Beware of Unintended Consequences

Jim Brown
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While everyone is celebrating cheap gasoline the energy sector is imploding. Goldman Sachs now believes up to $2 trillion in future oil investments are now threatened by low oil prices. Goldman said "Lower commodity prices and production overcapacity are forcing a renewed focus on capital discipline, cost efficiency and productivity across the industry. We expect significant price pressure to come through the supply chain." $2 trillion is definitely a significant number.

Goldman analysts lowered their long term price forecast to $70 per barrel on Brent crude. At that level billions in previously approved projects will be "uneconomic" and will be shelved. In the U.S. and Canada alone Goldman said investments of $930 billion are at risk.

Citigroup is now projecting an average capex cut of 33% for the companies they follow. They are now projecting $55 as an average price for WTI for 2015 and $65 for 2016. At those prices very few U.S. shale plays will be economically successful.

Goldman said companies will have to shelve any high cost project and cut costs by 20% to 30% in order to survive the oil crash. Chevron cancelled plans to drill in the Arctic. Exxon also cancelled their plans, which were already crippled by the sanctions on Russia. Conoco announced a 20% capex reduction.

It is one thing to "slow" spending to maintain profitability in a time of weak demand but we are rapidly approaching a phase where companies are going to be slashing spending in order to survive what is coming. Nobody is going to be able to go to the debt market to raise money for a long time. Those already overleveraged with a ton of debt are suddenly in a world of trouble. Oil at $100 was a gravy train of continuous profits. You could drill almost any well and make money. Now all those leases not on the productive fairway in every shale play are going to be liabilities rather than assets.

We are going to see a major round of M&A in the months ahead. Those companies with money and strong balance sheets are going to be picking up the assets of those companies trying to sell reserves to raise cash so they can pay their bills.

BP Plc said they were going to spend $1 billion to cut jobs and restructure. The company said they were reducing staff by cutting mid-level managers across the board in production, refining and in corporate offices across the USA. The CEO Bob Dudley said BP was testing future projects against oil prices as low as $60 to determine viability. Dudley said BP could cut another $2 billion from 2015 capex if needed. BP has one of the strongest balance sheets in the industry despite the constantly mounting charges from the Deepwater Horizon disaster.

The IEA gave investors a glimmer of hope on Friday with their Oil Market Report for January. They raised their expectations for prices for the latter part of 2015. They said the selloff had cut expectations for oil supply growth for 2015 by -350,000 bpd to +950,000 bpd. OPEC output rose +80,000 bpd to 30.48 mbpd in December. They said Iraqi output in December surged +285,100 bpd to 35 year highs and offset declines in Libya as a result of the civil war.

Global refinery inputs rose to a new high at 78.9 mbpd. Not all oil is refined. Some is used for other purposes and some is burned for electricity and heat. The IEA is expecting global demand to rise to more than 94.0 mbpd by Q4. Unfortunately the IEA projected lower prices in the short term before supply and demand begin to rebalance in Q4. The Bank of America projected a decline to $32 by the end of this quarter. Numbers that low would accelerate the panic in the energy sector.

The IEA continues to see declining demand in Europe as a result of economic conditions but said cheaper prices in the U.S. were producing a slight uptick in demand. While the IEA expects demand to grow by +900,000 bpd there are other analysts that are expecting closer to 1.5 mbpd as a result of the cheaper prices. Historically, six months after a major drop in prices of $20 or more, demand will increase by +500,000 bpd. It takes a few months for consumer buying habits to change. Larger cars are purchased. Homes are purchased a little farther away from work locations. Mass transit commuters reevaluate their circumstances and some move back to autos to be in control of their own schedules. When spring arrives there will be more outdoor activities and driving will increase.

We will soon face the end of stockpiling. Countries and oil buyers are currently taking advantage of six-year lows in prices to stock up on cheap oil. Once storage tanks are full the stockpiling will end and the pressure of excess oil will weigh on prices even more. Speculators are racing to lease super tankers to store oil at sea in anticipation of higher prices in the months ahead. This is a limited capacity effort. There are only so many available tankers and tanker lease rates just hit a new six-year high.

OPEC said the demand for its crude would decline to 28.8 mbpd, about 100,000 bpd lower than the prior month forecast. That is the lowest demand since 2003.

Shippers with committed contracts to ship their oil from Cushing Oklahoma to Texas are selling their space for as little as 50 cents per barrel and less than half the cheapest normal rate. The contract shippers are obligated to pay for their space and they are anticipating a drop in oil moving from Cushing to Houston. Currently oil prices in Houston are cheaper than oil at Cushing so there is nothing to be gained by shipping it to Houston. Shippers would actually lose money. This suggests that inventory levels in Cushing are about to return to the highs from several years ago before the new pipelines south were completed. Inventories have risen for six weeks and the longest streak since 2013.

Active Rigs

The number of active drilling rigs has fallen -255 from 1,931 in September to 1,676 today. Of that decline -209 were oil rigs. The last six weeks have posted the sharpest decline since records were started in 1987. There was a decline of -19 active gas rigs in the week ended on Friday to 310. That is a new 18 year low. The prior low was 310 set on April 4th, 2014. Oil rigs declined -55 for the week to 1,366. The Permian Basin in Texas lost the most rigs with a drop of -15 to 487. The Eagle Ford lost 12 to 165.

Other than during the financial crisis the number of active rigs has been above 1,700 since the beginning of 2006. We are poised for a significant decline possibly to the 1,100 level. The pace of decline will scare additional companies into panic mode.

Oil Inventories

Oil inventories rose +5.4 million barrels for the week ended January 9th. This was the first round of post December 31st deliveries where refiners don't have to worry about property taxes. Imports rose +600,000 bpd to 7.5 mbpd. U.S. production also rose +60,000 bpd to a new 30 year high at 9.192 mbpd. Cushing inventories rose 1.7 million barrels to the highest level since February 2014.

Gasoline inventories rose +3.2 million barrels for the 10th consecutive week of gains. This was after a whopping 8.1 million barrel build the prior week. The week ended Oct 31st was the last decline. Gasoline imports declined -248,000 bpd to 512,000 bpd. Gasoline demand remained solid at 8.88 mbpd but still below the holiday shopping levels. Just wait until spring arrives.

Distillate inventories rose +2.9 million barrels after an 11.2 million barrel spike the prior week.

The surge in refined products is the result of the strong push at year end to deplete oil supplies as much as possible to avoid property taxes. With the refinery utilization declining to 91% and probably lower next week the gain in refined products should slow.

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

Propane inventories declined by -.80 million barrels to 74.85 million. Demand declined slightly from 1.35 mbpd to 1.30 mbpd. With the cold weather this week and last we should begin to see higher demand over the next several weeks.

Propane inventories are so much higher this year than last that prices are very cheap. I bought 800 gallons this week for $1.64 a gallon in Colorado. That is a bargain since I paid $2.70 for the same amount last January. In February consumers were paying in the $3.60 range because of the shortage.

Natural gas inventories declined -236 Bcf to 2,853 bcf. Inventories are now -3.8% below the five year average at 2,966 Bcf and +11.0% above year ago levels at 2,571 Bcf. The recent cold weather caused the surge in demand and it could last until the end of January according to Accu-Weather.

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


The market rebounded on Friday due to short covering ahead of the three-day weekend. Futures opened up +5 points Sunday night before rolling over to trade at -3 around midnight. I would not expect any big gains on Tuesday because investors will be waiting to see what the ECB does on Thursday.

Jim Brown

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