When the International Energy Agency reported nearly a year ago that the United States would become the world’s largest producer of crude oil within 10 years and be completely energy independent by 2035, we all rejoiced, but it was one of those ephemeral pieces of good news because many of us assumed it would be years before we actually would see the benefit of the increased production.
That has not been the case because U.S. energy production fueled by the shale gas and oil revolution is here, and thank goodness because other supply sources have been less reliable.
“The U.S. is now producing the most oil [it has] in 22 years,” says Phil Flynn, senior market analyst at Price Futures Group. “It is changing the face of the global energy market. Look at the situation in Syria; if the U.S. was not producing the amount of oil [it is], we would have seen a much more significant spike in the price of oil. Instead of going up $10 a barrel, it would have gone up $30.” (See “Ramping up production,” below)
Protec Energy Partners co-founder Todd Garner adds, “From a U.S. standpoint, it is obvious that we are pretty well supplied, and we are getting ready to go in[to] a refinery turnaround period. Stocks have drawn down pretty hard in [August. Early September was] the first week that we have had a build in crude oil stocks and most of that came from a build in the Gulf [of Mexico]” (see Trader Profile, page 46). Garner thought crude was headed lower based on fundamentals when the Syrian situation and reduced production in Libya pushed it back up.
The United States also has been a reliable replacement source for gasoline and diesel during recent global supply disruptions. “We now export more refined products than we import in the United States,” says Dominick Chirichella, founding partner at Energy Management Institute. “It is a big change.”
All the analysts we spoke to agree that ramping of U.S. energy production has changed the global energy dynamics dramatically. Which begs the question, if we’re swimming in oil, why is crude still above $100?
There are supply reasons why crude has clung to the $100 level, and the threat of a military strike on Syria in early September and potential retaliation is what took it from $100 to $110.
“Crude oil is stuck in the Syrian news cycle right now,” Chirichella says. “Once it is over, whether the U.S. is going to bomb them or not bomb them, I don’t anticipate any impact on the flow of oil. The Syrian risk premium in the market will work its way out.”
Most analysts peg the Syrian risk premium at roughly $10, and that is based on fear of retaliation as Syria is not a big producer of oil. “If you actually see an attack on Syria, crude will spike up another $5 and then immediately reverse,” Flynn says. “You will see an impact on demand; you will see a release of oil from the global Strategic Petroleum Reserves (SPR). There will be a flood of oil and then the market will top out unless World War III breaks out.”
While the Syrian situation presents a risk premium, what has kept crude oil prices stubbornly high throughout 2013 is real supply fundamentals. “The underlying supply situation is relatively tight,” Chirichella says. “There are lots of problems. Libya is down to 150,000 barrels a day from 1.6 million; Iran is down to 1 million barrels a day; Iraq has problems, they keep blowing up the pipeline going into Turkey. North Sea is still under maintenance. The latest number that the EIA (Energy Information Administration) came out with in August estimates that we are running about 3 million barrels a day lower on global supply.”
Another pressure point on supply is Japan because it had to replace nearly all of its nuclear power production. “[Japan has] to replace that with something. It is either coming from [liquefied natural gas (LNG)] or it is coming from fuel oil,” says T.J. Sattler, portfolio manager at Treasury Management Services Trading. “[Japan is] a huge buyer of fuel oil right now. That has put pressure on crude. A majority of the LNG [it is] buying is based off of crude pricing. [Japan is] in a world of hurt.”
And who is to say what is normal these days? “If you look at normal demand patterns before the global economic crisis, the price of oil was going up about $10 per year, so with demand growth in emerging markets and the decrease in value of the dollar, $90 to $100 is where you would be at with normal demand growth,” Flynn says. He also notes that global quantitative easing and a weaker dollar also play into the price of crude.
Chirichella agrees. “The big robust revolution we are getting in the United States is being offset by a lot of those problems right now. Oil prices will come off, but I don’t think we are anywhere near a major collapse in prices until we see a recovery in some of these supply issues.”
WTI vs. Brent
It wasn’t long ago that the market was contemplating what would replace West Texas Intermediate crude as the global benchmark. Its hub is in Cushing, Okla. and demand growth was in China. Even U.S. East Coast refiners began benchmarking to Brent crude. “WTI was not going to matter anymore. All the demand growth was going to be in China, and WTI had logistical problems,” Flynn says, adding “If the price between Brent and WTI gets wide enough, people will find a way to get the oil out, and that is what we have seen.”
Sattler says, “The big problem is the gravitation from WTI. A lot of the majors [have] changed their risk management programs to Brent. All the refiners in the U.S. basically buy at Brent prices, especially along the Gulf Coast.”
The spread grew to more than $25 in 2011, which helped correct logistical problems (see “Brent not sweet at these prices,” below.) But then all is not rosy for Brent. “The North Sea is depleting rapidly. You are starting to see a shift in supply away from Brent. The volatility between WTI and Brent has changed dramatically,” Sattler says.
WTI even traded at a premium to Brent this summer before Libyan production problems and the Syrian crisis caused Brent to spike. “If Libya comes back and once North Sea maintenance is over, oil prices will go lower,” Chirichella says. “Ultimately, (Syria) will be a non-event. On the low side we can drop down to $90 a barrel (below $100 in Brent), and once the supply issues go away, the Brent/WTI spread will resume its narrowing trend.”
Perhaps more interesting are the dynamics in natural gas.
“If you are a patient investor, natural gas is an opportunity that you get once a decade. It is a classic case of a commodity cycle,” Flynn says. “Back in 2005 the price of natural gas was going crazy. Alan Greenspan said that the biggest threat to the U.S. economy was our inability to produce natural gas.”
