Chinese Refiners Adjust to Balance Shifting Fundamentals & Policy Changes
The robust economic backdrop, elimination of the oil stock surplus, and low OPEC spare capacity are very bullish for oil markets. However, prices may ease a few dollars over the next few months as the physical balances look somewhat less tight. China’s oil demand growth is expected to ease somewhat this year, but growth from the rest of Asia (particularly India) will strengthen putting the regional total at ~1.0 MMB/D. Growth for gasoline is easing while gasoil/diesel demand is improving, with growth rates for the two products converging. PIRA expects there will be an increase of ~0.8 MMB/D in Chinese refinery runs in 2018, partly to offset reduced imports of mixed aromatics and light cycle oil blending components which will become subject to higher taxes. With Chinese demand growth still healthy at ~0.5 MMB/D, net key product exports could rise by some 0.3 MMB/D this year. This expected increase in refinery runs in China is perhaps more bearish for gasoil than for gasoline as incremental distillate yields will probably be higher than lost light cycle oil imports. Overall, PIRA expects cracking margins in Singapore will still stay generally healthy, with an average of ~$6.50/Bbl for 2018.
Despite Cold Spurt, Outlook for Lower Prices in CY18 Remains Intact
The recent cold snap has increased January coal burn estimates and PIRA’s projected January stockpile draw, but we reaffirm our longstanding view that the pull from seaborne markets will fade and domestic demand will fall y/y in 2H18, dragging U.S. coal prices lower.
Chinese Growth Turns Stronger, as Rebalancing Continues
In 2017, the pace of Chinese GDP growth accelerated for the first time in seven years. Consumer spending continued to expand solidly, while the investment sector’s contribution to GDP growth became smaller for the fourth consecutive year. The trade sector recorded a major turnaround in 2017, as exports strengthened and the trade surplus increased. Uncertainties are high for this sector this year, however, after the value of the Chinese currency was allowed to strengthen sharply this month. In the U.S., the manufacturing sector recovered solidly during 2017, and the outlook appears bright for 2018.
Propane and Butane Prices Increase
NGL price changes were mixed last week. Propane and butane prices rose, while ethane and natural gasoline prices retreated. Some market sources attribute rising propane prices to the recent low temperatures in North America. Propane implied demand and exports remained robust at 1.54 million b/d and 0.94 million b/d respectively. Exports are expected to be about one million b/d again this week. Propane stocks declined 3.6 million barrels to 58.0 million barrels for the week ending January 12, according to EIA data.
Output Jumps
U.S. ethanol production jumped 65 MB/D the week ending January 12 to 1,061 MB/D, the largest one-week spike ever reported. Ethanol-blended gasoline output also increased sharply, rising to 8,515 MB/D from a two-year low 7,913 MB/D in the preceding week. Total inventories built by a mere 24 thousand barrels to 22.7 million barrels, with the largest gain occurring on the West Coast.
V-S-R
When is a three-letter acronym actually a four-letter word? When it’s spelled VSR. VSR stands for Variable Storage Rates, a mechanism implemented by the CBOT/CME back in 2010 for SRW (wheat) futures. In theory, VSR was supposed to help the convergence of futures and cash at expiration. Previous to the implementation with the July, 2010 contract, SRW futures would routinely expire as much as two dollars above the cash price. At the time Index funds were a large long in a small market and were blamed for the wide divergence. SRW futures were deemed “untradeable”, not by speculators but by consumers who sought other instruments such as OTC products for hedging. Obviously the exchange did not want to lose market share to the OTC market and came up with VSR as a solution. Why bring VSR up now? Because word is out that the CME is now considering it for corn and soybeans, reportedly at the urging of some of the largest owners of storage in the country.
