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Don't Look Back, We're Not Going There

Author: Brynne Kelly 9/06/2021

Ahead of a long US holiday weekend, the petroleum complex had to absorb 3 major news events:

  • Hurricane Ida Damage

  • OPEC Meeting

  • Release of SPR

According the the Bureau of Safety and Environmental Enforcement (BSEE) statistics from September 6, 2021, it is estimated that approximately 83.87% (1,526,409 barrels) of the current oil production in the Gulf of Mexico has been shut in, with only about 100,000 barrels added since Saturday. They also estimate that approximately 80.78% of the gas production in the Gulf of Mexico has been shut in (1.8 bcf/d).

A total of 104 oil and gas platforms and five rigs remain evacuated on Sunday, down from the 288 originally evacuated.

On the demand side, four oil refineries in Louisiana have initiated restart processes and five others have yet to resume operations, according to the U.S. Department of Energy. The four account for 1.3 million barrels per day of U.S. refinery capacity. According to the DOE, the five refineries still shut in Louisiana account for about 1.0 million barrels per day, or approximately 6% of total U.S. operable refining capacity. They also said that the restart timelines in New Orleans may take longer due to flooding and ongoing power supply issues. Utility provider Entergy Corp on Saturday said some of the refinery locations may be without power until Sept. 29.

Despite pressure from the U.S. to increase production at a faster pace, on Wednesday OPEC+ agreed to stay their existing course of gradual oil output increases. They did revise the 2022 demand outlook upwards, anticipating meeting 2019 levels in the second half of 2022. The next OPEC+ meeting is scheduled for Oct. 4.

These developments come at a time when US petroleum inventories registered their lowest levels for this time of year since 2015.

The U.S. Department of Energy announced Thursday it will utilize the nation’s Strategic Petroleum Reserve to address fuel shortages in Louisiana because of Hurricane Ida. It is curious to think that, with the loss of refining capacity, tapping the Strategic Petroleum Reserve is expected to provide much needed relief, according to U.S. Secretary of Energy Jennifer Granholm. A DOE statement said Granholm authorized an exchange with Exxon Mobile Baton Rouge “to alleviate any logistical issues of moving crude oil within areas affected by Hurricane Ida.” This week's EIA inventory report should reveal crippled refinery capacity utilization due to the storm. Releasing crude oil to refiners seems to be an ineffective Band-Aid.

What's interesting is the amount of forward-looking fear of oversupply that remains in the market. As if the conditions that led us to where we are now are likely to replicate themselves. The persuasive legacy that the last 10 years have left on oil markets is hard to shake. It all began with the Shale Era. And ended with the Covid-19 pandemic.

Over the last decade or so, oil prices have struggled under the weight of US crude oil production growth. This growth kept constant pressure on oil prices. It capped upside option premium and magnified the downside. The pandemic brought a poignant end to this cycle of production growth. As such, the historic growth in production stays just that, a time in history likely not to repeat itself.

The Shale Era

The “Shale Revolution” refers to the combination of hydraulic fracturing and horizontal drilling that enabled the United States to significantly increase its production of oil and natural gas, particularly from tight oil formations, which now account for 70% of total U.S. crude oil production.

The shale boom really started to take off in 2006, initially focusing on natural gas as it spread from the Haynesville shale in East Texas and Louisiana to the Eagle Ford shale. The shale crude oil boom began to take off by late 2011.

Even with oil prices recently surging above $70 a barrel, U.S. shale producers are keeping their pledges to hold the line on spending and keep output flat, a departure from previous boom cycles. Shale output remains well below the January 2020 peak of 9.18 million barrels per day (mbpd), with production from the seven largest fields this month running 8.09 mbpd, or 12% below that level, according to U.S. government data through week ending August 27, 2021 .

Since the beginning of 2012, US crude oil production has grown by 124% and WTI crude oil futures have dropped by 54%. This signifies the treadmill that production is on versus demand. Production is a complex organism that requires constant feeding. The production growth ushered in by the shale era was initially shocking (hence the big sell-off in futures prices in 2014/2015). Finally, a year of stagnant or governed production (via OPEC+ cuts in 2020) across the globe has drained inventories to levels that at the very least could become problematic and at best require diminished demand to support. Since 2010, US production has grown by over 100% while crude oil inventories have increased by a mere 39%.

