Stay Out of Russia

Jim Brown
 
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Exxon and BP and a few others got the bad news last week. Stay away from Russia.

Exxon (XOM) has a multibillion dollar deal to explore Russia's Arctic Sea with the first well costing more than $700 million. They thought they were exempt from the earlier sanctions because the contracts were signed a long time ago.

Regulators fixed that loophole and several others with the new round of sanctions enacted last week. Rosneft was specifically named as one of the big five Russian energy firms that U.S. and European firms can no longer do business with.

The initial sanctions prohibited U.S. and EEU firms from providing technology to Russia that would enable them to explore for oil and gas. Exxon and Rosneft forged ahead to start drilling the $700 million well in the Arctic. Exxon was challenged and they said they were not supplying technology. They were providing services and Rosneft was drilling the well.

Fast forward to last week and the new sanctions named Rosneft, Gazprom, Gazpromneft, Lukoil and Surgutneftegas. The new sanctions ban the export of goods, services and technology used in exploration and production of Russian deepwater, Arctic offshore and shale projects that have the potential to produce oil. Game over for Exxon.

BP was also hit because it has a 20% ownership position in Rosneft. Halliburton and Schlumberger are also locked out.

SeaDrill (SDRL) was in the process of negotiating several offshore drilling contracts with Rosneft when the July 29th sanctions were enacted. In order to beat the sanctions they rushed the contract signing for several billion dollars worth of rig rentals and closed two days before the sanction date. The deal was for six rigs at day rates in the $250,000 to $400,000 a day range. The total deal was worth $4.25 billion for SeaDrill and partner firm North Atlantic Drilling. One of those rigs is the West Alpha rig that Exxon is using to drill the Arctic well. Putin demanded that the rig begin drilling as soon as possible so he could thumb his nose at the sanctions. The drilling began on August 9th.

The majority owner of SeaDrill and North Atlantic, billionaire John Fredrikson, admitted on Friday that the contracts may now be in conflict with the new sanctions. A second part of that deal was for Rosneft to take a $1 billion stake in North Atlantic Drilling in return for 150 rigs and a cash payment. That deal is also in trouble.

Russia exported $356 billion in oil and gas in 2013 and that accounted for 68% of Russian exports. If the U.S. and EU can figure out a way to cut into those exports it will force Russia to back off its aggressive behavior. There is clearly a trade war developing that could have serious consequences to the global economy. Russia is expected to announce retaliatory sanctions against the U.S. and EU next week.

The Russian sanctions have the potential to wreak havoc on earnings on multiple companies in the months ahead. Russia was mounting an aggressive exploration program and this should slow it significantly. This will produce further pain for the already weakened energy sector.

Oil Inventories

Oil inventories declined by -1 million barrels for the fourth week of declines. We should be nearing the point where inventory levels rise every week until December when refiners will try to reduce inventory levels to avoid year end property taxes.

Crude imports fell by -54,000 bpd and U.S. production declined -40,000 bpd. Refinery utilization rose unexpectedly to 93.9% and the high for the year. We can only speculate that refiners were making one last burst of runs before shutting down for maintenance and converting over to winter blend fuels.

Distillate inventories shot higher by +4.1 million barrels and the biggest gain in several months. Apparently those increased refinery runs also included more diesel, home heating oil and jet fuel. Also boosting the total was a sharp drop of -544,000 bpd in distillate demand. Labor Day travel is over and the associated jet fuel demand declined. Imports declined by -66,000 bpd.

Distillate inventories are at the bottom of their five-year average range and rising. They have plenty of room to grow but until demand picks up they will probably remain at the lower levels. Refiners don't want to inventory a product that is not selling. However, they are being very successful in selling excess gasoline and diesel for export so they can continue to run at full speed and simply export the excess until U.S. demand improves.

Gasoline inventories rose +2.4 million barrels to reverse the -2.3 million barrel decline the prior week. Now that Labor Day driving is over the demand for gasoline fell a whopping -869,000 bpd and gasoline production dropped by -607,000 bpd. Imports fell by another -477,000 bpd. Clearly the end of the driving season drastically changed the picture for gasoline.

If you are paying attention you probably noticed the big discrepancy in the utilization numbers and the gasoline production. Utilization spiked to the high of the year but gasoline production declined -869,000 bpd. That is a huge drop. You have to think we have another accounting error here that will be corrected next week.

Gasoline prices are declining weekly and some areas are already in the $3.00 range with others at $3.20. Analysts expect it to decline another 15-20 cents in the weeks to come thanks to the falling oil prices. WTI is trading just over $91 this weekend and we could see a dip under $90 to test support.

Gasoline inventories are right in the middle of their five-year range so there is no stress on supply.

Brent crude, which is responsible for a lot of gasoline pricing, has declined from $112 to $98 in recent weeks. This is the main driver of gasoline prices since coastal refineries still import the majority of their oil.

In the graphic below green represents a recent high and yellow a recent low.





Propane inventories declined -80,000 barrels to 76.05 million. That is the first week of decline since spring. It is still at the highest level since October 1998. Obviously the recent cold weather has prompted the start of the fall fill up process for homeowners. Demand rose from 1,017,000 bpd to 1,350,000 bpd.


Natural gas inventories rose +92 Bcf to 2,801 bcf. Inventories are still -14.2% below the five year average at 3,264 Bcf. There are only 7 weeks left in the injection season and at the current rate we could reach 3,500 Bcf. That is still about 400 Bcf below where we need to be going into the heating season.

The blue line in the chart below shows the current inventory relative to the five year average.


Hurricane Edouard is changing direction to the northeast and will not be any danger to the Gulf of Mexico. There are no other storms in progress in the Atlantic. The Pacific has Hurricane Odile heading up the Baja coast but there are no oil rigs in that area.

This has been a very calm hurricane season and the normal season peak was last week. That does not mean the risk is over but it will diminish from here.

Market

The S&P futures are down -7.50 Sunday night and WTI futures are down -1.30. The market appears to be afraid of what may happen at the FOMC meeting on Wednesday. If the Fed changes the language in the statement to allow for faster rate hikes the market may not take it well. However, we have already had some pre meeting selling so anything is possible.

We could also be seeing some selling from fund managers and individuals raising cash for the Alibaba IPO. I doubt that is weighing on the futures tonight but it should impact us on Monday.

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Jim Brown

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