Primary Vision Insights – March 16th, 2020

Primary Vision Insights – March 16th, 2020

By Mark Rossano

Frac Spreads Set for a Collapse

The reset in oil prices will cause about 10% of completion crews to pause over the next 30 days in order to asses realized prices, preserve cash, and adjust drilling plans. We have been highlighting the problems with demand, and these concerns have now all been pulled to the surface due to COVID-19 and OPEC+. KSA is sending about 5 ships filled with 10M barrels of oil to the U.S. that will take about 40 days to reach our coast based on sailing time. Our focus has been on demand problems in refined products, which has now been exacerbated by COVID-19 and the breakdown of the OPEC+ agreement. Russia can only get back to 11.55M, but the additional volume will have no where to go as COVID-19 impacts Europe and the U.S. The brunt of the completion slowdown will happen in the Permian, Eagle Ford, and Williston. In the near term, the national spread will get back to 300, but as prices worsen (stay sub $35 which is likely) the spread count will get to 285. Diamondback (FANG) is the first to announce the stoppage, but others will follow so total Permian work will get down to about 120 spreads, Western Gulf down to 40, Williston down to 30, and Anadarko 25.


A significant amount of risk to production is now emerging. We started the year believing that Exit 2020 would be below Exit 2019, but the current backdrop in oil, NGL, and condensate pricing is likely to push U.S. production below 12M barrels for the year. The U.S. refining complex already couldn’t consume the flood of light sweet crude and had to be exported into the market. The problem is now there is a growing volume of OPEC and Russia volumes that will push U.S. crude back onshore and into storage tanks. This will strike hard at well-head realized prices and will limited hedges through the end of the year- the only option will be for shut-ins and preserving capital. The tells will be

  1. Exports – fell to 3.4M and will continue to decline to 2.5M
  2. Imports- rose to 6.4M and will shift higher over the coming weeks
  3. Refinery Utilization rates- shifted down to 86.4% and will take out the lows in 2017
  4. Storage- rose by 7.66M barrels with more big builds on the horizon

Refinery Utilization Seasonally Adjusted

U.S. hydrocarbons being stuck at the dock and displaced at the refiner will cause mounting pressure that we will be evaluating constantly to keep clients abreast of changing impacts, geo-political adjustments, Supply-Demand shifts, and macro assessments. The COVID-19 will keep striking down demand in Europe and North America while Asia starts to get pick up some of the paused demand. The bigger issue remains the lack of ability to stimulate growth as economic headwinds have existed since last year. Below is a quick breakdown of the current issues we are facing

OPEC+ Ends in Tears

Our big report in Dec mapped out the death of OPEC+ with a focus on why Russia was preparing to walk away from the deal after OPEC+ met Dec 6, 2019. Novak said- we need to consider life after cuts because they can’t go on forever.” We helped highlight the growing OPEC+ focus on evaluating the full market impact as COVID-19 decimated demand across the global supply chain. We have been pointing to oil demand problems since last year following consistent weak economic data that hindered refined and petrochemical demand. COVID-19 pulled forward the many cracks that have been sitting just beneath the surface paved over with the liquidity from central banks. Just yesterday (3/10/2020) the FED carried out $123.625B overnight and $45B on the 14-day operation, which was oversubscribed by $48B- today (3/11/2020) the Fed put $132.375B into the overnight repo. These numbers are staggering and gives a glimpse into a struggling financial market (someone big is insolvent or at least exposed to people who are). Other central banks will react with more actions coming from the ECB on Thur in order to support Italy and other nations struggling from COVID-19. The BoJ has set a new record buying ETFs, but the persistence of Central banks has led to a massive problem of the Law of Diminishing Returns. President Trump has also announced a payroll tax cut, special small business loans, and paid leave for hourly workers in order to offset some of the economic brunt. The problem remains many tax cuts/ Fed actions took place with the market at all-time highs and limits the total supportive action that can happen on a fiscal or monetary level. The Trump Administration has also announced potential for subsidized loans to energy companies, which would just prolong the required consolidation within the U.S. and the bankruptcies that are needed to clear the system.  In 2019, central banks rolled out about 135 rate cuts- which limits the total support that can be provided on an economic level to not only support but spur growth. Lebanon is now the first country to default on its dollar denominated debt, and the pain will spread as exports struggle and their ability to take in USD to cover interest expenses weigh on foreign reserves.

