PRIMARY VISION INSIGHTS MONDAY 3 February, 2020

PRIMARY VISION INSIGHTS MONDAY 3 February, 2020

By Mark Rossano

  • U.S. Frac Spreads increase, but consumables remain soft
  • Oil and Gas Demand issues accelerate globally; all eyes on consumption
  • Coronavirus Update: We need another month to evaluate
  • Libya, Russia and Nigeria Output Updates
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U.S. activity rebounded throughout January as crews returned to work following a prolonged holiday vacation. Activity will trend higher over the next two weeks as completions are accelerated in the Permian and Eagle Ford specifically, but it will remain seasonally slow in comparison to the last three years. In 2017, while pricing was comparable, the market was still driving forward to prove out acreage and optimism arose from the OPEC+ agreement struck in Dec of 2016. These components pushed activity up, but the market is structurally different at this point of the cycle in 2020. Seasonality will factor into the recovery, but the movement of proppant has been slow to follow limiting the speed of completions. The pace of additions will remain slow over the next few weeks based on the growing issues across the supply chain- product demand/ coronavirus/ realized prices.

The front half of 2020 will be supportive of moderate activity as the spike in crude pricing allowed for hedging, but the steep backwardation in the curve only provided enough room to get “favorable” terms through about June of this year. The rejuvenated CAPEX budgets and favorable hedges will keep activity front loaded in the first 6 months of the year. The below seasonality chart and WTI curve helps highlight the shift higher in the front months while the rest of the curve remained depressed. This is driven by the overarching issue of slowing demand across the supply chain driven by a refined product glut. The outbreak of the coronavirus (more on that below) will act as a massive headwind as industries remain shut throughout China. Refined product exports have already been surging, and now with this large slowdown in domestic demand- there will be an even bigger surge into the open market.

The below shows the seasonally adjusted national frac spread and based on normalizing the chart- there is support for activity to get back to the average of about 315.

The increase in the national spread count will be driven mostly by the Permian and Eagle Ford as the rest of the areas see a slower response in activity. The Bakken (Williston) has already seen an increase but will level off as the economics (while still weak) support activity geographically closer to refiners/export terminals. The reason I believe there will be a muted recovery in these areas is driven off the following:

  1. Oilfield Service commentary surrounding NAM activity
  2. E&P commentary regarding US activity
  3. Proppant deliveries/loadings into key basins
  4. Headwinds persisting on realized prices as refined products grow (more on that below)

The canary in the coal mine will remain the proppant loadings- below is a look at the Permian and Eagle Ford (Seasonally adjusted).

Permian Seasonally Adjusted Frac Spread Count

Permian Seasonally Adjusted Proppant Loadings

Eagle Ford Seasonally adjusted Proppant Loadings

The above breakdown of proppant helps drive home the typical decline in year-end loadings as equipment is idled and everyone heads home for the holidays. But, the turnaround is quick once everyone gets back to work in January. The current backdrop is bucking the trend with proppant loadings remaining at seasonal lows as completion work increases but at a much slower pace. Rig activations have started to creep higher, but at a very controlled rate with little reason to increase it too quickly. Many of the SMID Cap E&Ps are facing significant headwinds as investors focus on living within cash flow, and it will come at the expense of production. The market faces an alarming amount of demand issues, but supply is also facing headwinds as General Haftar has cut supply coming out of Libya. OPEC+ has talked about maintaining cuts (recent commentary from Russia and UAE) through June at their next meeting scheduled for March. The rumors have started to grow stating a March cut is possible but given current physical loading schedules it doesn’t seem likely. Nigeria has already sold about 2M barrels a day worth of oil (above their OPEC+ target) in March, and Russia has maintained a strong export presence above OPEC+ targets. Demand issues are going to accelerate (more on that below) that has already resulted in shipments being deferred, and I expect some of these future loadings to be canceled as refined product builds grow globally.

What does the Coronavirus mean for us all?

It is always a black swan that causes the cracks we have been discussing to truly be pulled front and center. The virus is an event that has pulled center stage- and to be clear- it isn’t because this has a massive casualty rate (2.3 vs normal flu of .114), but rather the infectious rate that it carries. This happens to be highly contagious- and just like a cold or flu- contagious when no symptoms are showing. With an incubation period of 1-14 days (average of 10-14 days), it is proving to have an infection rate of 2.6-3.8 (average is closer to 2.6-2.9), which is huge and makes quarantining nearly impossible. By the time the Chinese government reacted, the virus already spread well outside the initial city limits of Wuhan. The virus wasn’t treated seriously for several weeks, and of the initial people diagnosed many of them never went to the seafood market. This is just an example of the prolific nature of the virus, which effectively doubles every 6 days. The panic is being compared to SARS/ Bird-Flu but the timing is vastly different. Ground zero- Wuhan- is now attached to the rest of China through high speed- rail, roads, and airports that have only been completed over the last 10 years. The infectious nature, interconnective China, and fear are leading to a mass slowdown across all of China. A new estimate for China’s Q1 GDP has been shifted to 5% (still seems high) and will continue to shift lower the longer facilities remain shuttered.

