Shale Asset Backed Securities

10/21/2019 12:37 pm EST


Phil Flynn

Senior Energy Analyst, The PRICE Futures Group

New International Maritime Organization (IMO) rules may tighten supplies and is pushing some energy producers into a risky investment offering similar to mortgaged backed securities, reports Phil Flynn.

The oil market has some big shorts to deal with. Bloomberg News reports that the short position in WTI crude oil has almost tripled since mid-September. Still, overnight oil is lacking conviction in two-sided overnight trading with more downticks than up.

Traders are still betting on slowing global growth and are convinced that this will lead to an oversupply of oil. Traders are also fixated on the Brexit soap opera on Saturday wondering whether they would stay or go. They voted to delay Brexit. Today British Prime Minister Boris Johnson did not sign the request to the EU to delay hopes to put his Brexit deal to a vote in Parliament. Yet the Speaker of the House John Bercow said he might not allow it. That might potentially lead to the so-called “hard Brexit” that is supposed to happen on Halloween. Scary.

Of course, as we get closer to winter and the new International Maritime Organization (IMO) rule is around the corner with surging oil tanker rates the focus at some point should switch to tight supplies. Refiners will have to come out of maintenance, and we are so far below average on ultra-low sulfur distillates that we could have big problems. 

Beginning on Jan. 1, IMO, will set the new limit for ocean going vessels to 0.5% by weight, down from 3.5%, which was established in 2012. As I told Barons, “While it sounds like a noble goal, it will come at a cost,” says Flynn. “The new fuels will tighten supply and drive up costs,” he says, adding that the IMO has said that fuel prices may increase by 20% to 30%. The rules will “put maritime fuel buyers in direct competition with trucking, planes, trains, and other forms of transportation. That will lead to a squeeze on supply, raising the cost of goods to consumers.”

It should raise the cost of oil products and despite the market’s fixation on macro issues, the lack of focus on the supply side may get up and slap those heavy shorts right across the face. This week we probably will see more product draws. That will challenge distillate buyers as supply is already 11% below the five-year average. On top of that there are more signs that U.S. oil producers may not produce as much oil as anticipated. The Wall Street Journal says that, "Desperate for cash, shale companies are trying to court investors with a new and potentially risky financial instrument that resembles mortgage bonds. The companies are floating a type of asset-backed security that involves existing oil and gas wells. Producers transfer ownership interests in the wells to special entities that then issue bonds to be paid off by the output from the wells over time. Raisa Energy LLC, a Denver-based oil-and-gas company backed by private equity firm EnCap Investments LP, closed the first such offering in September and several others are planned before the end of the year, said people familiar with the transactions. The bonds will pay nearly 6% interest on the best quality wells, the people said, with higher rates on riskier assets."

The investments are drawing attention from insurance companies, large money managers and other traditional investors of asset-backed securities. They represent a new avenue for shale companies as the industry’s traditional investors sour on the sector following years of disappointing returns. While similar in structure to securities backed by mortgages and auto loans, the securities pose potential risks because projecting the long-term output from shale wells remains an inexact science. Shale drilling only became a widespread method of extracting oil and gas in the past two decades. Modeling future production has proven difficult because of the complex geology of shale basins and large variability from one well to the next, engineers say. Thousands of shale wells drilled in the past five years are pumping less oil and gas than their owners forecast to investors, The Wall Street Journal previously reported."

Natural Gas

It is going to get cold but natural gas supply is ample. Natural gas supplies are going to pass the five-year average. The Energy Information Administration (EIA) reports, “Working natural gas inventories in the lower 48 states totaled 3,519 billion cubic feet (Bcf) for the week ending Oct. 11, 2019, according to the U.S. EIA Weekly Natural Gas Storage Report (WNGSR). This is the first week that Lower 48 states’ working gas inventories have exceeded the previous five-year average since Sept. 22, 2017. Weekly injections in three of the past four weeks each surpassed 100 Bcf, or about 27% more than typical injections for that time of year. Working natural gas capacity at underground storage facilities helps market participants balance the supply and consumption of natural gas. Inventories in each of the five regions are based on varying commercial, risk management, and reliability goals."

When determining whether natural gas inventories are relatively high or low, EIA uses the average inventories for that same week in each of the previous five years. Relatively low inventories heading into winter months can put upward pressure on natural gas prices. Conversely, relatively high inventories can put downward pressure on natural gas prices.

This week’s inventory level ends a 106-week streak of lower-than-normal natural gas inventories. Natural gas inventories in the lower 48 states entered the winter of 2017–18 lower than the previous average. Episodes of relatively cold temperatures in the winter of 2017–18—including a bomb cyclone—resulted in record withdrawals from storage, increasing the deficit to the five-year average.

In the subsequent refill season (typically April through October), sustained warmer-than-normal temperatures increased electricity demand for natural gas. Increased demand slowed natural gas storage injection activity through the summer and fall of 2018. By Nov. 30, 2018, the deficit to the five-year average had grown to 725 Bcf. Inventories in that week were 20% lower than the previous five-year average for that time of year.

Throughout the 2019 refill season, record levels of U.S. natural gas production led to relatively high injections of natural gas into storage and reduced the deficit to the previous five-year average. The deficit was also decreased as last year’s low inventory levels are rolled into the previous five-year average. For this week in 2019, the preceding five-year average is about 124 Bcf lower than it was for the same week last year. Consequently, the gap has closed in part based on a lower five-year average.

Trade strategy may be key to ride out the crazy moves that will come with the headlines so keep in touch with our daily analysis. We had a great response to our Money Show in San Francisco! Watch for our Videos! Thanks to all. Makes sure you are getting my Daily Trade Levels! Read Phil’s energy report at Price Futures Group. Twitter: @energyphilflynn |Facebook: Phil Flynn

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