Author: Brynne Kelly 2/21/2021
Texas, the energy hub of the US, came to a grinding halt this week when the ERCOT power grid crumbled under the weight of cold weather. A state rich with energy production as far as the eye can see, was suddenly unable to continue operations without electricity and the dominos began to fall one by one.
What unfolded was disturbing, as we witnessed in real time, the concept of Cascading Failure. A cascading failure of a system of interconnected parts happens when the failure of one or few parts can trigger the failure of other parts and so on. Such a failure can happen in many types of systems, including power transmission, computer networking, finance, transportation systems, organisms, the human body, and ecosystems.
In finance, the risk of cascading failures of financial institutions is referred to as systemic risk: the failure of one financial institution may cause other financial institutions (its counterparties) to fail, cascading throughout the system. Institutions that are believed to pose systemic risk are deemed either "too big to fail" (TBTF) or "too interconnected to fail" (TICTF), depending on why they appear to pose a threat. Note however that systemic risk is not due to individual institutions per se, but due to the interconnections. A related (though distinct) type of cascading failure in finance can occur in the stock market, exemplified by the 2010 Flash Crash.
The modern world increasingly relies on electricity at it's core. Multiple systems depend on the reliability of each other, yet these systems are largely managed and regulated independent of one another. Cold weather led to failures across the energy system, and this was exacerbated by failures in the ERCOT power grid. The loss of basic electricity services in Texas cascaded down to the production of energy, transportation systems, water distribution and the performance of telecommunications.
Diverse infrastructures such as water supply, transportation, fuel and power stations are coupled together and depend on each other for functioning (example below). Owing to this coupling, interdependent networks are extremely sensitive to random failures and to targeted attacks, such that a failure of a small fraction of nodes in one network can trigger an iterative cascade of failures in several interdependent networks
To underscore this point, we need only to look at headlines of the failures that cascaded through the system in Texas last week:
Officials for the Electric Reliability Council of Texas, which manages most of Texas’ grid, said the primary cause of the outages last Tuesday appeared to be the state’s natural gas providers. Many are not designed to withstand such low temperatures on equipment or during production.
Production of natural gas in the state plunged, making it difficult for power plants to get the fuel necessary to run the plants (natural gas power plants usually don’t have very much fuel storage on site, rather the plants rely on the constant flow of natural gas from pipelines that run across the state from areas like the Permian Basin in West Texas to major demand centers like Houston and Dallas).
Widespread power failures knocked out or disrupted water supplies in many parts of Texas. Emergency officials had to air-lift pallets of bottled water. About 1,000 of the state’s 7,000 local water utilities were offline or unable to ensure supplies were fit for human consumption.
The state had to deploy airplanes because highways in many parts of the state were choked with ice and snow, and low supplies of diesel made it impossible to rely on trucks, emergency management officials said during a media briefing.
Governor Greg Abbott waived a ban on using off-road diesel on highway vehicles in an effort to expand fuel supplies amid refinery shutdowns.
According to the latest FCC data, somewhere around 302,793 wireless subscribers have been unable to access essential communications services as the area struggles to recover from historically cold weather. Because they require broadband and power to function, the FCC states that another 33,331 Texas and Oklahoma residents have lost access to their internet voice (VOIP) services. According to the FCC, due to the interdependencies between power and communications service, power outages and rolling brownouts are forced communications service providers to rely on backup power, and icy roads affected their ability to refuel generators.
Texas oil and gas companies filed 174 notices of pollution releases above permitted levels between Feb. 11 and Feb. 18, four times the number the prior week, according to the Texas Commission on Environment Quality (TCEQ) data.
With the worst of the recent cold weather behind us for now, the restoration of basic services has begun. What remains unknown is the damage left behind and the complexity of bringing each individual system back on-line in unison. As a result, we have multiple systems competing for priority in the restoration process. Examples of this include:
Refinery operators are assessing facilities to determine the scope of the damage and taking action to repair any damage to pipelines, cooling towers and other equipment before slowly and carefully restarting.
Texas officials last week asked natural gas suppliers to prioritize deliveries to electric utilities and residential customers, leaving less of the fuel to supply refinery operations. Shortages and high prices for natural gas have also affected refiners.
What impact will we see in the market? There are three major dynamics to watch:
The resumption of production lost due to last weeks' storm ahead of the resumption of refinery throughput
The loosening of crude oil supply due to an eventual tapering of OPEC+ crude oil production cuts,
The tightening of the supply of refined products due to the shut down of refinery operations last week coupled with previously lowered output due to the coronavirus.
The Return of Production vs Consumption
According to IHS Markit estimates, more than 5.2 million barrels per day (b/d) of Gulf Coast capacity and 730,000 b/d in PADD 2 has been impacted by the winter weather. On the production side, they estimate that upwards of 2-2.2 million barrels per day has been shut in due to last weeks' storm.
