Energy Market Scan - Jan 2023

Welcome to the first Energy Market Scan of 2023!

Posted on Feb 8, 2023 by Prakash Kini (PK) and Anup Singh

It’s funny how everything is relative. $77/b WTI crude oil prices seem cheaper now as compared to the $120/b levels they had flared up to. Similar is the case with $2.6/MMBtu US natural gas after a peak of over $9/MMBtu, and in Europe €55/MWh natural gas prices versus the peaks of €340/MWh in Sep 2022.

2022 has been a super interesting and profitable year for commodities overall, oil and gas companies, as well as energy utilities. On the whole, both the IEA and OPEC present a bullish outlook for 2023.

We, at Solera Advisors, analyse markets through a couple of lenses -

  1. The Trading Desk lens; powered by our merchants diary suite of tools
  2. The Narratives lens; powered by our sift platform

These lenses each provides us a unique perspective on the markets, and feed off each other. We quite often begin our hypothesis journey through observations via the trading desk lens, to further find related humanint (human intelligence) and additional colour through the narrative lens and often identify a brewing narrative via our narrative lens and thereon seek fundamental and technical insights through our trading desk lens corroborating our social findings.

Starting this year, we are going to attempt to blend conclusions and observations from both our lenses in our monthly scans.

Conclusions from our Trading Desk lens

Crude oil price may have found its “normal” level for 2023. In the absence of a significant demand shock or a significant supply shock, the crude oil price may have found its “normal” level for 2023 with support in the $70-$80 range and resistance at $90. Lack of exploration and a lower discovery rate coupled with near-term production capacity limitations may limit available countermeasures to an upside demand shock.

A ceasefire in the Russian-Ukraine conflict may temporarily ease prices but would also create a secular demand shock as fuel will be channeled to rebuild both countries.

Conclusions from our Narrative lens

The following forces will be driving a push and pull in energy prices in Jan 2023 …

Forces that will be driving up and keeping prices up:

  • Demand recovery due to China opening up, however muted by Covid spread and pre-existing maladies in the Chinese economy such as real estate and tech, and China’s own proactive purchases into crude oil reserves through the past couple of years
  • OPEC+ motivation to keep oil prices high by curtailing drilling and oil supplies
  • Protracted Russia-Ukraine war and sanctions and embargoes against Russia
  • Still not enough impetus on E&P upstream investments, so supply crunch will continue
  • Slower pace of interest rate hikes anticipated in the US and globally
  • There have been many US oil SPR releases through 2022, the drained strategic reserves will need replenishment
  • Countries in 2022 have had to revert to coal fired plants, in 2023 they may switch to natural gas given lower natural gas prices
  • Climate change may lead to warmer summers, and thus more air-conditioning

Forces that will be driving down prices:

  • Global recessionary pressure
  • Demand destruction due to high retail bills
  • Milder winters, especially in Europe
  • European countries are close to filling up their strategic natural gas reserves
  • EU and G7 price caps on both Russian crude and refined oils
  • Warmer talks and deals with previously sanctioned sources such as Venezuela
  • Renewables gain share of power generation, EVs preferred on the road

Forces acting as volatility suppressors:

  • Multiple countries preparing to become long term oil and gas re-exporters
  • OPEC+ has been the traditional volatility suppressor, but its power to do so is fast diminishing

From the Trading Desk

Crude oil price may have found its “normal” level for 2023

In the absence of a significant demand shock or a significant supply shock, the crude oil price may have found its “normal” level for 2023 with support in the $70-$80 range and resistance at $90. Lack of exploration and a lower discovery rate coupled with near-term production capacity limitations may limit available countermeasures to an upside demand shock.

A ceasefire in the Russian-Ukraine conflict may temporarily ease prices but would also create a secular demand shock as fuel will be channeled to rebuild both countries.

Macro Influences

The US Strategic Petroleum Reserve releases concluded towards the end of 2022 curtailing a supply avenue. The SPR releases occurred under 3 structures, Mandatory Sales (Q4’21, Q1’22), Exchanges (Q1’22) and Emergency Sales (Q2-Q4’22) and concluded following last deliveries in Dec 2022. The sanctions on Russian oil and refined products took effect through early 2023.

Source: Solera Advisors | Merchants Diary Platform

There is a broad spectrum of narratives surrounding the impact of the sanctions on available supply of petroleum. Our thinking is that while the sanctions increase ‘friction’ in access to the petroleum, the presence of sanctions creates a framework in which destination markets can take ownership of the cargoes. Narratives aside, OPEC did not increase production during the oil price peak of 2022 suggesting that OPEC is limited in its ability to add incremental supply.

