Primary Vision Insights – February 17th, 2020

By Mark Rossano

  • U.S. Completion Activity Update
  • Is U.S. Production growth capped?
  • What is COVID-19?
  • OPEC, Russia, Venezuela, Libya and China

The completion activity has leveled off after spreads were reactivated following an extended Christmas holiday. So far, the trend of the data is mirroring 2017 in terms of direction and pace of additions, which started at a higher-level vs 2017. Oil pricing faces a significant number of headwinds in the near future as the market attempts to understand coronavirus demand impact, Libya shutdown, OPEC+ recommended cuts, and seasonal impacts as winter limits refined product demand. The IEA was already predicting an oversupply in the 1H2020 by 1M barrels per day, and this will take another 200k to 500k barrels out of the market depending on how quickly China comes back or how far this virus spreads. The reported Chinese numbers are following the same transparency as most China numbers as the country moved the goal post by “adjusting” how they report confirmed cases. These unknowns driving depressed crude pricing and capping the WTI curve limits many options for E&Ps. Airlines have extended their timelines for limiting flights into China and Hong Kong with Teapot refiner utilization falling 30%, Sinopec reducing by 15%, and CNOOC taking the refinery in Huizhou down 8%. These are just the reported numbers but doesn’t cover some sweeping reduction discussed in a previous report or other items talked about below.

The above count follows the trajectory outlined last month, with an increase across the National, Permian, and Eagle Ford completion crew. The shift lower in the Permian this past week is likely transitory as E&Ps adjust drilling plans and focus on streamlining operations for 2020’s drilling program. Realizations remain problematic in the Permian (and around the country) for natural gas and natural gas liquids (NGLs) so the focus will be to drill areas with the best takeaway pricing and limit the amount of liquids produced as a byproduct. The discount for condensate continues to widen and can range from $8-$15 as demand domestically and international is under pressure. This condensate pressure comes from shuttered demand in China as well as new flow out of Russia that has been creeping into the market. The crude curve has shifted into steepening contango as the market prices in the cost of storage- on the water and onshore. Commentary has started out of Vitol, Shell, and Litasco to research floating storage as crude demand continues to fall out of China (more below). At the moment, storing crude on a vessel wouldn’t be profitable, but given the rising U.S. crude storage numbers and global builds across OECD nations- the front month will fall further making storage profitable again.

National Frac Spread Count- Seasonally Adjusted

The builds in the U.S. are starting with the EIA reporting 7.46M addition, and to be clear- seasonally there are builds this time of year. The key will be the pace of builds as companies/countries look for ways to store crude as the U.S. has the most (and cheapest) storage levels. The below EIA report helps highlight the amount of space available in the U.S., and where some crude can find a home as contango steepens enabling for storage. The pace of builds will accelerate as China defers purchases of waterborne crude. Implied demand pared back across gasoline and distillate, while exports dipped across gasoline- which will remain off normal flow as builds in gasoline grow globally. Distillate will see a tough market abroad as builds start to rise as China’s impacts ripple through the market. The below Bloomberg chart shows how U.S. crude storage is hovering around the average over the last 10 years. As product demand abroad struggles, refiners will see a decline in runs that will be worse due to an increase in unplanned downtime. This will push refinery utilization down and help send crude storage higher.

As the U.S market faces mounting pricing pressure (across oil/ gas/ NGLs/ condensate), location options are limiting the ability for E&Ps to grow production. The expectation coming into the year was for a net increase on exit 2019 into exit 2020, but mounting pressure in the market will limit growth. The crack margins across Europe and the Mediterranean for U.S. cargoes is well below (by $3-$4 vs Urals/ Bonny/ CPC blend), which will hurt U.S. exports on top of the declining flow into China. Given current balance sheets/ hedging profiles, it will be difficult to see completion crews follow the upward momentum of 2017, but rather level off closer to 330 as pressure persists in the market. There is enough support to keep activity supported around 310-320, which will be driven by Permian, Eagle Ford, and Williston completions. But in the current environment, getting a sustained move in activity above 330 is difficult to finance with cash on hand. The Northeast (Marcellus and Utica) will see mounting headwinds as natural gas prices face a storage glut and now rising fears on LNG not flowing from the U.S. The lack of winter weather in the U.S., and now growing concerns the global LNG glut will get worse is driving fears that counterparties will “pay” and not “take” volume. The fears are a bit overblown because the question on not flowing LNG from the U.S. is a complex problem that has many competing variables including:

      • Fixed costs (tolling or penalties)
      • Variable costs- shipping/ gas pricing
      • Contract structure- DQT (Downward quantity tolerance) weighted against the annual flow total/ Take or Pay/ spot vs contracted
      • Type of contract index- oil/gas linked. Does the contract have a destination clause attached?
      • Who is the end user- is it a company selling into a wide rate base (power company) or a portfolio player?