The natural gas price spiked to $15 before the bottom fell out of everything in 2008. Then there was the explosion in fracking production, which proved the old adage of high prices curing high prices. “Now the U.S. is the Saudi Arabia of natural gas; we have 100 years of natural gas,” Flynn says.
“Nothing has changed in natural gas other than supply continues to rise,” Chirichella says. “We have seen a bit of an increase in the manufacturing side. We lost some on the coal switching as it went back above $3.”
And while the United States may be the most aggressive producer of shale oil and gas, the shale revolution is not just a domestic story (see “Peak energy? What peak energy?” below).
Another issue that has kept natural gas at historic lows is leasing arrangements that allowed land owners to opt out if producers did not drill.
“Requirements for ‘hold by production clauses’ meant that once you went out and paid a land owner, [producers] agreed to begin drilling on their land by a certain time frame,” says Kyle Cooper, managing director of research for Cypress Energy. “Bottom line, there was some drilling from companies bound to drill wells by a certain time frames or the money would be forfeited and the land owner would no longer have to grant them access to the land. That prevented someone from paying [to access the land] and then never drilling on it.”
While lease agreements prevented moving some production off-line, the real driver is the explosion of wells, some 500,000 in the United States. Sattler listed a quick half dozen new gas production facilities across the country that are producing a great deal of natural gas. “These are all new supply sources that have come up since 2008, so you have a huge new supply that is regional,” Sattler says. “It used to be that you had all the supply in the South and all the demand in the North. Well now in Pennsylvania with the Marcellus Shale, you found a Gulf of Mexico in your state. With the Utica coming online in Ohio and Kentucky you have this regionality in supply that you never had before.”
And as opposed to crude, which is a global market, natural gas is domestic and more sensitive to supply/demand issues, though that is changing.
“We are trading at $3.50 and internationally it is trading at $12-$14. How long can we do that?” Sattler asks.
He says we are building up our LNG facilities to meet demand from Japan and other countries, but to do that takes several years. “Currently there are five facilities in the U.S., but they are set up to import LNG. We have to set them up for export. [It’s] a totally different plant that [we] have to construct. [We] have to build liquefaction where [it has to handle] 265 degrees below zero.”
Flynn concurs. “We are going to be exporting natural gas to other countries. The LNG import terminals are going to be switched to export terminals. We are going to be shipping natural gas to other countries that desperately need it. Last winter there were parts of China that [were] paying $20 for LNG, in Japan, $15 and here in the United States we are at $3 or $4. Europe is going to demand that we export it; they don’t want to be held hostage to Russia. Natural gas is the fuel of the next 20 years.”
One possible issue is environmental concerns over fracking. “If you reduce fracking, buy everything,” Cooper says. “If you significantly curtail fracking, buy every hydrocarbon associated asset you can find because it is going way higher.”
But he adds: “We have been fracking for a long, long time. There are some risks and every once in a while things do go wrong, and when they go wrong the people who were wrong should be held financially responsible for it. I don’t think that a systematic catastrophe is waiting to happen. The facts bear that out: There are 500,000 wells across the country producing.”
“Assuming nothing major happens in the Middle East, WTI should start to head back down,” Garner says. “I don’t think we will get back down to $80, but it is a possibility. We’ve got $10 in the price of crude that has to do with the Middle East situation. Fundamentally we should be around $95-$100, maybe less than that.”
Most analysts agree with Garner. “I don’t think [crude] can go much higher,” Chirichella says. “Maybe we can get to $120. I don’t anticipate any further major supply interruptions and somewhere above the market there is a put option, and that is the [SPR]. If we see the price continue to firm, the U.S. and Europe are going to be aggressive in agreeing to a release from the SPR because the economies of Europe and the U.S. are still relatively fragile.”
Chirichella sets the range in crude for the remainder of 2013 at $90 to $120, with a bias to the low end.
Flynn adds, “By [year end] if things calm down in the Middle East, prices can drop dramatically. The risks to the downside are peace in the Middle East and [Federal Reserve] tapering. Interest rates are rising, which is bearish for oil.”
The wildcard is Syria, and Chirichella says, “If this whole Syrian thing is still lingering, I do not think the Fed will make a move.”
Sattler calls the top part of the range in crude at $125 to $128 if tensions in the Middle East escalate. On the downside he sees $78 to $82. “Shipping rates are abysmal and if the Eurozone implodes and demand decreases and the U.S. economy falls again, it is possible.”
On the natural gas front, there is not much relief from low prices for producers. “There are no issues from a fundamental point of view that suggest natural gas will surge past $4 before we get to the winter and then it is all about what the winter turns out to be,” Chirichella says. “We are struck in a broad range of $3 to $4 and a narrower range of $3.25 to $3.75.”
Sattler says natural gas could reach a low of $2.70 if we have full storage going into December. On the top side he sees $4.20 with a cooler fourth quarter and if more coal plants retire early. “Some of these companies are accelerating those retirements by virtue of the lower gas price. If they accelerate those retirements, there would be increased demand for power. A nuclear plant is closing in Wisconsin because gas prices are so cheap.”
Slightly more bullish is Cooper who says natural gas could easily approach the $4 to $4.50 range depending upon weather in the fourth quarter. “The draws that you could see with weather that is not considerably cold could indeed shock people and if you had a cold November/December such as what we had in 2000, the price would be significantly higher than that.”
It is a brave new world in energy markets and U.S. production is the driving force.
“The U.S. has become a huge exporter of product,” says Flynn. “We also are producing more oil than we import. Now the logistical problems are with the Brent crude because of declining North Sea production. We are starting to see WTI as a reliable source of energy. Number one, the U.S. is going to be one of the world’s largest oil producers, number two we are going to be one of the biggest oil consumers, number three [the U.S. is] going to be a major importer, and number four, [it is] going to be a major exporter. You are going to have everything going through the United States.”