By Mark Rossano

The energy market closed out the year with a big drop in the frac spread count, which carried forward into the second week of January with a move down to 275. The drop was driven by the Permian, which has seen a big decline over the course of 2019. The Permian activity now resembles something closer to 2017 but will rebound back soon as activity accelerates with new spending in Q1. This should support rig activity as DUCs need to be replenished as some of the quoted drilled but uncompleted wells will maintain that “status” due to many issues making them useless at this price deck. Some of the wells were drilled for the “parent-child” which has yielded poor results, had a poor landing (fell out of zone), or is drilled in an area that isn’t economic at this strip. This will keep rigs relatively flat after the substantial decline of about 100 rigs over the last year.

The frac spread fell below 300 for the first time since 2017 as activity slowed down well ahead of normal seasonal adjustments. Typically, completion crews slow down into the holiday season, so a down move is expected- but the scale and pace were a bit surprising. The pendulum always swings too far in both directions, so there will be some support for activity as completions crews start to come back from holiday. There may be one more down move towards 270, but this should be the low (for now) as activity picks back up with new CAPEX programs. The CEO of Patterson was on CNBC talking about how the rig count bottomed in Dec, which is likely as some work picks back up in Q1’2020. It is hard to see too much growth as E&Ps look to manage portfolios as hedges increased throughout Q4 taking advantage of the rise in crude pricing. The backwardation of the curve steepened as companies looked to buy protection even as the front month ran- so the average hedging price probably averaged around $56-$58. Things have reversed considerably following the recent events with Iran (more on that below), as the fundamentals in oil play out to the downside.

There remains a large amount of marketed spreads (about 500) with many of them sitting idle as only 364 are currently active. Companies such as Patterson (Universal), Keane, BJ Services, Halliburton have a lot of capacity on the sidelines that could get redeployed to a new basin with reduced pricing (hard given current costs) to compete for work, or get scrapped or idled indefinitely. Halliburton has already talked about shifting equipment and manpower down to the Permian, so some of those assets could come back- but some capacity will be retired given the age of some fleets and increase wear and tear due to the rise in proppant and pressure reducing the useful life of assets. This will help keep a lid on U.S. production as exit 2020 falls below exit 2019, but activity will recover enough to keep total 2020 oil production for the year above 2019 oil production of about 12.4M barrels a day. The problem will remain realized prices as the world the demand for heavier crude rises around the world. API Gravity is a term everyone should get more comfortable with as “heavier” crude finds more favor- especially oil that is on the heavy/sweet end of the spectrum. API Gravity is a measure of how heavy or light a petroleum liquid is in comparison to water. China has brought online massive facilities, but many of them are complex requiring a heavier blend of crudes to operate. This has created tightness in some of the global spreads, but as the refined product market struggles under cyclical demand declines and structural oversupply- oil demand faces many headwinds as economic run cuts and extended turnarounds limit refining capacity. Oil pricing was inflated by the geo-political uncertainty (which is fluid but ebbing lower) as Iran faces growing local opposition (bearish crude) and Libyan factions discuss a ceasefire.

Even with some properly timed hedges for U.S. E&Ps, oil growth will face significant headwinds as Russia considers “life after the OPEC+ deal.” E&P companies had an opportunity to hedge some production in the first 6 months of the year at prices ranging between $56-$58 as the backwardation steepened considerably driven by the OPEC meeting and geo-political uncertainty. The above chart highlights where WTI prices went quickly allowing for some “decent” priced hedging in the first half of 2020. Russia has come out saying they are considering life after cuts as you “can’t cut forever,” which is interesting as they actively increase their condensate production. Many will point out that OPEC countries don’t include condensate production in their totals (which is true), so it makes sense for Russia to exclude those figures. On the flip side, it also frees Russia to increase their condensate production considerable as ESPO is expanded and gas is pumped into the Power of Siberia. The additional condensate can be blended into Urals as well to reduce total sulfur content, and increase flow as Ural demand has fallen due to IMO 2020 requirements. It also opens up the opportunity to “classify” something as condensate that doesn’t actually meet the API gravity standards. (We have never seen OPEC+ nations lie… I know!) Typically, Russia consumes all the condensate it produces, but with new wells coming online- Russia is facing a surge in condensate production, and the new OPEC+ quotas allow for expansion away from the eyes of the market. I will discuss in greater detail below on the geo-political situation.

