Oil Supply Concerns Grow As Spare Capacity Is Tested

Friday July 6, 2018

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. UK highest cost of production

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- The UK and Australia had the highest cash cost per barrel of oil equivalent (boe) in 2017, according to Rystad Energy.
- More than 40 percent of the cost came from capex.
- The UK also has the highest production cost, as the North Sea is a particularly expensive place to produce oil.
- Still, costs have declined significantly in recent years.
- In June, Royal Dutch Shell (NYSE: RDS.A) gave the greenlight to its second North Sea oil project this year, a sign that the oil majors have not given up yet on the region.

2. Higher gasoline prices cutting into U.S. traffic volumes

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- Gasoline prices are on the rise, and motorists are taking note. U.S. traffic volumes have leveled off and even taken a dip recently, after years of blistering growth.
- In April, the volume of traffic on U.S. roads declined by 0.6 percent compared to the same month a year earlier, seasonally adjusted, according to Reuters.
- It was the first year-on-year monthly decline since 2014. Even if April was an aberration, the pace of growth had slowed significantly since 2016.
- In the years between 2014 and 2016, traffic volumes spiked because of cheap gasoline, typically rising by as much as 3 percent, year-on-year.
- But gasoline is now approaching $3 per gallon nationally, which will likely curtail miles traveled and spur interest in more fuel efficient vehicles.

3. Refinery runs skyrocket, but margins fall

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- U.S. refinery runs topped 17.8 million barrels per day in the week ending on June 22, marking nearly two consecutive months of increases.
- That has resulted in a sharp buildup in gasoline inventories in the U.S., although the stockpile of gasoline has been overshadowed by the significant drawdown in crude oil inventories. Gasoline stocks stood at 241.2 million barrels for the week ending on June 22, pushing levels above the five-year average. Gasoline stocks dipped in the most recent week for which data is available, but remain above the five-year average.
- Viewed another way, the strong drawdown in crude is seemingly bullish, but it is the direct result of high levels of refinery processing. Much of that oil is simply translated into higher gasoline inventories.
- Ample supplies of gasoline are weighing on refining margins. The Nymex gasoline crack spread, often cited as metric for refiners' profits from gasoline, fell by 30 percent in June.

4. Mexico's peso plunges in lead up to election, regains ground

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- Mexico's peso weakened as the presidential election approached, falling on fears that the expected winner, Andres Manuel Lopez Obrador, would pursue an agenda of reckless spending.
- The peso fell more than 10 percent between April and June. But the peso has gained more than 2.5 percent since the election last Sunday. On Tuesday, the peso posted its strongest single-day gain since 2016.
- Lopez Obrador repeated his intention to maintain fiscal discipline and monetary independence, soothing the fears of the markets. "Investors are being reassured by the speeches by Lopez Obrador," Carlos Capistran, an economist at Bank of America Merrill Lynch, told Reuters.
- Lopez Obrador has selected Carlos Urzua to be finance minister, and Urzua told Reuters that the administration supports cost cutting at state-owned Pemex.
- The reassurances suggest that despite his past rhetoric, for now it seems better than 50-50 that Lopez Obrador does not seek to derail the energy reforms passed several years ago, which has opened up Mexico to investment from international oil and gas companies. Details of the new agenda will be released in September.

5. Petrochemical surge

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- Prices for natural gas liquids are trading near multi-year highs due to a pickup in demand for both domestic consumption and for export.
- The spread between ethane and natural gas prices has widened as a result of surging petrochemical demand, with the differential hitting $2.30 per MMBtu recently.
- Ethane is the feedstock for ethylene, which is used for a variety of plastics.
- A handful of greenfield ethane crackers have come online recently in the U.S. Gulf Coast, with several more in development. A few will come online in mid- to late-2018 and 2019.
- Royal Dutch Shell (NYSE: RDS.A) is building a massive greenfield cracker in Western Pennsylvania to take advantage of abundant shale gas supplies.

6. Spare capacity not all it's cracked up to be

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- President Trump has repeatedly demanded more oil from OPEC, and seems to think that Saudi Arabia will add 2 mb/d of new supply.
- The growing number of outages is starting to overwhelm the available spare capacity from OPEC.
- The IEA estimates that real spare capacity, which can be ramped up in short order, only amounts to about 1.1 mb/d, half of which comes from Saudi Arabia.
- A looser definition of spare capacity - output that can be brought online over many months - puts the total at about 3.4 mb/d, with Saudi Arabia accounting for 60 percent of that.
- Saudi Arabia is already in the process of ramping up output, perhaps to as much as 11 mb/d in July.
- That will cut into spare capacity, leaving only about 1.0 to 1.5 mb/d in Saudi Arabia, a dangerously low level.

7. WTI futures curve steepens on front end

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- The WTI futures curve became a lot steeper at the front end in the last week.
- WTI for August delivery are trading at a greater-than $2-per-barrel premium to September contracts, a startlingly wide price differential.
- The spike at the front end of the curve reflects growing concerns about near-term supply.
- The proximate cause of the heightened backwardation is the 360,000-bpd outage in Canada and growing concerns about flattening production in the Permian basin.

That's it for this week's Numbers Report. Thanks for reading, and we'll see you next week.