For practical purposes, China is open and activities inside China are recovering. China has been taking ownership of crude oil imports throughout the lockdown and the reopening may not drive the much-anticipated surge in imports. Increase in transportation activities within China and resumption of outbound travel and tourism will increase the demand of aviation fuel and transportation fuel demand at tourist destinations.

Most central banks have been increasing policy rates in response to inflation experienced through the second half of 2021 through the present. Higher interest rates aim to restore the rate of inflation to the respective target rates. Policy measures have caused significant volatility in currency exchange rates with varying impacts on economies dependent on imports. Tight labor markets have kept and likely will keep wages and incomes firm. Higher interest rates, while encouraging saving over spending, will adversely impact capital investments. Historically, an increasing cost of capital has encouraged deleveraging over new investments. In short, the effect of higher interest rates on inflation and capital expenditure may create the intended as well as some unintended consequences.

In the short run, the role of the relative strength or weakness in the US$ exchange rate needs to be sized appropriately in the context of near-term affordability of destination markets to take ownership of crude oil and refined products. A lower crude oil price and a relatively weaker US$ creates the conditions for a resumption in consumption. The long-range impact of the relative strength of the US$ will likely vary by destination/consumption market.

Merchant Markets

COVID changed people’s mobility patterns and impacted transportation fuel consumption, ranging from personal transport, commuter mass transit, long-distance mass transit and cross-border (and trans-continental) mass transit. Changes in business practices have impacted the demand for capacity in the aforesaid categories. The change in consumption patterns led to a change in the refined product mix and a potential mismatch between refining capacity and demand in destination markets. Volatility created opportunity and emphasized the role of re-exporters in the global supply-demand balance sheet. Markets with flexible demand and asset mix arguably have been able to monetize intrinsic value of their asset mix, while providing the market with some semblance of supply stability.

Refining margins (reflected by the crack spread) have widened considerably indicating a persistent demand for refined products (gasoline, diesel and aviation fuel). Crack spreads when calculated based on the NYMEX WTI price reflect refining margins of $25 to $35/barrel of crude oil, compared to the historical average of $15-$20. At these margins, available refineries should be running at max operational capacity. The actual margins in the re-exporter markets are probably different dependent on the Cash Basis of that location, albeit still very attractive. If refining margins on the screens are indicative of cash basis, the market should continue to see a bid for crude oil and an offer for refined products.

While the US SPR has drawn down, the US Commercial inventories have been building from the lows of 410-415M bbls to the upper 448M bbls in EIA last release of January 2023, close to the 5-year average of 450M bbls, indicating a return to normal levels. Market participants are pricing current normal at $75/BBL, and the persistent average $1.50 backwardation traded most of 2022 has been replaced by a cautious 20-25 USc contango in the front of the curve.

Field production in the US has resumed considerably, from the lows of early 2021 of 275M Barrels or 9.15MBD to current 385M barrels per month or 12.78MBD, a recovery of almost 33%.

On the demand front, vehicle miles driven will seasonally trend up with the move to warmer temperatures. Resumption of mobility in China will reflect in the increase in demand for transportation and aviation fuel. And these factors of demand are probably priced in.

Retailer inventories have accumulated as a result of “just-in-case” buying practice and need to be liquidated prior to the resumption of trans-continental purchase and manufacturing orders. Containerized charter rates also reflect a return to “normalcy” in capacity and demand as well as some routing relief. Lower charter rates reflect a reduced need to move goods.

From the Narrative Lens

Deep Dive: Geopolitics and War

China, Singapore, Malaysia, India, Turkey, (and Vietnam) evolving to be long term energy re-exporters

First, let us lay out our observations:

  • India and China on a crude oil buying spree, and not just cheap oil from Russia, but also from the US and Abu Dhabi
  • China and India expanding their SPR storage capacity
  • China making provisions for more gas supply from Russia through a new pipeline
  • China re-routing Russian LNG to Europe
  • India providing a back door to the UK for Russian oil, and selling them refined gasoline
  • Malaysia is selling twice as much oil as it produces, a good amount of that oil could be Iranian and Russian oil
  • Traders in Singapore are mixing and reselling cheap Russian oil
  • Turkey is reselling Russian oil

Our inference, as we connect these dots, is that countries such as China, Singapore, Malaysia, India and Turkey (followed closely by Vietnam) are evolving to being long term energy re-exporters.