Geopolitical Risks Could Rattle Undersupplied Oil Markets in 2018
Geopolitical risks became increasingly supportive of oil prices in the second half of 2017, due to the dramatic reduction in surplus inventories and OPEC spare capacity near historical lows. OPEC supply disruptions quietly diminished as prices rose, driven by improvements in Libya and Nigeria. However, history indicates the next major outage is likely a matter of time, and an unexpected disruption in 2018 would jolt increasingly tight oil markets. With the Middle East showing no signs of stabilizing, several risks currently overhang our outlook. Most notably, an intensifying rivalry between Saudi Arabia and Iran headlines the danger of military miscalculation, while Iran’s strengthening regional presence risks destabilizing consequences for Iraq, Israel, and Jordan. Meanwhile, Libya and Nigeria are both producing near capacity, making current output risks significantly greater to the downside. Even with Brent around $70/Bbl, economic woes continue to plague the world’s largest oil exporters. Fiscal stress threatens oil investment and raises risks of possible unrest or in countries including Venezuela, Iraq, Iran, Angola, and Algeria.
U.S. Huge Stock Decline
Overall commercial inventories had one of the largest declines in recent years, falling 13.8 million barrels, roughly evenly divided between crude and products. Cushing crude stocks declined as forecast by 4.2 million barrels, the largest weekly drop ever recorded. Gasoline stocks built 3.6 million barrels, a much lower rate than the last two years, while distillate stocks drew 3.9 million barrels, the largest weekly draw for this week in over 5 years. Next week’s EIA data is forecast to show another below normal gasoline stock build while distillate inventories continue to draw at the highest rate for this week in over 5 years. Lower crude runs largely related to extreme cold in the Gulf Coast cause overall crude stocks to be flat with a likely build in the Gulf Coast offsetting a 2.1 million barrel Cushing crude stock decline.
Four for Four
Against an already building chorus of “it will never happen five years in a row”, corn and soybean markets are digesting the “fact” that according to NASS enumerators and the less than 63% of U.S. farmers that actually returned their production surveys, both yields were above trend for the fourth year in a row. As if that wasn’t enough, the most aesthetically unpleasing corn crop that we’ve seen since 2012 yielded the third record in the past four years at 176.6 bpa, which followed 174.6 last year and 171 in 2014, due to adequate moisture at planting and a prolonged fill period thanks to relatively benign August temperatures and a late first frost for many. The record corn yield trend would certainly bring “hope” to farmers that they can still produce their way out of this price slump, but doing so will also bring the obvious risk of over-supplying a market.
U.S. Gas Weekly Report
A second-round of cold weather over the past week helped lift Henry Hub to a seven day average of $4.04/MMBtu for the week ended January 18, an increase of 89 cents/MMBtu (28%) W/W and the second-highest weekly average after the EIA week of January 4 since late-November 2014. The February 2018 contract increased steadily after the first week of the January, reaching as high as $3.23/MMBtu for the January 17 settlement and only slipping down to $3.19/MMBtu on January 18 after whipsawing through the bearish EIA storage number release on that day. The NYMEX Henry Hub Cal-18 futures strip has remained relatively unchanged from the beginning of the month, increasing by only 2cents/MMBtu (1%) to $2.89/MMBtu
As China Pushes In, Counter-Seasonal Demand Becomes Ever More Profitable
With all the headlines of surging Asian demand, a small handful of terminals currently show weaker Y/Y demand. As China muscles its way into the market, some terminals, even in Asia, are showing some lower winter utilization. One such terminal, Samcheok, in South Korea stands out and has significantly lower demand than even just several months ago and probably represents the best LNG trade book in Asia. The country was able to procure some very low spot cargoes this summer in the $5.00/MMBtu to $6.00/MMBtu range that they can now sell into the domestic market. This is gas that might cost upwards of $12.00/MMBtu to replace – a 100% profit in half a year is not too shabby of a return.
After Recent Correction, Italian and Spanish 2Q Contracts Look Undervalued
The expectation of a relatively warm and wet February across Europe is extending to 2Q, lowering prices in Italy and Spain below their fair value based on Y/Y comparisons of market fundamentals. Hydro stock levels and French nuclear availability are the key price drivers, but we expect power to stay strong on the back of stronger Y/Y fuel and carbon prices.