As noted earlier, it's reasonable to assume that the production growth witnessed in the US over the last 10 years will not be replicated. In fact, it's more likely that going forward the more pressing issue at hand is whether or not current production levels can be sustained without significant investment. Moreover, another drop in demand - catching the market completely flat-footed - like the one we had in early 2020, is unlikely to repeat itself.

Instead of being concerned with the a repeat of the last 10 years of history, it might be time to focus on whether or not oil and oil products supply can simply keep pace going forward. The gradual return of OPEC+ production to pre-2020 levels is not sufficient for a growing world. This deficit in production is best illustrated via the future curves.

Futures Curves

There is no escaping the reaction by oil futures this year to the dynamic mentioned above. Typically, a rise in oil prices across the curve have led to producer hedging to quickly bring them back in line. Given the obsession by the market with weekly inventory reports and the reluctance of prices to move above the $70 level in WTI, the long-term structure remains supportive and fairly nonplussed by hedging activity.

We have actually entered the hedge window, a time when producers hedge future production for the next 2 calendar years. Hedged production typically gets produced. However, with the calendar 2022 strip continuing to trade above $65 (green line below) and calendar 2023 well above $60 (gold line below), the market is either absorbing this hedge activity without blinking or hedge activity has yet to commence.

Calendar Spreads

There is no better way to observe tight supply than 12-month calendar spreads. One of the most popular spreads to depict this is via the popular year over year December/December calendar spread. The prompt spread (lime green line below) in WTI crude oil tried to break above the $5.00 level, but has since been settling just below that. Prior to this year, the market had broken above the $5.00 level 4 times since 2012. In the spirit of 'surge pricing' during peak demand, this spread has the potential to make another run higher into the holidays. As mentioned earlier, releases from the US SPR are expected to hit the market immediately. The exchange program allows oil refiners to borrow SPR crude during declared emergencies and requires full repayment with interest at a later date. A reason calendar spreads have hit resistance. Borrowing oil at today's market with the hope of paying them back later at cheaper prices might be the only reason year on year calendar spreads don't move higher from here.

Refined product spreads are also approaching peak levels in the same year over year December calendar spread relative to history. Constrained refining capacity due to hurricane Ida are supportive of this. Imagine the remainder of the US hurricane season! SPR releases of crude oil become less relevant when refining capacity is offline.

It is a long held belief that commodities that are factors of production are unlikely to outstrip inflation over the long-term, and if they do there will be alternatives found. These days, alternatives to oil dependence have never been more prevalent. Tax incentives, investment attitudes and an optimism about what the future energy mix should look like are the priority these days. Yet, none of the aforementioned creates refinery capacity. SPR reserves are only relevant if they can be converted into consumer-facing refined products.

As the holiday season is fast approaching, refined products will be in high demand. Manufacturing, online orders and in person shopping are about to ramp up. Coupled with the start of a new school year (that is attempting to return to in-classroom learning), oil demand should be front and center.

The conditions over the last decade that have led to collapse in prices are quickly evaporating. Don't look back, we are not going there.

Over the weekend:

According to Bloomberg, on Sunday Saudi Aramco notified its Asian customers in a statement that it would cut October's official selling prices (OSP) by around $1.30. The price cuts were larger than expected; signaling Saudis are chasing to keep its Asian market share intact; Asia is the largest oil export hub for Saudi Arabia.

The Saudi price differential in September was a premium of $3.00 per barrel, the highest since February 2020. The $1.30 price cut for October by Saudi Aramco against September was the largest monthly reduction in a year, and it took the market by surprise as buyers had been expecting prices to drop $0.20-0.40 a barrel, in line with changes in Dubai benchmark prices. But the deep price cuts were likely to increase demand for Saudi crude, encouraging buyers to choose full volumes for October.

As a reminder, Saudi Aramco kept the price differential of light crude to northwest Europe unchanged, at a discount of $1.70 per barrel versus ICE Brent crude. It also kept the price differential of light crude to the United States unchanged at a premium of $1.35 per barrel versus ASCI. So, Saudi Arabia is now pricing its Asian customers in line with Europe and America.


EIA Inventory Statistics Recap

Weekly Changes

The EIA reported a total petroleum inventory DRAW of 7.20 for the week ending August 27, 2021 (vs a net DRAW of 4.50 last week).

YTD Changes

Year-to-date cumulative changes in inventory for 2021 are DOWN by 112.40 million barrels (vs down 104.70 million last week).

Inventory Levels

Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to draw as long as backwardation in the market persists.


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