Buyers have to elect for cargoes 30-60 days out, and some of the older contracts structured in Qatar and Australia allow for DQT movement or delayed receipt of cargoes. For example, if a cargo is deferred in March, a company can purchase their allotment in November as long as it is in the same calendar year. These differing values will be weighed when buyers look to purchase cargoes as the market is already oversupplied and has gotten worse with China declaring force majeure on several cargoes. Natural gas realized prices aren’t being helped by the pressure across the liquids space either, which will keep pressure on completion activity across wet gas throughout the Northeast. Ethane, propane, and butane pricing across the country has been and will remain under pressure as bottlenecks limit exports, and supply keeps rising out of Texas and the Mid-con.

Permian Frac Spread Count- Seasonally Adjusted

The Permian has always been the place considered for growth, but as economics come under the pace of completion activity is waning. Activity will start to pick back up, but getting back to 2019 highs is impossible without crude prices recovering by $15. Many of (if not all) E&Ps in the area struggle to break-even let alone achieve free cash flow, but as long as the bond market remains open- these companies will continue to raise capital. A key natural gas hub, Waha, is pricing gas at $.20 with WTI Midland Light pricing a discount of $1-$2 to WTI Cushing, which will start to widen if the discount in the Eagle Ford is any indication. The Eagle Ford Condensate is trading at a $15 discount to WTI Cushing as of 2/10/2020, which will only worsen as China demand for crude wanes[2]. Chinese refiners (state-owned and independent) have cut back about 2M barrels a day of runs, while Shandong crude storage reaches a one year high. The slowdown in crude demand continues to extend as activity within China remains impeded by the coronavirus. The below chart helps highlight the seasonally adjusted levels of crude in storage throughout the specific area. Large parts of the country haven’t returned to work with Shanghai traffic down 80% against daily volume, while rail traffic across the country was down well over 80% compared to days following Lunar New Year in 2019. Many people haven’t returned to the areas where they live and work, and anyone who has traveled are required to undergo a 14-day home quarantine.

“The reporter learned from the China National Railway Group Co., Ltd. (hereinafter referred to as the National Railway Group) that on February 8, the national railways sent 1.27 million passengers, a year-on-year decrease of 7.45 million, a drop of 85.4%, and the national railway transportation was smooth and safe. On February 9, the 16th day of the first lunar month, the national railway is expected to send 2 million passengers, a year-on-year decrease of 82.2%.”[3]

Total Shandong Crude Stockpiles- Seasonally Adjusted

The decline in rail traffic ranging from 80% to 99% depending on location is put in perspective by looking at the population levels throughout key locations experiencing lockdowns/ quarantines. The above chart shows the build in oil across the teapot refiners with half of them already hitting tank tops. The utilization rate has fallen to as low as 35% given the full shut down of facilities, which will get worse if refined product demand doesn’t pick up internally. Independent refiners have specific export guidelines, making it difficult to be able to just sell product straight into the open market. The below chart shows flight cancellations and the amount of populations across major cities/provinces that have seen a precipitous fall in all forms of travel.

The impacts are wide ranging across the supply chain as factories remain shuttered or have less than 15% of normal workforce present. This impact spreads across all of China with key ports still shuttered stopping the flow of product from reaching key industrial hubs. Some early estimates has been a reduction of between 1.2-2M barrels a day, which will remain until 2/18/2020 at this point given new commentary from the government. Any traveling home has to be self-quarantined for 14 days, which will keep a large majority of people out of the workforce and facilities well below normal output. The coronavirus (now named COVID-19) will remain a key factor as china adjusts the way they calculate new cases. China has announced they will no longer count individuals that test positive but don’t show symptoms. The roads in key cities, such as Beijing and Shanghai, are below normal congestion levels ranging from 35%-60%. The congestion metrics helps highlight that activity still remains well off of averages, and the world’s supply chains won’t be back to normal any time soon. While all of these fun things keep impacting the overall market, the crude curve has started to price into contango. The curve still currently doesn’t cover the cost of storing in a VLCC, but the front month faces significant headwinds given the below backdrop. As China keeps delaying March purchases, the contango will steepen in order to put crude into storage.

Crude pricing is also facing two very big unknowns: Libya and Russia.