The following is a summary of commentary from several experts that have put together some fantastic commentary that is simple enough for even me to understand. The coronavirus is an RNA virus that mutates rapidly with an example given of a single family that had 6 different versions of the virus among all the infected. The virus mutates in a volatile sense making vaccines near impossible because by the time one is ready- it could be utterly useless by the time it reaches the populace estimated at 9-12 months. The focus has shifted to anti-viral treatments, such as things used to treat AIDS (another RNA virus) that stops the mutation process and effectively destroys replication enabling the body to defeat the infection. There is now a wider spread of the coronavirus outside of Wuhan versus inside, which is indicative that the quarantine came too little too late. The spread of the virus is now outside the walls of the attempted isolation, which means there will be a ramp of infections through at least February. The death rate remains low and is only problematic for those with weakened or compromised immune systems and can be viewed as a really bad flu. It doesn’t mean a continued mutation can’t make it worse- just that the current setup makes it highly contagious but not a death sentence. The contagion is being hypothesized to grow as it is proving to now be airborne or spread within a 1-2 meter radius. The underlying problem remains a person is contagious even when no symptoms are present- which can vary from 1-14 days making it very difficult to track. With an infection rate of 2.6-2.9, the spread will continue to get worse and cases won’t stop until the number falls to 1 or below.[1][2]

China has effectively cordoned off 26 provinces with about 65 million people isolated to their region with no ability to travel. This is still only about 5% of the Chinese population of roughly 1.3 billion, but as people can be walking around infected with no symptoms the expectation is for this to get worse through February. As the cases grow, China’s industrial sector will be directly impacted as people are told to stay indoors and away from crowded places. These are industries that don’t function with a “work from home” option. The below gives a breakdown of the expansion rate, which won’t stop expanding until it falls below 1. To put this into context:  Seasonal flu has reproductive number of 1.3; Spanish flu was 1.8; SARS was 2.5-3, after quarantine was 1. For a value > 2, you need to quarantine at least 50% of all case to contain the virus, but according to experts this level of containment is not possible at this point. This makes the below a likely trajectory over the coming days.

None of this is meant to be an alarmist view or reason to live in a bunker for the next three months, but rather to highlight the damage it will due to crude, refined products, and Chinese GDP. China is expanding the Lunar Holiday to February 3rd-8th (depending on location), which will keep industrial facilities and other GDP accretive regions down for an extended period. This will directly impact everything from oil demand (consumption), refined product demand, internal consumption, and total travel. Based on the quarantine, miles driven will fall drastically as travel is impossible in key industrial regions, factories remain shuttered limiting the demand of diesel/fuel oil, flights have been canceled limiting jet fuel, and chemical/refining facilities operating at reduced utilization rates. Either way- this will directly impact China’s GDP, which expands into the global economy based on their exports and consumption.

Our target for the crude move was $52, which was reached and now starting to rally a bit off the lows. As my old boss used to say- “too much too fast” – so a bounce was going to happen as the market normalizes. Some commentary has highlights by extrapolating the SARS oil shock into today’s China results in a reduction of about 260,000 barrels a day according to Goldman Sachs. This is a grossly misstated number based on current Chinese run rates on a refining and petrochemical metric. China has seen refined product exports increase over 53% after reaching a record of about 12M barrels a day of crude imports. This flows into both refining and petrochemicals, and just based on the current oversupply of refined products in the global market Chinese exports were already struggling to find a home. Local demand was already softening with guidance of a 2020 GDP targeted at 6%- so we already had a slowing economy, mixed with falling local demand for refined goods, and now a quarantine across 26 provinces. It is safe to say that 260k barrels a day will prove to be a low estimate for crude demand with something closer to 500,000 barrels and likely rises towards 750k-1M as the virus spreads limiting activity. So as the virus spreads, other regions will experience a slowdown in travel- not an all stop quarantine- but a means of limiting trips and travel. The ripple effect will cause additional gluts in refined product, so between the glut and limited workers at facilities- run cuts will strike across the Chinese system. This will directly impact crude demand by redirecting cargoes through re-sale, deferral, or heading into storage.

There have been a bunch of new events outlined below:

