The Weekly Report: U.S. Energy in 2011 (Part II)

22 December 2011


In this second instalment of the series, we focus on a few key developments in the U.S. energy industry. As the largest global consumer of energy, events in the U.S. have a significant effect on global energy dynamics. However, due to the rise of China as a global scale consumer of commodities, and several domestic factors in the U.S. itself, the nature and extent of this effect is changing.

The U.S. as Energy Exporter?

With an estimated 500 trillion cubic feet (tcf) of reserves and growing (compare to T&T’s 30ish tcf), the U.S. now has an ample and relatively inexpensive energy supply. In fact, several companies are now looking at the possibility of exporting liquefied natural gas. Cheniere Energy is the leader of the pack thus far, having inked off-take deals to provide LNG to BG, which would then sell it on to other clients globally: Latin America, Europe, and Asia. Rumours are also afoot that Cheniere could sign another LNG off-take deal with GAIL, the massive state-owned Indian natural gas company, securing a foothold in that crucial growing market. These two contracts would only be for a portion of Cheniere’s capacity; more contracts should definitely be expected in the future.

This is a complete reversal from just a few years ago. In 1996 it was projected that the U.S. would need 24.4 tcf per year in gas imports to meet its needs by 2006. U.S. production at the time was around 18 tcf and expected to decline rapidly. In 2003, Alan Greenspan went as far as to say that LNG was the ‘only solution’ to meet U.S. natural gas needs in future. 8 years later, regions of the U.S. with shale gas are experiencing a boom that is a stark contrast to the economic lethargy prevalent in large swaths of the country. Midstream and pipeline companies such as Kinder Morgan are scrambling to keep up with output and expand or build the necessary infrastructure to convey the gas to major demand centres across the country. Natural gas may even become a major vehicular fuel, mirroring the T&T government’s quest to promote CNG adoption.

While U.S. demand is quite strong, even without factoring in future conversions from coal to natural gas, there will definitely be an incentive to export natural gas due to the huge price differential between U.S. and global gas prices. LNG prices in Japan are currently at or above $16 USD per mmBTU while in the U.S. the price has struggled to maintain itself above $4 per mmBTU. This is a price differential of 4 to 1. The premium is less dramatic for other markets but still comfortably above the Henry Hub benchmark. This heralds a bright future for LNG exports from the U.S.

Changing the Plumbing

As mentioned in the first part of the series, there was a marked increase in the price difference between Brent (a UK-based benchmark which is the basis for 65% of global crude trade) and the WTI crude oil price, which tends to reflect demand in the U.S. and the Americas more than globally. We explored the impact of the Libyan conflict on the price; however the U.S. supply/demand picture, and particularly internal logistics, also played a role.

As seen in the image below, there was a very substantial drawdown in US crude oil inventories of around 12% from around 370 million barrels of oil to around 330 million barrels. Inventory levels almost touched the 27 year moving average for the first time since before 2008. In other categories such as gasoline and distillates (diesel), the inventory levels actually dipped below that same moving average. This is consistent with a robustly stable economy and in line with the positive economic data trends explored in a previous Firstline article (‘A Look at the Bright Side’).

While definitely nothing close to the boom years of the mid-2000s, it is certainly not a recessionary demand pattern. This is especially remarkable when you consider the fact that the U.S. has added crude oil supply, as many hydrocarbon-bearing formations in shale regions (especially the Bakken shale) yield crude as well as natural gas. Lastly, it was confirmed again with the inventory numbers of December 21st, where the decrease in crude inventories was far more substantial than estimated (10.6 million barrel actual versus 2.8 million consensus).

The more astute readers will stop me here and state:  if inventory is going down but supply is increasing in the U.S., that still does not explain the difference between WTI and Brent. Well, as usual, the devil is in the details. Producing oil is one thing, moving it to where it needs to be is another. WTI is priced at Cushing, Oklahoma, which is a landlocked transit and transportation hub for crude produced in the U.S. (much like Galeota in Trinidad). Demand is much stronger on the Gulf and East Coasts, but currently there is not enough capacity to transport crude to the demand centres, leading to persistent gluts at Cushing, and thereby keeping prices somewhat lower than other international benchmarks.

Adding to the glut is the fact that most of the new crude being stored at Cushing is Canadian oil sands crude; in other words Cushing is a central depot for 2 large scale crude producing nations. In fact, one of the major pieces of news this year was EnCana’s acquisition of a 50% interest in a pipeline that extends from Cushing to the Gulf, and where it will literally change the plumbing, providing the means for more crude (including processed Canadian oil sands crude) to leave Cushing which has had periods of chronic oversupply. This is bound to continue, as the Republicans have outfoxed Obama on proposals to go ahead with another pipeline (Keystone) from Canada into Cushing.

In other words, WTI may appear to no longer appear to be an appropriate benchmark for U.S. crude pricing, much less global pricing. However it remains the largest and most liquid contract that can be used for hedging by global producers and end users. Additionally, Brent is far from perfect, having experienced severe declines in production and a variety of logistical issues of its own.

Nasty Divorces

This subheading is a bit misleading. The divorce in question here is a recent trend where integrated oil companies that typically included exploration, production, refining and marketing under one umbrella, are now deciding to spin off their refining and marketing businesses from their more profitable exploration and production ventures. The trend was kicked off by Marathon Oil, which carved out its refining and marketing assets into Marathon Petroleum.

While the share price hasn’t done so well due to some macro uncertainty and other issues, analysts believe that long term it will be a boon for Marathon Oil, as globally the refining subsector has not fared particularly well. Companies such as ConocoPhillips are now considering similar manoeuvres in order to create long term value for shareholders. If this trend goes global, it may put additional pressure on refiners, as they will no longer have in-house crude supply. They may likely pass on some of that pricing pressure to consumers, which in turn could impact the global economy. While the impact of this development is unclear, it is worth keeping an eye on as the implications could be critical.

Conclusion

Increased production, declining supplies, prospective natural gas exports, logistical issues, pricing disparities, and financial engineering of oil firms have all had different impacts on complexity in 2011 energy markets, and will affect outlook for 2012 and beyond.

Firstline is developing an equity investment strategy that will allow our institutional and high net worth clients to benefit from in-house expertise and understanding of this complexity in order to produce superior risk adjusted returns on investment. For more information, send me an email at michael.cooper@nullfirstlinesecurities.com

Michael J. Cooper
Trading & Strategy Consultant

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