The oversupply in the market will worsen now that China has increased runs across their new state-owned facilities and started pushing more refined product. China tightened the physical oil market as oil flowed in to bring new equipment online. It is important to note that China has also been slowing down the ramp of some facilities, and even at this reduced pace- continue to export a record amount of refined products. In the below chart, it is clear where the new facilities turned on with more coming over the coming months.

This is just a quick example of a facility ramping: “Zhejiang Petrochemical Company Limited continues with the trial runs on the 200,000 b/d Crude 1, 100,000 b/d Residual Hydrotreater, 40,000 b/d FCC Gasoline Hydrotreater, 9,000 b/d Alkylation and 76,000 b/d Reformer 1 at its Grassroot 400,000 b/d Zhoushan (Daishan) Refinery. The units were previously expected to come online by the end of December 2019, however, now plans are to begin commercial production by the end of February, 2020. Meanwhile, a 76,000 b/d VGO Hydrocracker, 52,000 b/d BTX 2 have successfully started up on December 18, 2019, and the 200,000 b/d Crude 2 which started up on May 21, 2019, is currently running around 80% capacity and scheduled to reach full throughput by the end of February, 2020.” “Negotiations for the January paraxylene (PX) Asia Contract Price (ACP) have fallen apart because of a wide bid-offer gap. Japan’s JXTG Nippon Oil & Energy placed its offer at $930/t cfr, while all other sellers offered at $920/t cfr. All the sellers declined to change their offers from initial levels. Bids for the January PX ACP were at $720-770/t cfr. The ACP-linked sellers are JXTG Nippon Oil & Energy, Idemitsu Kosan, SK Global Chemical, S-Oil and ExxonMobil. There are six buyers – OPTC, Capco, Yisheng Petrochemicals, Shenghong Petrochemicals, Mitsui Chemicals and BP. Negotiations for the January benchmark ACP were brought forward to 27 December because of the year-end holidays.” The additional capacity is hitting prices across petrochemicals and refined products on a global level. As margins worsen, the question remains who will be the first to cut runs?

How does this link back to the U.S.? The U.S. typically exports from the Gulf of Mexico into Lat Am and Europe, but with the new wave of products coming out of Asia the whole energy trade flow is adjusting. The new product from China is filling local demand just as other product from South Korea and India is pushed out of Asia and into other areas- such as Europe and Africa. This limits flow from the Middle East into Asia, so pushes more Middle East product into Africa, Europe, and some LatAm demand. So now you have European product that is competing into the LatAm market as well as the East Coast of the U.S. Now that we are back to the coast of the U.S.- where is the place that the product can compete? The U.S. can try to protect market share in LatAm and Europe, but it is getting harder as more refined product is moving around the world at fire sale prices. This has caused a buildup of U.S. product, which is now reverberating back through the system with rising builds in Europe and Asia. It is a key structure that is weighing on crack spreads and pricing as product can’t flow along its normal routes.

The pace of Exports will fall for refined products, but crude exports will recover as demand rises given the increase in shipping rates and the spread widening between Brent and WTI. This will keep exports elevated from the U.S. on a crude level.

To make matters worse, South Korea and China have been focused on a view that others should roll out economic run cuts- so each country has been producing products at unfavorable pricing waiting out the rest of the market. U.S. refinery utilization rates have kicked off the year near the 5-year low from 2016.

The pace of builds will increase on a seasonal level as Martin Luther King Day is the last big travel weekend before we hit the winter lull. This will result in a reduction in utilization rates, which is so far below the average and trending lower. The slowdown in exports has pushed more product into storage and keep crack spreads capped. It is already showing up in time spreads, and will struggle as the flow of product out of China accelerates.

The market is struggling with both a structural change out of Asia, and the cyclical impact of lower demand on a global level. There is a positive view that the China/US Trade deal will unlock more near term demand, but the market is saturated in light/sweet crude, and the trade war still has many steps involved to get back to a “normal” trading relationship. In the near term (aided by seasonal slow downs), WTI should trend lower towards $53, completion crews will shift back to 300, Permian back to 100, and rigs should find some support at these levels.

Geo-political Update

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 12^th, 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.