The recent news in the market will push WTI Cushing down to about $27 a barrel with Brent closing the gap getting to about $30. U.S. exports will be hit as more product is pushed into Cushing as refiners will prefer to run floating barrels with better specifications. In the past, this changing dynamic would have caused WTI and Brent to go to parity- but with the U.S. exporting as E&Ps produce well over refinery demand- WTI will have to find a clearing price below Brent. This new dynamic will create a shift in the market because the U.S. already got a discount due to shipping and quality (depending on grade), and now with cheaper barrels from closer locations come to market- the U.S. will have to price at a steeper discount. LLS (Louisiana Light Sweet) and Magellan East Houston are the two best grades to identify spreads- these will be more likely to find parity against Brent while WTI Cushing prices at a discount to the whole suite. Bahri (KSA National Shipping Co) booked 5 VLCC ships to move crude into the U.S. markets. With each carrying 2M barrels, this will likely find its way into refiners but also into storage for use later. The hope will be to drive additional demand by increase refinery margin (lower feedstock cost), but also to help price U.S. volume out and into storage. U.S. flow into Europe will be pushed back as Russia looks to take back more market share, which will also be pressured by a drop in oil demand driven by COVID-19. Russia has been able to grow production while giving up a minimal amount of total expansion, but with ESPO expansion/ Power of Siberia Operational/ Condensate Exports rising- the benefit of being part of the OPEC+ agreement no longer existed. Russia needed to buy time in order to get assets operational, but with new long-term contracts signed (India) and shifts in Ural blending and condensate exports it was time to lift the veil. Just an example, even after the oil route- Urals are back to trading where they were 2 months ago. “Vitol Group and Trafigura Group Ltd. failed to find buyers on Monday when they offered to sell Urals crude at the deepest discounts to a regional benchmark in almost two months- According to Bloomberg.” Pricing in the physical market into Europe has been terrible as refiners struggle to make money due to terrible demand (before COVID-19) resulting in run cuts and slowing petrochemical activity. The problem is only exacerbated now with Italy fully shut-down, which limits refined product demand further and will spread throughout the rest of Europe. Based on the list below, Italy is the 9th largest importer of energy in the world, which will push more product back onto the water. The focus has always been on China and the fact they reduced operations cutting 4.5M barrels a day, but now we have COVID-19 spreading throughout other major demand centers that will keep demand depressed well through the rest of shoulder season. A large part of U.S. exports have been flowing into Europe taking market share, but also enabling refiners to reduce the sulfur levels at the front of the stack (before it gets cracked into products.) Russia has a growing amount of condensate that they can now blend into Urals helping to cut down some of the sulfur, and the focus has shifted to pricing the U.S. out of the market. The below chart helps show how contango has fallen allowing for profitable storage in both tanks and ships:

U.S. crude while light/sweet- it is also high in sodium, heavy metals, and paraffin (wax). These issues are well known and managed before they are run through a refiner/chemical cracker- but cause for acid to be created in the process that must be adjusted. The problem is- the quality of U.S. crude is on the lower end and on a geographical side it is also disadvantaged and the furthest barrel from many end markets. As more barrels hit the market from GCC nations, West Africa, Latin America, it will be hard to compete across the global complex. This will hit exports that will shift down to between 2-2.5M barrels a day with the rest being sent to storage. Coastal refiners will be incentivized to run “heavier” blends to optimize coking units now that floating barrels (specifically KSA) have fallen by $7 in price. Iraq also cut April crude sales, and has targeted a rise in exports, which is unlikely to be very large as they never cut too deeply and were the worst “cheaters.”