More Records, Low Stresses
The S&P 500 continues to set new records as it surpassed the 2,800 level on Wednesday and then set another record high, Friday. Credit remains constructive, though the divergence that has developed and visible in certain key charts remains baffling and cautionary. Even with equity records being set, volatility (VIX) increased 11% on the week, but oil volatility (OVX) fell -9.5%. The U.S. dollar continues to weaken noticeably, down -0.4%, while commodities were generally weaker. Even so, the reflation trade and strong economic growth paradigm remains the central theme. The St. Louis financial stress indicator moved higher on the week.
Japan Get Ready for Record Low Crude Stocks?
Runs were little changed with higher crude imports, which produced a crude stock build of 0.7 MMBbls. Finished product stocks built with the driver being a noted rise in gasoline. Naphtha and kero were partial offsets. Aggregate demand grew a strong 383 MB/D and driven by a partial recovery in gasoil demand. Trend demand (4-week avg) has yet to turn higher, but should next week. Gasoil demand began to rebound from the holiday nadir seen the previous week. Kerosene demand rose as expected and the stock change rate moved back to a draw of -76 MB/D, which is near seasonal norms. Implied refining margins remain relatively good, but have slipped slightly from their December average. Retail prices continue their rise, but the indicative marketing margin has improved a bit. Gasoline remains above norms, while gasoil/diesel remains below norms by a slightly lesser degree.
U.S. Ethanol Prices Bottom
U.S. ethanol prices bottomed the week ending January 12, but rebounded after the DOE’s weekly supply report production fell below 1 million barrels per day and stocks drew in the Midwest. D4 RIN prices fell again last week, continuing a downward trend that began following the EPA’s announcement of the 2018 mandates that began in November. Brazil’s South Central region is in its inter-harvest period. A season-low 2.56 million tons of sugarcane were processed during the last two weeks of December. Only four mills continued operating after January 1.
Downside Risks Begin to Mount, Starting with Weather and End with a Full Menu of Alternatives in Power Generation
The market continues to wobble and the price risk to the downside is gaining proponents. Disruptions in Norway and the Netherlands over the past week barely caused a ripple in prompt and forward prices compared to one month ago, a sure sign that supply flexibility is increasing and concerns over short-term balancing are waning. If anything, the incentive to increase Dutch gas production is now in place, as the government has delayed a new production limit on Groningen for another month. Given that one of the options at the policy level is a complete shutdown, it would be logical for the operator to maximize its returns, while it still has the option to do so.
Coal Pricing Diverges, With Strength in Pacific and Weakness in Atlantic
There was a notable divergence in coal pricing this week, with extended gains in FOB Newcastle and FOB Richards Bay forward markets, while CIF ARA prices faded markedly. The prompt market for FOB Newcastle in particular has been quite strong with physical assessments rising to nearly $108/mt, while 1Q18 forwards rose to $105.80/mt, a new recent high. At the same time, CIF ARA forward prices declined by $1.25/mt for 1Q18, with more modest declines across the curve through 1Q19. The pricing divergence was likely due to cold weather in China exacerbating concerns about stockpile adequacy ahead of the Lunar New Year, while coal buyers in the European market are feeling more comfortable with current inventory levels (particularly in light of a tepid near-term coal demand outlook). However, as dry bulk freight rates have weakened, this divergence in pricing cannot last much longer as trade flows will adjust. To PIRA, the weakness in CIF ARA in the face of stronger FOB Newcastle pricing is another signal that prices will correct downward fairly soon.
Will Proposal to Open Most U.S. Outer Continental Shelf Make a Difference?
