the total of production.

India has not yet joined the commuter generation. In India taxes on new cars run 50-70% of the purchase price. This prevents the average person from owning a car. However, Honda's sales in India rose +80% in 2013. As India moves up the consumer ladder their total sales will rise. However, tens of billions will need to be spent on roads before they can take the next step in car ownership.

Oil prices are going higher long term. There is no doubt that declining production and rising demand will produce higher prices.


This could be an interesting week in the markets. The Dow closed at a new high by +3 points and the S&P is only about 10 points away. The futures are up +3 late Sunday night but still a lot of darkness before morning.

If we succeed in opening higher on Monday we risk triggering another sell cycle with a trade on the S&P in the 1,897-1,900 range. The last time we hit that level there was a two day decline back to support at 1,850.

We are approaching the middle of May and so far nobody is going away. They are rotating out of the small caps and momentum stocks and into the blue chips. If those blue chips begin to weaken we could see a significant decline.

However, on the positive side a strong breakout by the Dow on Monday could trigger additional short covering that lifts the S&P to the level mentioned above.

Like I said, this should be an interesting and possible pivotal week.

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Jim Brown

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