  • The Iraq US Embassy was attacked with 5 rockets- 3 hitting the intended target and one striking the cafeteria. It is unknown how many injuries occurred, but it is clear some impact occurred which will result in a ramp in activity against Hezbollah in the region.
  • There have been a ton of protests across the region against the Iraqi and Iranian governments that are increasing the uncertainty in the region. They have been put down with brutality (live ammo) against relatively peaceful protestors, and it will only lead to more animosity and the continuation/ increase of protests.
  • Libya has walked away from the cease-fire without anything formal signed, and General Haftar maintains his closure of the oil facilities. Libyan production is heading to 72k barrels a day from its current 262,000 barrels. These facilities are offshore and insulated from the issues on land.  General Haftar is demonstrating his control of the key Libyan revenue source, and while this is a large disruption- it is temporary.
    • The issues remain fluid as now tankers are sailing away empty as the blockade is still holding firm based on the shutdown led by General Haftar. It has resulted in about 1.18M barrels being pulled off the market. This came by way of shuttered facilities in the Gulf of Sirte, Hariga Terminal, as well as Mellitah and Zawiya terminals following the loss of oil flow. The issues remain temporary as this is a clear show of force, but isn’t causing any lasting damage to the facilities or source rock. The issues can be resolved quickly on a physical movement level- the political side is vastly different. (a summary of earlier comments are below).
  • A USAF plan has crashed in Afghanistan, and so far, it looks to be a plane crash. This means it wasn’t shot down by the Taliban, but right now, all information is fluid.
  • The news is playing up the concussions from the Iranian ballistic missile attack, but when a missile explodes a few yards away- there is bound to be a residual effect on those in the area. These consequences won’t be enough for the U.S. to strike Iran directly, but the continued attack on the Iraq green-zone will keep the U.S. engaged with Iranian proxies.
  • The biggest issue is and will remain the massive glut in refined products. OPEC+ nations have already commented (specifically UAE and KSA) regarding a potential additional cut in March if oil continues to drop. We already have canceled shipments out of Russia and Nigeria, and I believe their will be additional cancellations.
  • Houthis attempted a missile/drone attack on Jazan- a city on the coast of the Red Sea and close to the border of Yemen- but was unsuccessful as all incoming assets were intercepted. The area hosts a 400k barrel a day refiner (not fully operational), a military base, and several other important facilities. The refined products are slated for domestic consumption and some local export but doesn’t have any oil producing/exporting assets. The attack is an escalation, but not unexpected following an escalation of tensions in Yemen.

Nigeria and Russia have increased total output in March based on the combined loading programs across oil and condensate. Nigeria is expected to export about 2.02M barrels a day, which is up 6.4% m/m. This is going to be problematic as more crude is left on the water due to the shutdown of China, refinery turnarounds in March, and seasonal weakness. Russia has also announced something similar for January by reaching an output level (so far in Jan) of 11.283M barrels a day- which is a five-month high. This comes on the back of the new agreement excluding condensate from the total- but it is unclear how much of the growth is driven by condensate growth. Russia failed to meet its 2019 OPEC+ deal throughout most of the year, so it isn’t much of a surprise to see a continued non-compliance setup from the region. Supply in the market remains relatively stable with Venezuela exporting about 1M barrels a day, Guyana operational, Norway at about 1.55M barrels a day, Russia, Nigeria, Angola, and the U.S. are keeping the world amply supplied- which is limiting geo-political fears throughout the Middle East. Even with fog and a shutdown Houston ship channel for a day or so, the U.S. still exported about 3.5M barrels a day last week.

The bigger issue has been refined product builds on a global level, and the impact that will have on total crude demand. Q1’2020 was already supposed to be a tough period for builds and crude demand, and the Chinese coronavirus is just making that worse. So while people say- “China demand will be short-lived and not that bad”- which could be true, but it is happening at the worst possible moment from the perspective of the oil supply chain. Below is a quick snapshot of U.S. refined product demand:

Finished Motor Gasoline- Seasonally Adjusted

Distillate Fuel Oil- Seasonally Adjusted

Singapore builds have been following a normal seasonal trend of builds across the facilities, but it will start to increase this week and accelerate driven by issues throughout China. Singapore/ Fujairah/ Europe are other key places that builds should start to rise as China slows consumption of refined products and maintains some exports. As utilization rates fall, exports have the potential to remain stable/if not elevated as product is turned abroad making up for lower rates of throughput. Crude pricing will remain stable here as support is generated by OPEC+ talks, and the fall from $65 back to $53 in WTI. Oil prices will remain range bound in the near term, but the risk remains to the downside as product builds weigh heavily on the near to medium term pricing structures.

Libya Commentary from Previous report

Libya is moving front and center as the Libyan National Army and the Government of National Accord (UN Recognized) failed to come to an agreement after General Hafter (leader of the LNA) refused to sign the truce. The cease-fire still remains in place after being brokered between Russia, Turkey, and all Libyan parties. The next attempt at coming to a “longer-term” agreement will be in Berlin later this week. Saber rattling has increased as Egypt demonstrated “readiness” drills in response to Turkey sending proxy troops to Libya. General Hafter holds the upper hand currently based on the areas under his control- essentially cornering Tripoli. So far, the LNA have held off on a new offensive in Tripoli and Misrata. The cease-fire took effect Jan 12th, and so far- crude production hasn’t been impacted and should remain relatively stable. Both sides NEED the oil revenue to survive going forward, so all infrastructure and assets will be spared. There could be some near-term stoppages if fighting gets too close, but NO ONE and I mean NO ONE is going to target anything oil related. This is something to watch for near term disruptions, but little in terms of long-term impacts.


[1] https://www.biorxiv.org/content/10.1101/2020.01.26.920249v1

[2] https://twitter.com/DrEricDing

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