Here are the key stars that have aligned to create this re-export opportunity:

  • This opportunity is fueled by an extended war scenario and the net neutrality of relations that these countries have, straddling the non-sanctioned and sanctioned pools and their balance of trade and payment with the other key supply & demand countries
  • This idea of also being on the selling side might have also originated out of necessity - to provide optionality to sell the excess resulting from fluctuating domestic demand due to sluggish local economy & the pandemic and high variability in goods export demand and thus production levels of local manufacturing industries due to global economy jitters
  • Burgeoning refining capabilities, so these countries can buy crude from sanctioned and non-sanctioned sources and co-mingle and sell refined products, thus obfuscating the divide between these sources
  • Filled up oil reserve storage, so oil available for re-export once there is enough for domestic demand
  • Improved storage, shipping, LNG and pipeline capabilities and fresh deals struck both for supply & demand and transportation of supply & demand

This does add another twist to the energy tale and actually might assist in attenuating the volatility of energy prices, as these re-exporters will form a secondary demand whenever prices go down, and a secondary supply whenever prices go up. So, we now have a new volatility suppressor in town. This is critical, especially with the OPEC+ which was the volatility suppressor of yore, now either having maxed out of capacity and hence unable to, or even if not maxed out is unwilling to.

Who stands to gain when EU weans off Russian gas and oil?

The US and Middle East have a lot to gain when the EU weans off Russian gas and oil. US LNG is in a boom period that continues into 2023 and beyond, unless climate change gets winters in Europe to go much milder, which might also lead to European countries to fill up their gas reserves, and/or demand destruction kicks in as retail prices stay high.

A new gas pipeline is being setup between the Permian basin and proposed LNG export port on the west coast of Mexico.

Similarly, over to the Far East, Australia and Malaysia have to gain from the increased LNG demand by Korea and Japan.

Meanwhile, Russia will continue to hold its own through oil exports via intermediaries, new pipelines and LNG.

Deep Dive: 2023 Forecasts

Curated 2022 observations and 2023 forecasts

Deep Dive: Oil

Spread between Brent and Dubai has reached the lowest level in a year

Spread between Brent and Dubai, which is considered as the spread between sweet and sour crude grades, has reached the lowest level in a year of around $8/b. The spread had jumped to over $12/b in March 2022. This, in conjunction with China reopening and a return of industrial activity, is going to encourage international trade in crude.

Upstream investments growth in 2022 was slow, pace may grow in 2023

The Refinery industry sees a spate of new launches & expansions

Iran emerges as the 4th highest oil producer in the OPEC for Dec 2022

Iran, with 2.72 million barrels per day, is 4th in the OPEC oil production list of Dec 2022, following Saudi, Iraq and UAE.

OPEC’s total crude production in December stood at 29.19 million bpd, 40,000 bpd less than the previous month.

Saudi Arabia was the top OPEC producer in December 2022 with a daily production of 10.48 million barrels of oil, followed by Iraq with 4.45 million bpd and the United Arab Emirates (UAE) with 3.23 million bpd of production.

Reuse of food waste and cooking oil as fuel

Food waste and recycled cooking oil are being tapped as sources of renewable natural gas and jet fuel respectively.

Deep Dive: Natural Gas

Demand for natural gas to go up

Demand for natural gas will increase as power generation switches to natural gas from coal, as natural gas prices have reached viable levels. Moreover, LNG export facilities in the US are back in action.

Ships go for dual fuel engines

Carriers are choosing dual fuel engines for new ships, which use diesel and LNG (or diesel and methanol or diesel and LPG) over single fuel engines.

Countries investing heavily into floating LNG terminals

Several countries are investing in floating LNG terminals or the FLNG tech, these are LNG regasification plants built on a ship or barge that help load, store and unload LNG. These can reload to other ships and/or have ship-to-truck loading facilities.

Deep Dive: Electricity/Power

California gets a high tech energy storage

California has chosen a compressed air energy storage solution. Here, power is used to coil up air like a spring into a high pressure shaft, and then this air is used to turbines to generate power as and when needed. Hydrostar claims to have resolved a few of the concerns and issues with such storage.

Energy storage is a critical piece of the energy transition puzzle as energy produced using renewable energy tech is unpredictable. For example over in Texas, the ERCOT wind generation toggles between 10-20+ GW on a daily basis. Lithium, is the other energy storage option, but lithium prices have risen rapidly, and lithium mining has raised many concerns.

Is nuclear making a comeback?

As power demand increases, there is a renewed push for nuclear, even from the decarbonizing lobbyists. For many years, nuclear disasters such as Fukushima have tainted public opinion, and the industry has been on a steady decline. But now the energy crisis, especially in Europe, has countries turning back towards nuclear (as well as coal) as part of the solution. It remains to be seen if this is the start of a new wave or will these attempts end up being a sputtering blip.

Is Hydrogen the future?

Hydrogen, which started as an alternative fuel for cars and trucks, is now extending into rail, sea and air transport. This tech comes with its own set of risks, one of which is hydrogen leaks.

New hydrogen innovations and project announcements continue to come out globally on a regular basis:

Pakistan is facing a power crisis

Pakistan faced a blackout where over 200 million people were without power. A cost cutting measure carried out, brought down the whole grid. The country is reeling under a severe economic meltdown and balance of payment crisis.