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Crude Supply Build vs. Geopolitical Risk

05/22/2019 12:22 pm EST

Focus: COMMODITIES

Phil Flynn

Senior Energy Analyst, The PRICE Futures Group

Crude oil rallied this morning on an increase of 2.4 mill barrels, but risk to Middle East supplies also has grown, warns Phil Flynn.

The short-term outlook for crude oil looks a bit murkier this morning, A surprise 2.4-million-barrel increase in oil inventories reported by the American Petroleum Institute (API) and concerns that the Trump administration is looking to expand the technology ban it put on Huawei. Stocks rallied back as the Trump Administration granted a bit of a grace period, but reports that he is expanding the ban to other Chinese companies like ZTE Corp. (ZTCOY), Hytera and Dahua, as well as others caused some oil selling overnight on concerns the trade war might hurt global oil demand.

Yet while crude oil struggles on the headlines of the moment (see chart), talk of a tight oil physical market and less than satisfying 350,000-barrel increase in gasoline supply with a draw of 237,000 barrels in distillate supply shows that. For petroleum products there is a tight market and not a lot of room for error. Refiners at some point will have to rise to the occasion and start ramping up soon and these recent crude oil increases will soon become a distant memory.

Crude Oil WTI

Oil is also easing on reports that the threat of hostilities with Iran has cooled off. The Wall Street Journal reported that Acting Defense Secretary Pat Shanahan, who briefed congressional lawmakers, said that the prospect of an Iranian attack on Americans has been put ‘on hold’, outlining a reduction of the potential threat after earlier U.S. intelligence suggested a high degree of danger. “Our steps were very prudent, and we’ve put on hold the potential for attacks on Americans,” Mr. Shanahan told reporters. “And that’s what’s extremely important.”  That easing of tensions, while not a guarantee, is reducing some of the risk premium.

Risk premium is real and does affect prices. I hear from some folks that think that risk premium is just an excuse to jack up prices, but they are wrong. Bloomberg News for example reported that “Not since 2005 have the world’s insurers considered shipping in the Persian Gulf so dangerous for oil tankers.” The Joint War Committee of London’s Lloyd’s Market Association said Friday that it would expand its so-called ‘listed areas’ -- those regions that pose the greatest risks for shipping, and potentially warranting higher insurance costs -- to include the entire Persian Gulf. The last time the entire region held the designation was a period that ended in June 2005 and encompassed the most recent Iraq War. It highlights the growing risks in the world’s most important export region and chokepoint for oil.”

That report confirms what we have said; that the risk to oil supply was the highest since the Persian Gulf wars and it is being fairly reflected in the price. Now as those risks recede, so will the price. No one complains when prices go down because of a reduction of risk. But if the market failed to consider those risks and reflect those in the price, it could cause a calamity for the global economy.

You can say we should ignore those risks and not price them in because it is unlikely that something bad will actually happen. I guess you could say the same thing about your house insurance. But if you have a house that is worth $500,000 and you only insure it for $100,000, if it burns down you will take a huge financial hit.

We also still have issues in the shale patch that may signal that the loftier projections of U.S. crude oil output may be overstated. There are also signs that shale companies must rein in costs if they are going to achieve profitability. Reuters for example reported that Pioneer Natural Resources Co, (PXD) one of the largest producers in the Permian Basin of West Texas and New Mexico, announced on Tuesday that it had cut about a quarter of its workforce to save costs and boost shareholder value. Irving, Texas-based Pioneer laid off 230 employees this week at its headquarters and in its Permian Basin offices, and cut another 300 workers in April, the company said in statement it expects $100 million in cost reductions “in order to remain competitive with our peers,” Pioneer said in a statement. “Decisions like these are never easy. In this case they were necessary to both align our cost structure with our business strategy and to create value for our shareholders over the long term,” the company said in a statement.”

Yet cutting costs may also lead to lower output. For shale, you must keep drilling and spending money to offset the steep production decline curve. A curve that is getting steeper with every shale well drilled.

Natural Gas

The Wall Street Journal is reporting that Saudi Arabia has agreed to purchase U.S. liquefied natural gas from Sempra Energy (SRE), a new strategic direction for the kingdom as it seeks to establish a footprint in the growing global market for the fuel.

Saudi Aramco, plans to purchase gas from San Diego-based Sempra Energy's Port Arthur project in Texas, people familiar with the matter said. The financial terms of the deal couldn't be determined, and it wasn't clear whether Aramco would also take an equity stake in the project, the people said. Aramco had been expected to close a deal to purchase LNG after holding talks with several U.S. producers and a Russian producer in recent months. It isn't clear whether the gas will be used to power the kingdom's local economy or sold on to international buyers. Aramco didn't immediately respond to a request for comment made outside business hours. Sempra didn't immediately respond to requests for comment.

The Journal says that the deal demonstrates how the U.S. energy boom is dramatically changing global trade. Historically, Saudi Arabia has been a major supplier of oil to the United States, but with the evolution of U.S. shale production, the Energy Department predicts America will become a net energy exporter next year. Shale has catapulted the United States to being one of the top shippers of LNG, with the Energy Information Administration forecasting it will become the world's third-largest exporter in 2019.

That natural gas market is going to be the biggest growth sector in energy in the next 20 years and the United States is going to be a major global supplier.     

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