The recent proposal from the Trump administration to open up the majority of federal offshore areas is a step that is welcome by the industry. However, it is very likely to face many legal challenges and the prospectivity of the new areas is not as significant as the GOM (currently mostly open for leasing) with the exception of Alaska. Breakevens for GOM are becoming competitive but are still approximately $10/Bbl higher than U.S. shale oil. Also, these new areas will have higher breakevens compared to the GOM due to lack of infrastructure, less available seismic data and harsh conditions (Alaska). Currently, we do not envision any of the new areas being developed in any significant degree for the next 20 years with the GOM continuing to be the primary source of U.S. offshore production. While the step has a symbolic value to producers, there is the possible option value that with new data or technology, the new areas may prove to be more prospective than expected.
Equity Markets Sets More Records
Global equity markets continued to set many new records. The U.S. market was higher by 0.9%, with the S&P 500 breaking above the 2,800 level, holding its gains and closing the week on a high note. The strongest gains were registered in consumer staples (+2.5%) and technology (1.5%), while energy was the weakest performing tracking index (-1.3%). All the international tracking indices again gained on the week, with the best performances being in Latin America (+3.1%), China (1.9%), emerging markets (+1.9%), and emerging Asia (+1.5%).
Argentine Dryness
With fears of a 500+ million bushel U.S. carryout allayed in the January WASDE for now, soybeans had four positive days in last week’s holiday-shortened trade as the market focused on Argentine dryness. That trend continues as the only meaningful moisture in the growing region over the next 120 hours appears to be slated for the northern reaches of the growing belt, an area that has not been short of moisture while the south has been dry. $10+ November soybean futures is good news for U.S. producers who missed the early December rally and we expect them to continue to take advantage of such pricing as they did late last week.
A Bird’s Eye View of the Global LNG Market
2017 was the year we expected to see growing manifestations of oversupply in the global LNG market, with production capacity growth looking like it would outpace global demand. Indeed, the market has shown clear signs of being well supplied with volume, and volume flexibility. However, supply has grown more slowly than expected, and the implementation of a coal-to-gas switch policy initiative in China accelerated demand growth above our expectations.
Asian Oil Demand: A Drop in Growth Performs as Expected
Our snapshot of Asian oil demand growth slowed sharply to 738 MB/D vs. 1,244 MB/D seen last month. The drop was on-target with PIRA’s expectation for a drop in the demand snapshot to 765 MB/D. Looking forward, demand growth in the February snapshot should rise to about 840 MB/D and then drop back to 675 MB/D in March. Growth is expected to temper back in later 1Q to about 575 MB/D. Our annual average 2018 demand gain for Asia is 970 MB/D, a modest slowing from the 1,100 MB/D posted in 2017. This month, the key drivers of the 506 MB/D incremental drop in demand growth was dominated by China, where apparent demand fell back 478 MB/D, but still exhibited Y/Y growth of 427 MB/D. Demand growth in India slowed 27 MB/D, but still posted a Y/Y gain of 232 MB/D. In China, the slowdown in apparent demand was mostly a function of lower crude imports. The latest economic data from India remains constructive with an acceleration in industrial production through November, including key energy intensive sectors and along with manufacturing.
Will the Russian Government Ever Change the Current Oil Tax System?
The Russian government recently advanced a new, profit-based tax for a small portion of the country’s oil projects. However, implementation has been delayed by one year until 2019, and objections from the finance ministry and operators of certain tax-advantaged fields indicate a broad move away from the current revenue-based model remains years away. The majority of oil industry taxes are currently based on production (independent of operator’s investment or costs), through a Mineral Extraction Tax (MET) and an Export Duty (ED), with several fields and sectors receiving ad hoc tax breaks. The current system is progressive, so becomes increasingly favorable to the government at high oil prices and to the producers at low prices. Oil operators have lobbied for profit-based taxation, claiming it will increase production and better reflect costs and risks. However, the government will be reluctant to fully implement the new scheme unless it results in a tax take equal or higher than the current system. It is probably safe to assume that a change to profit-based taxation will take a long time to be fully implemented.
The information above is part of PIRA Energy Group's weekly Energy Market Recap - which alerts readers to PIRA’s current analysis of energy markets around the world as well as the key economic and political factors driving those markets. To read PIRA’s Market Recap first, subscribe to PIRA Perspectives here.