The latest inventory data out of the EIA only includes activity through the week-ending February 12, 2021 (US crude oil production, left; US refinery utilization rate, right).
Regardless of the loss tally since then, going forward the focus will be on whether refiners and producers return capacity to the market at equal rates. At the moment, it appears that producers suffered less overall damage and will be able to resume normal operations quicker than the refiners. This has kept the front month calendar spread in WTI weak and calendar spreads further out on the curve strong.
If anything, the expected production loss drove deferred calendar spreads to new yearly highs last week before pulling back slightly by Friday (Dec/Dec 12 month spread, left; rolling 12 month spreads, right). The expectation is that we will see another large inventory draw in next week's EIA report which will take the bearish inventory narrative of 2020 off the table. The cautionary note here is that OPEC is currently withholding a significant amount of production from the market and is expected to taper those cuts going forward. Aside from US storm-related production losses, the global market anticipates a loosening of supply out of OPEC+ going forward.
The Tapering of OPEC+ Production Cuts
In their December 2020 meeting, OPEC and its oil-producing allies agreed to increase oil production by 500,000 barrels per day beginning in January 2021. Ahead of the meeting, the oil-producing cartel was widely expected to extend production cuts of 7.7 million barrels per day through at least March. This was preceded by a record cut of 9.7 million barrels per day started on May 1, 2020 which tapered off to 7.7 million in August.
In their January, 2021 meeting Saudi Arabia pledged to cut an extra 1 million barrels a day of crude output in February and March. Other OPEC+ producers agreed to continue at current rates, except for Russia and Kazakhstan, which increased production slightly.
The next OPEC meeting is scheduled to take place on March 4, 2021. At risk are the extra 1 million barrels a day of Saudi production and the rate of tapering (currently set at +500,000 bpd per month). All else being the same, production out of OPEC+ 'could' increase by 1.5 bpd come April 1, 2021.
The US has certainly benefited from these cuts as crude oil inventory at both Cushing and PADD 3 have retreated significantly from the high levels accumulated at the onset of coronavirus lockdowns last year.
This quick decline in US oil inventories since the end of last year has moved oil from a contango structure to a backwardation structure. The caveat being that the front month spread in WTI continues to be weighted down into the roll period and expiration (as noted earlier).
Tightening Supply of Refined Products
Lower refinery throughput has done much to reduce the overhang of refined products in the US and across the globe. Prior to last weeks' weather in Texas, market participants had grown cautiously optimistic that the worst was behind us when it comes to storage levels. Even so, it still felt like we were one regulation or one inventory report away from a return to excess inventory builds. With the advent of winter storms in Texas and their related impacts on the refinery complex, conviction that US refined products will get tighter in the future began to grow.
It has been estimated that since Monday February 15, around 4.2 million bpd of refinery capacity was temporarily shut due to the weather conditions, including the 640,000 bpd Motiva Enterprises facility and the 600,000 bpd Marathon Petroleum Galveston Bay refinery, some of the largest refining facilities in the US. About 2.5 million bpd of capacity was shut in between Houston and Louisiana and another 540,000 bpd in the Corpus Christi area was affected. This represents a significant portion of the region's total capacity of 8.7 million bpd.
Combine this with another external shock, such as a repetition from last year’s hurricane season, and it could result in very tight product markets for the second half of 2021. This caused the 12-month backwardation in NYH RB gasoline futures to soar to new highs by the end of last week (red line below).
This is an incredibly bullish signal if the pattern continues. Gasoline futures have moved rapidly from the most bearish in the complex to the most bullish. Yet, in the US at least, gasoline inventories are still comfortably high for this time of year (blue line below).
The expectation is that there will be LARGE withdrawals of gasoline inventories going forward. Brace yourself if this is not validated in Wednesday's EIA inventory report.
Finally, we can expect an epic post-mortem analysis of the cascading failures of the Texas system in the weeks, months and years to come. This could lead to some short and long term regulatory and operational changes that change the structure of markets radically going forward. It's the actual and perceived risk of immediate, knee-jerk policies that will set the tone going forward. This could include hefty debates on whether or not to relax renewable policies and obligations, specifically in crisis situations. Something that the market has been grappling with as RIN prices continue to rise. With Texas being the US hub for exports of energy products to the rest of the world, some now wonder if the events of last week will cause global buyers of US energy to pause and question it's reliability. Regulations meant to address reliability generally increase costs across the board. Increased production costs (of both raw and refined products) in the US could make cheap US energy less competitive or attractive.
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EIA Inventory Statistics Recap
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 10.10 million barrels for the week ending February 12, 2021 (vs a draw of 4.30 million barrels last week).
YTD Changes
Year-to-date total inventories in 2021 are DOWN by 8.70 million barrels, with crude oil inventory now down 23.70 million barrels for the year (vs 16.40 last week).
Inventory Levels
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years continue to show signs of recovery.