Iran remains a key focal point, and now France/ Germany/ and the UK have triggered the dispute mechanism in the 2015 Joint Comprehensive Plan of Action. This was driven by Iran’s violaton under the agreement terms, and European leaders now have 15 days to resolve their differences or the UN sanctions snap back into place. This would be more of a symbolic gesture as many of the sanctions have already been re-instated, and will find new support given the shoot down of the Ukraine airline and rampant killing of protestors. The protests are ramping against the current regime, and chanting for the end to the current regime (which is punishable by death). This is also coming after about 1500 protestors were killed following the rallies against the rise in fuel prices. These protests occurred throughout Nov and Dec, so the anger against the regime has only been fanned with the death of their enforcer (General Soleimani) and now the killing of innocent Iranian citizens when two missiles destroyed the plane. Below is a follow-up of the Iran response to the U.S. precision strike.

Iran Fires Ballistic Missiles into Iraq as Soleimani is buried in Kerman

Iran officially launched 15 ballistic missiles (NOT ROCKETS!!!!!!!!!) into Iraq striking two Iraqi bases housing both U.S. and coalition troops.

The IRGC launched the following:

• 10 Fateh 313 missiles at Ain al-Asad (very similar to the Fateh 110 Missile)
• 5 Qiam-1 at Eribl
  • 3 of them failed in flight
  • 1 was shot down by a US CRAM

All relevant militaries placed assets on high alert in anticipation for a response to the killing of the high-level people listed in my previous report. The high alert allowed equipment to pick-up the launches instantly and take appropriate measures to ensure no loss of life. All personnel were able to take cover, and the sheer size of Ain al-Asad also means a “successful” strike can occur without causalities. A helicopter can be replaced… a runway can be rebuilt… a life is irreplaceable.

The attack was a way to boost morale at home or as it was quipped “funeral fireworks” as the strike was timed with the official burial of Soleimani in his hometown. Iran launched a strike against Iraq assets, as the tit-for-tat continues to take place outside of Iran borders. I mention this because Iranian assets have launched attacks on Iraqi citizens in multiple regions, which has spurred further protests. Here is just one example-“Iraqi protestors attack pro Khamenei Hashd al Shaabi militia building in Dhi Qar, #raq. The fight against Soleimani & Khamenei’s oppression continues.” The U.S. and Iraq government need to send a signal of unity at not tolerating further aggression, but Iraq must go further and focus on expelling the Iranian assets operating within their borders. The U.S. has been moving assets around the region in order to provide air support and a potential response if deemed necessary. The early indications are that the USAF at al-Dhafra (located in the UAE) and Diego Garcia are on high alert (just meaning they can launch aircraft in under 15 mins). The U.S. has moved high value assets F-35s and B-52s to Diego Garcia in order to provide support throughout the region.

It is also worth noting that the Iraq meeting held on expelling the U.S. from their sovereignty could not come to a vote or hold a quorum because all Sunni and Kurdish members held a walk out in protest. This just means that what was “officially” entered into the record books was a non-binding request. So out of 328 people only 170 remained to hear the potential timetable for U.S. withdrawing assets. It is also possible for the U.S. to remain in Iraq within the semi-autonomous region controlled by the Kurds. “The vote, he explained, was a party-line vote by Shia Iran supporters in the parliament. Kurdish and Sunni lawmakers had boycotted the session despite threats from the very same Shia militia that kicked off the current cycle of violence, leading to a barely functioning quorum in the chamber.

Of course, to admit threats of political violence from pro-Iranian militia would undermine the media narrative that the parliament, like the militia mob that attacked our embassy, represents everyday Iraqis. What these pro-Iranian lawmakers passed was no United States ouster, but a non-binding, partisan resolution that the United States should leave. The “quorum,” Abdul-Hussain writes, “was 170 of 328 (half + 4, just like Hezbollah designated a [prime minister] in Lebanese parliament with half + 4).”?”[1]

Iran has stated they will next strike Israel and Dubai if the U.S. responds to the attack, and based on the course of action- the U.S. is within its right to strike Iranian soil since the launches occurred from inside Iran. The launch sites are well documented, as well as other strategic sites that would be of importance. I find it unlikely that the U.S. will launch such a counter due to the ineffective (thankfully) nature of the ballistic missile attack resulting in no causalities. The U.S. may instead take action on Iranian assets and proxies within the Iraq borders, but most of the Iranian populace doesn’t support the current regime and it would be foolish for the U.S. to provide propaganda. Some will point to the funeral procession as saying this is false, but when you close all bases, government buildings, schools, and business and require people to show up- it is easy to show a large “outpouring of support.” I am by no means saying some of these people weren’t vehement supporters- 35 people were killed and others injured as a surge and riot occurred just to touch his coffin. It also shouldn’t be lost on the populace that he was a popular war hero from the Iran- Iraq war as well as a very savvy military strategist and leader. So some may have come out for support, others out of respect for his service in the Iran-Iraq war, and others because they had too. The generational dynamics of the country are clear, and this regime is facing a changing tide at home.