The OPEC+ commit has recommended an additional 600k barrel a day cut, but so far, the next meeting is still scheduled for March 5th. Russia has said it will “study” the OPEC+ technical committee’s new output proposal, but the longer they delay the less likely the country will be willing to go along with the new recommendation. Russia has seen their exports rise now that the new agreement excludes condensate from the calculation. The “new” cut would be on top of the already agreed to 2.1M cut. Novak and other oil executives were set to discuss the proposal Wednesday, but Russia has been looking for ways to begin distancing themselves from the deal and after the new agreement with India this could be an opportune time. Indian Oil Corp and Rosneft are working to sign a 2 million ton a year deal for oil, which should be finalized sometime this month. This comes at an interesting time where the U.S. is talking about sanctions against Rosneft for actions in Venezuela. So far- the U.S. has turned a blind eye to flow with Venezuela crude at about 1M barrels a day heading into India and Singapore. This is also complicated by the amount the U.S. imports from Russia already- this will limit how the U.S. can levy sanctions. The U.S. has already issued sanctions against Iran/Venezuela cutting heavy crude available to U.S. assets, but also to key allies in Asia- so it will be difficult to see this gain traction.

The physical crude market keeps showing the pressure in the market impacting multiple grades of oil across the market. Nigeria is still sitting on 90% of their crude for March, while Angola has 20 cargoes unsold out of 45. The price keeps falling with the most recent offer of $.50 above dated Brent. The physical market is also complicated by the loss of Libyan flow. Saudi Arabia and Kuwait are in the process of ramping up the neutral zone with 10k barrels flowing as of Monday. The zone is capable of flowing 500k barrels a day, but the first runs will be small just to test systems that have remained unused since 2015. Libya wrapped up a meeting in Cairo, Egypt to cover some of the below key topics: The United Nations is holding a conference in Cairo on Sunday-Monday to discuss the situation because as the UN Special Rep Ghassan Salame stated- “The mission wants the oil to flow as soon as possible.” The UN continues to work with the NOC (national oil company), UN backed Government, and General Haftar’s tribal leaders in order to structure a longterm agreement. Haftar rolled out this shutdown to highlight his control of the oil infrastructure in order to strength his interests in a new government. Both sides still recognize the legitimacy of the NOC, and have done nothing to damage any assets. There remain constant discussions between all parties to create a long term action plan to unite the country. It is worth understanding why a meeting in Cairo is so important in this back and forth.

1) Who backs General Haftar (head of the LNA- Libyan National Army)
a. The UAE has been a long time backer, and rumors remain that the KSA/UAE have been providing money and assets turning this blockade
b. Russia has been on the ground for over a year now providing support through personnel, equipment, and intelligience
c. General Hafter lived in the U.S. for over 20 years and is a U.S. citizen
   i. We put him back in the country to help overthrow Gadhafi, and we recognize Haftar’s forces as the best for eradicating terrorism in the region (ISIS/Al-Qaeda and others)
   ii. The U.S. runs sorties on his behalf to strike at specific terrorist targets
d. Italy and France run sorties on General Haftar’s behalf under the same agreement as the U.S.- they also have a back-room deal- that he agrees to stop migration from Libya across the Med, and when people are picked up mid-crossing Haftar has several drop zones on the coast to keep them from entering Europe.
e. Egypt has come out in favor of Haftar, and has increased their involvement as Turkey looks to extend their interest into the region

2)Who backs the GNA- Government of National Accord
a. They are recognized by the UN as the legitimate government of the area.
b. Turkey has been increasing their support of the GNA with soldiers, equipment, intelligence, and logistics.
c. Italy has started to favor the GNA more while France plays both sides.

The key factor given Egypt’s growing involvement, and rising tension between Russia and Turkey as well as the US and Turkey- makes the location of this meeting very interesting and significant as to who is carrying more favor. There have been 3 meetings in the last month- Russia, Germany, and now Egypt- two out of 3 are openly in favor of General Haftar.

The meeting broke with “Libyan Economic Expert” studying the distribution of oil revenue across parties. The group will reconvene in early March in order to discuss findings about ways to create a lasting peace in the war-torn country. Nothing has emerged as to the resumption of crude exports from Libya even as several ships remain in port. The growing issue has been Turkey moving assets into the country, as Turkey and Russia sit on opposite sides of the table in both Syria and Libya. Turkey and Syria (AlAssad) have now exchanged fire resulting in multiple casualties as Turkey has started retaliating against aggression. The initial agreement in Syria was between Russia and Turkey with Al-Assad not present for the establishment of a “safe zone” along Turkey’s border. The fact many of the Sunni’s being attacked are Turkmen can’t be lost as Turkey looks to stem the flow of migrants into the country (currently totaling 3.6M refugees already.) Russia and Turkey also have several arms deals and bilateral/military cooperation that are at risk if things devolve. As Iran’s ability to influence Assad wanes, Russia will have to force Syria to conform to the agreement as Russia doesn’t want to lose the two military bases they received for aiding Al-Assad. In turn, I expect Turkey to make concessions in Libya for concessions in Syria. The maritime border will become a bigger focal point, which was signed between Turkey and Tripoli allowing for oil and gas exploration. Israel, Greece, and Egypt are opposed to the new borders and will be a source of negotiation as Haftar looks to keep Egypt on his side of the table.

