How Sustainable Is This Rally?

Friday, March 11, 2016

In the latest edition of the Numbers Report, we'll take a look at some of the most interesting figures put out this week in the energy sector. Each week we'll dig into some data and provide a bit of explanation on what drives the numbers.

Let's take a look.

1. U.S. joins LNG export market

- Cheniere Energy's Sabine Pass export facility came online in recent weeks, which means that the U.S. has joined the ranks of global LNG exporters. 
- Four other LNG export terminals are under construction. Three are on the Gulf Coast, including Cheniere's Corpus Christi LNG project (capacity: 2.14 Bcf/d. Startup by 2018); Sempra Energy's (NYSE: SRA) Cameron LNG terminal (capacity: 1.7 Bcf/d. Startup by 2018); and Freeport LNG (capacity 1.8 Bcf/d. Startup by 2019). Dominion Energy also has the Cove Point facility under construction on the Chesapeake Bay in Maryland (capacity 0.82 Bcf/d. Startup by 2017).
- Federal regulators have approved one more project - Southern Union's (NYSE: SUG) Lake Charles terminal - but construction has not begun. 
- There are an estimated 9 additional projects pending review by the Federal Energy Regulatory Commission (FERC), but even if approval is forthcoming, market conditions will prevent many, if not all, from moving forward with final investment decisions.

2. Oil speculators turn bullish

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- Hedge funds and other large investors have liquidated their net short positions at a rapid rate since February. Shale production declines and a growing sense that markets are adjusting led to a sharp short-covering rally. 
- The move was particularly bullish for Brent, pushing the international crude benchmark above $40 per barrel on March 7. 
- We have been keeping a close watch on the situation since last fall, when net-short positions hit multiyear highs, a situation that was clearly untenable over any lengthy period of time. 
- Reuters reported that net-long positions have climbed by over 200 million barrels of oil since the beginning of the year. 
- WTI is not seeing as much strength, as a record level of storage weighs on market sentiment.
- It is important to highlight that the rally was strong - up almost 40 percent since the start of February - but technical in nature. That is, the underlying force behind the rally is because of a shift in sentiment, not fundamentals. The buildup in short positions could not last, and so once a rally started, short investors scrambled for the exits.
- A technical rally is less durable than a fundamental one. Oil is still oversupplied. That will prevent any meaningful price rebound in the near-term.

3. Shale declines picking up pace

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- The declines in U.S. oil and gas production from shale continue to gather momentum after an extended period of resilience.
- The EIA sees oil production falling by another 106,000 barrels per day in April, which could put the U.S. close to dipping below the threshold of 9 million barrels per day, a level not seen since mid-2014.
- Declines are led by the Eagle Ford (-58,000 bpd), the Bakken (-28,000 bpd), the Niobrara (-15,000 bpd), with the Permian seeing a slight decline (-4,000 bpd).
- Natural gas production is also falling as a glut of storage affects that market too, pushing prices to lows not seen since the late 20th century. The Marcellus shale, where the bulk of the country's shale gas comes from, has started to decline. Production will fall by 108 million cubic feet in April. Other losses include the Eagle Ford (-182 mcf/d), the Niobrara (76 mcf/d) and Haynesville (61 mcf/d).

4. Volatility has eased since February

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- In February, oil volatility spiked to its highest level since the financial crisis in 2009 as uncertainty in the oil markets combined with turmoil in global financial markets.
- The CBOE Crude Oil Volatility Index (INDEXCBOE: OVX) jumped to its highest level since 2009 in February. 
- A sense of calm, if not stability, has washed over the oil markets as many investors believe there is little room left on the downside. With production declines solidifying but oil inventories still high, oil bounced around in the $30s per barrel over the past month, with daily movements more subdued than in months past. 
- For front-month contracts, implied volatility for Brent fell by 16 percentage points since February 1, while WTI fell by 14 percentage points. Both benchmarks have implied volatility at around 50 percent on an annualized basis.

5. Natural gas storage surging

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- Natural gas inventories in the U.S. are climbing fast, a bad omen for natural gas prices and any investors in natural gas producers. 
- Record production ran head long into an unseasonably warm winter, a time of year where storage levels are typically drawn down. Inventories still ticked down this winter, but at the slowest rate in over three decades. 
- Since the winter season started with elevated storage levels, the market is now suffering from elevated inventories heading into the injection season.
- Storage levels were 666 billion cubic feet above the five-year average as of February 26.
- In short, record storage levels are crushing prices and will continue to do so until inventories are drawn down and production is curtailed. Prices are down to around $1.70/MMbtu, near the lowest levels in nearly two decades and may not rebound this year. Investors in natural gas producers should take note.

6. Chevron goes long on shale

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- Chevron (NYSE: CVX) announced the startup of its $54 billion Gorgon LNG project this week. It also announced a shift in strategy, backing away from hugely expensive projects like Gorgon. 
- Instead, Chevron decided to focus on "short-cycle" investments, namely, U.S. shale. 
- This highlights the future of oil drilling in an era of cheap oil. Gone are the days of massive megaprojects that cost tens of billions of dollars. 
- Chevron hopes to triple its production in U.S. shale by the end of the decade. It also said that it would not spend any more money on large-scale projects like Gorgon if they are not already underway.

7. Commodity shippers reeling from too much capacity and weak demand

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- Shippers of bulk commodities ramped up the number of vessels over the past decade to take advantage of China's blistering growth.
- The number of the largest commodity vessels, known as Capesizes, hit a record 1,655 last year, double the number from 8 years ago, according to Bloomberg.
- The timing was poor: China's economy has slowed, commodity prices have collapsed, and demand for coal, iron ore, and other commodities is weak. Not only are upstream commodity producers getting slammed from the bust, but dry bulk shipowners have seen earnings vanish. Rates to lease a Capesize have halved since 2014 as shipowners compete for a shrinking pie.
- That has resulted the in collapse of share prices for commodity shippers, including Star Bulk Carriers (NASDAQ: SBLK), Pan Ocean (SGX: AGY), and Golden Ocean Group (NASDAQ: GOGL).