Russia has been playing the “transponder” game by turning them off at different times to hide their full export levels. The focus shifted to prime the pump for demand, while also striking at some of their biggest competition in the U.S. Rosneft has announced plans to increase production by 300kbd within two weeks with Saudi Aramco talking about a quick move to 10M with a possible push to 12M (unlikely). The bigger benefit for the market was the cut in OSPs: “It slashed its popular medium crude by $7 a barrel to the U.S., by $8 a barrel to Northern Europe and by $6 to the Far East for oil deliveries next month.” The addition of 300k barrels of production in Russia would just take them back to just above the Dec 31st highs. The below chart helps drive home how Russia has consistently driven production higher while KSA has taken the brunt of oil cuts in order to protect pricing. Saudi Arabia has about 160M barrels of storage globally with about 50-60M within the kingdom. The idea of reaching a stated 12.4M is possible by pulling from storage, due to the structural limitations on spare capacity which sits at between 11.4-11.7M barrels a day. The Neutral Zone ramp will add about 250k barrels to total product, so to hit that additional 1M a day will require pulling from storage. By reducing prices by about $7, essentially moves storage from one person’s tank to another.

Saudi Arabia (KSA) has taken the brunt of the cuts (along with other GCC) nations and threatened to walk away if countries continued to cheat. The issues became complicated as demand has fallen significantly (and well above even my bearish estimates). The market is facing a true Black Swan event with COVID-19 that is impacting top energy importers- in parentheses highlights GDP rankings as of Oct 2019.

  1. China (2nd largest economy in 2019)
  2. United States (Largest Economy)
  3. India (5th)
  4. Japan (3rd)
  5. South Korea (12th)
  6. Netherlands (17th)
  7. Germany (4th)
  8. Spain (13th)
  9. Italy (8th)

China saw about 4.5M in demand destruction out of about 14M utilized per day. The total amount can vary as some of the 10M consumed was sent to storage or run through refiners to be stored as product. There has been some recovery in the market, but nowhere near normal levels. Europe on a whole consumes about 15M barrels a day with German/ Spain/ Italy rounding out the top spots. Italy is now fully shut down with more reductions coming as Germany and Spain are about 9 days behind Italy with Spain 10.5 days based on the statistical spread of COVID-19 (chart below). As this reaches other critical points, other pieces of infrastructure will be reduced. European refiners (before COVID-19) were facing demand problems so 15M is probably kind here, but I expect to see another 3-4M of demand come out of Europe as the slow down accelerates. On average, about 60% of oil demand is driven by transportation (cars/ boats/ trucks/ planes) so as the supply chain remains broken. The pain will expand with more flights canceled and freight movements paused. The U.S. is also seeing a similar trend as issues spread and more events, schools, and areas (public places) shut down. Below is a good statistical backdrop of where we sit in the spread of COVID-19… we are far from a peak and it will impact demand further.

Saudi Arabia (and the rest of OPEC) offered up cuts of 1.5M barrels (additional to 2.1M barrels), but wanted Non-OPEC (aka Russia) to take 500k barrels a day of that breakdown. It remains unclear if that 1.5M included or excluded Libyan barrels that have declined from 1.2M to about 200k a day. My assumption was the cuts weren’t going to include the Libyan reductions. This also comes at a time where the Neutral Zone is in the process of becoming operational, and Russia/ Nigeria/ Iraq continued to cheat. The best comment was from Nigeria recently saying they are going to lift oil production after the pact failed. The comment assumes they ever cut, which is easily a lie- especially when we factor in the posted crude offerings in the market. The below chart is from 12/6/2019:

Nigeria has said they can increase output to more than 2M barrels a day, but given current restrictions due to geo-political risk and infrastructure- it will be difficult to get above 2.2M barrels a day.

The above is Nigeria’s “official” data, but it is important to look forward as Nigeria and Angola (West Africe- WAF) are the first to post their loading schedules. Nigeria was “supposed” to pump 1.75M barrels a day, but were already at 2M barrels a day.

The crude loading chart for Nigeria above is made worse because 12-20 cargoes remain unsold in March with Angola dealing with two unsold cargoes. This compounds the problem of 70% of April unsold, which will likely grow as March shipments are deferred into April: “About 70% of the April export programs for Nigeria and Angola — out of about 100 cargoes — still haven’t found buyers, traders said

  • Compares with a typical level of 50% sold for this point in the trading cycle
  • As many as 55 cargoes out of 62 for Nigeria in April are unsold; for Angola, 18 out of 37 planned shipments haven’t found buyers” According to Bloomberg