OPEC is looking to decide on cuts over the next two weeks, as they monitor the Chinese coronavirus, Libya negotiations, and potential U.S. sanctions against Rosneft (Russia). Based on the current physical market, shipments have come to a standstill ranging from VLCCs to Baltic Cape size (chart below). The question jumps out- “why is the market still so resilient?” The answer is- the central banks continue to pour money into the market with the Fed putting an average of $30B-$50B in REPO money directly into the market each morning over the last 3 days. This also came in the backdrop of China pushing another $9.58B into the market, while also cutting interest rate on medium-term lending facilities and reducing the loan prime rate. The market remains skewed as the combination of central bank balance sheets expand across the globe (chart below). The downside risk remains very real as we head into the weekend, as economic data remains mixed across the globe- and will be directly impacted by the shuttering of Chinese industry. The below is the beginning of trying to stimulate the economy through some repo operations.

PBoC Total Reverse Repo Amount in a Week

China has also extended their focus on fiscal and tax support with the Minister of Financia Liu Kun allocating 72 Billion RMB to help fight the epidemic. The PBoC has increased their initial round of special lending with 300 billion RMB earmarked with loans made to nine national banks/ several local banks across 10 provinces. The target of the loans is for key industries focused on epidemic prevention and control with a capped interest rate of 3.15%. The government is expecting 160M people to return by Feb 18, but that doesn’t mean business as usual. Many stipulations have to be met to return to work, and it is unlikely anything normalizes ahead of March. China announced a bunch of fiscal stats and all of them missed targets by relatively wide margins (for China) as the country attempted to ease in 2019. These kind of figures and attempts to stimulate growth hinder future measures as monetary stimulus is difficult as inflation has already shifted higher and leverage within China is already problematic.

The big news: The government missed its 2019 revenue targets.
• Total revenues clocked in at RMB 19.04 trillion – up 3.8% y/y, but missing the target for 5% growth.
• Central government revenues were up 4.5% y/y – missing the 5.1% growth target.
• Local government revenues increased by 3.2% – missing the 4.9% growth target.
          Tax cuts explain a lot of the missing revenues.
• Domestic VAT increased by 1.3% in 2019 – down from 9.1% growth in 2018.
• Personal income tax revenue decreased by 25.1% – down from 16% growth in 2018.
• Meanwhile, increases in expenditures greatly outpaced revenue growth:
• In 2019, total government expenditures were RMB 23.89 trillion, an increase of 8.1% y/y.[5]

As the spread of the virus remains uncontained, the problems will span across all commodities and even the Phase 1 trade deal. There is specific language in the trade deal where a natural disaster or unforeseeable event triggers a clause to open a consultation with the US over the potential impact (coronavirus outbreak) on the ability to fulfill the agreement. Chinas has announced a 50% reduction of tariffs on $75B imports from the U.S., and has finally allowed the WHO and CDC to enter the country. The cuts (are desparetly needed at this time) are inline with the agreement signed on Jan 15th, but we will be seeing negotiations on total imports from the U.S. ongoing given the current limitations on volume. The fact they are allowed to enter now could have 2 specific implications:
1) Things have been contained, and China wants to show off how good they have done.
2) Things have gotten so out of hand they are requesting a significant amount of help.

My inherent distrust in the CCP makes any of them plausible, but the spread of the virus within the country appears to be pervasive- which leads me to below “2” is most likely. The rumor mill continues to churn out videos/ comments/ mis-information- but the actions show things remain uncontrolled on the ground. The disruptions have spread into South Korea, Taiwan, and Japan specifically on the impact on supply chains, but the problems will be broadly felt as China makes up about 1/5th of the Global Economy. The initial whistleblower Dr. Li Wenliang has passed away, which has started to create strife within the CCP and country: Li posted about concerning signs of the new virus on an online chat group for fellow doctors at the end of December. He was then detained by the police and accused of spreading “rumors.” He was released on Jan. 3 after signing a document saying he committed “illegal acts,” The Washington Post reported. Later that month, he came down with the virus himself. ” The distrust in China is growing, which is driving people to stock up on essentials in case the spread continues in other locations.

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