Saudi Arabia has started by cutting their OSP (official selling price) in order to pull more oil into the market but haven’t fully announced a ramp in production. There has been commentary thrown around about taking production back over 10M barrels a day from the current 9.74M barrels a day. Saudi could take their levels to 10.144M barrels a day and still be “in-compliance” with the OPEC+ agreement. In order to make a statement (outside of price cuts) would be to take volumes closer to the 10.5M level to send a message. The benefit of the near-term price cuts (reducing differentials) helps to provide refiners with additional margin as crack spreads improve with a lower feedstock price. The view is that the collapse in the front month helps pull more crude into storage as refiners look to lock in advantaged feedstock costs for a future recovery. European and Asian refiners have been facing terrible margins through most of last year, which only got worse in 2020 as demand fell further. A deepening of OPEC cuts would have “supported” oil pricing for a short period of time but given the lack of refined product demand and rising feedstock prices- refiners would have been forced to cut runs further. This would have exacerbated the oil demand decline as refiners reduce operations. KSA cut pricing, which enables the refinery to capture a better margin by the reduction in differentials. Saudi can effectively prime the demand pump, but it will take time for it to move through the system.

Refiners that take advantage of the cheaper price will benefit by either storing the crude or finished product. There are two schools of thought concerning the practice- 1) this is great for spurring demand and boosting emerging market economies and supporting the global economy with cheaper gasoline/ distallate/ jet fuel 2) the other is- it will create a bigger glut that will take longer to clear once demand starts to pick back up. KSA and Russia had a choice- they could either “store” the oil  in the ground with additional cuts and support pricing or increase production (currently cutting prices) to increase storage in tanks and ships. Each has their own benefits, but the current economic backdrop is problematic at best. Economies around the world have been struggling with weak GDP/ PMIs, which have consistently been protected by central banks easing through rate cuts, repo operations, outright printing, or straight asset purchases. For example, the Fed issued an emergency 50bps cut and has now increased term repos from $20B to $45B and overnight operations from $100B to $150B. This was all supposed to be shrinking, but the new backdrop of COVID-19 has caused actions to reverse course sending the balance Fed balance sheet higher. The move will quickly expand the balance sheet, while expectations rose of another 50bps cut on March 18th.

In China, the expectation is for another RRR cut in March to unlock about 300B yuan liquidity while also cutting interest rates on medium-term lending facilities according to Standard Chartered. This is all relatively predictable, and the current backdrop lends itself for a cut in rates sooner from the PBoC as the country tries to spur growth. “Last Friday, the China Enterprise Confederation (CEC) released the results of another survey assessing the Q1 performance of 299 large manufacturers with one-third of the companies being state owned enterprises (SOEs) and the rest private.” Within this grouping, 95% saw their revenue drop with 80% reporting a rise in operational costs, and to make matters worse- over half said they couldn’t survive or could barely survive the losses incurred. The disruptions experienced won’t go away any time soon as the supply chain is impacted across the globe, and in response these companies have requested additional tax and fee cuts as well as reduced financing costs. The average Chinese bank is saddled with 35x leverage, and has been asked to accept “lower” quality collateral, less collateral, delaying bad debt recognition, and provided a list of acceptable projects/companies to invest. Our bigger report has a full backdrop on the limitations of China’s easing policy and ability to spur growth.

There are many moving parts right now in the Middle East with Libya still down 1M barrels a day due to blockades, Iraq looking to increase (maybe 100K), Nigeria (about 200k), while Iran sits behind U.S. sanctions. Many of these countries may talk about increases, but actually getting them to market will be difficult in the current demand backdrop. Venezuela is limited by U.S. sanctions, which continue to find work arounds through Russian assets. Even with this help, output remains under pressure. In the meantime, the U.S. has offered aide to Iran through the Swiss, and the chance of an Iranian regime change has risen in 2020. Not saying it is imminent, but those in power keep seeing their prowess erode and the people push for more and more change. The IRGC still controls everything, but

  1. The U.S. Has taken out their top guys
  2. Israel has POUNDED their supply chains
  3. The populace hatred for the regime grows by the day
  4. COVID-19 has done to their economy what we wished sanctions did

This limits the ability for Iran to strike at the heart of KSA capacity, but there could be some noise around the shipping lanes. The near term move in crude will be supported with the following:

  1. KSA isn’t committing all of their spare capacity (first stop is 10M) rest coming from storage with OSP cut
  2. Russia is helping to keep Libya off the market (if GCC really wanted to shake things up- stop paying Haftar)
  3. Iran is no longer able to strike
  4. Iraq is no longer able to strike
  5. Growth is coming from outside OPEC nations away from rockets/missiles

Russia has been facing depressed realized prices throughout Europe for some time, and according to companies within Russia they claim to be able to tolerate low prices for 6-10 years. The fact oil prices fell over 30% and Urals are BACK to the lows 2 months ago helps drive home the pricing pressure. The below graph highlights the advantages that Russia has- specifically through ESPO. Between Power of Siberia and ESPO, the country can maximize realized prices even in this depressed backdrop. KSA has consistently moved further down the hydrocarbon chain and increased exposure to refining and petrochemicals. This helps insulate some of the pain while pricing pressure remains through the system.

The below is from our big report in Dec 2019 (much deeper dive in the Dec report).

A Global Breakdown of the Shifting Energy Markets

After the oil price crash and collapse of OPEC in 2014, the industry braced for a wave of shale consolidation and bankruptcies that never came. Instead, U.S. shale thrived in the capital markets, raising significant debt and equity. Pioneer raised $2.5 billion in the first half of 2016, near the trough of the cycle, SPACs and private-equity backed E&Ps came to the market with multi-billion-dollar valuations, despite little-to-sometimes-no production. The view was built off of “future” growth driven by a surge in acreage value as investors were led to believe costs would fall, production would rise, and free cash flow was only several years away. It was all about patience, moving down the learning curve, and building infrastructure in order to move away from exploration mode and into full development. Over the past five years, these companies raised nearly $25 billion, and at its peak, total market cap surpassed $130 billion.

Why does this matter?

There were several key factors at play during the collapse of OPEC in Nov of 2014 and the years following:

  1. U.S. Oil and Gas balance sheets were in a better place with less debt.
  2. The U.S. was still unlocking shale oil and gas—investors (equity and debt) were willing to look past the cash burn for the future growth.
  3. Acreage values were going from $7,000 an acre to $47,000 an acre as well results, delineation, down-spacing, new frac recipes, and efficiencies were the focus.
  4. Hedges were well placed across products.
  5. Service costs were rapidly falling while down-hole and above-ground efficiencies were gaining as we moved down the learning curve.
  6. The U.S. could export oil for the first time.

Many people in the international market never believed shale was real, but not even five years later, the U.S. will average between 2.8M to 3M barrels a day of export and costs continue to drop on a per stage basis.  The view was that this growth would drive free cash flow and unlock the value investors were promised. Even with the decline in costs and moving down the learning curve, E&Ps have been unable to generate free cash flow and continue to burn through investor capital with little to show for their efforts. Oilfield service companies are also struggling to compete and generate revenue, so it is unlikely that much more can be pulled out of their balance sheets.

There are core differences today that are quickly changing across the energy landscape:

  1. U.S. Oil and Gas balance sheets are loaded with mounds of debt with companies merging to survive, selling non-core assets to raise capital, or evaluating bankruptcy again.
  2. The Majors weren’t involved at the beginning, and now they are involved and prepared to run the small inefficient companies into the ground.
  3. Shale core vs non-core and product mix is more understood today, and acreage values have fallen precipitously, impacting NAV and total value.
  4. Hedges of any meaningful value/protection are non-existent.
  5. Service costs can’t go much lower (as oil-field service companies also face bankruptcy).
  6. The U.S. has reached a saturation point of coastal infrastructure and limited new demand for product.

Why would OPEC want to pave the way for another lifeline to U.S. companies? OPEC found some sort of agreement back in Sept of 2016 to cut production, and over the last two years was able to bring Russia into the fold to limit output. To be clear, this just slowed the pace of Russian oil growth, which has expanded over the last several years. The country also tends to walk the line on “compliance” with the agreement. Saudi Arabia, Kuwait, and the UAE have born most of the cuts, while others were either exempt or offered up a nominal cut. The only reason these cuts were remotely effective was the collapse of Venezuela and renewed Iranian sanctions. Each nation that has cut gave up market shares that will be difficult to get back as new capacity has come onto supplement—North Sea, Brazil, Guyana, U.S., Nigeria, and Libya.