Those in power have been in power since 1979, but the younger generation doesn’t want to live under the thumb of a repressive regime. If we look throughout time, the Persian Empire (Iran) has a long history with Europe, India (other parts of Asia), and throughout the region. The current toxic relationship between Iran and the west is something (if we look at this as measured in generations and not single years) a blip in the long history of cooperation and trade between the two parties. This is coming full circle, and a U.S. response against the populace, holy sites, or important civilian assets would just galvanize the population and delay a conversion back to an open society. Nothing happens overnight- especially generational cycles- but the movements are in place and taking out one of their top assets can help speed the process. Soleimani was responsible for putting down many of the protests throughout Iran, Iraq, and Syria, and is responsible for killing, jailing, torturing, and raping 1,000’s over his reign. The Bush and Obama administrations have always considered him as a viable target, but deemed the ends didn’t justify the means. This has changed over time as protests against the Iranian government have intensified across Iran and Iraq.

An interesting point to be made- Iran carried out a precision attack against Abqaiq, but failed to strike “revenge killings” as they called it. Does this mean the remaining technology isn’t as good as perceived? (Iran has an estimated 2k ballistic missiles) Did they miss on purpose to save face and truly don’t want direct conflict with the U.S.? Was there an inside deal between multiple parties to eliminate Soleimani? Some of these are farfetched and others are plausible, but at the moment- everything points to a limited U.S. response and no escalation at this time. The assumption is additional attacks on Iranian proxies within Iraq, but not a strike on Iranian soil currently. Anything is possible as the whole remains fluid, and we will get more details over the next several days- but things will calm down over the next few hours. It doesn’t mean we tell our USAF to stand down or take anything off of high alert, but it just means this could be an exit ramp for de-escalation. Iran also shot down a Boeing 737 Ukrainian passenger jet carrying 180 people using two anti-missiles crashing near Tehran just after takeoff. The government tried to blame mechanical error and bulldozed the site, but intelligence gathered from the U.S., Europe, and Canada concluded differently.

This forced Iran to admit it’s error, and has enraged the populace launching even bigger protests throughout the country against the regime. Sadly- this wouldn’t be the first time something like this has happened, and just after the attack from Iran- China and U.S. barred passenger jets from flying anywhere near the area.

On the market front, WTI hit a high of $65.65 before turning lower to sit at about $63.63 up about 1.5% from the close today. The S&P futures reached a low of 3181, which was down about 40 handles from the close as gold future briefly spiked to over $1600. The oil markets will hold some risk premium from the initial attack while the rest of it fades into the morning, and if the EIA confirms the API report of a massive product build- oil prices will quick fall. All of this remains negative for refiners across the board, and provides a good time to fade crude. Gold remains a key holding, but timing is everything on re-entry. Even if the risk premium remains, there are many nations (Russia and KSA) that would quickly look to sell into this elevated price environment. There is a significant amount of oil supply available in the world and a massive glut of refined products around the world. The main goal is to take advantage of fear and price dislocation as fundamentals always win out in the commodity/physical world- which can’t be said for the equity markets.

The final point is on the U.S./China trade agreement that is expected to be signed this week in Washington D.C. So far the details emerging are as follows:

• China will agree to purchase $200 Billion in U.S. goods per year
  • $75 Billion in manufactured goods
  • $50 Billion in energy
  • $40 Billion in farm products
  • Between $35 billion and $40 Billion worth of services

In exchange- the U.S. will lower the 15% tariff on $120 billion in goods imposed earlier last year to 7.5%, and delay imposing the new 25% tariffs that were initially slated to hit in December of 2019. The U.S. also took the symbolic action of removing China as a “currency manipulator”, which has no impact on operations. The deal reverts the standoff between China and the U.S. back to October, and doesn’t even scratch the surface of the real issues of bilateral tensions across IP theft, state support of Chinese firms, IP protection, state- sponsored espionage, and a litany of other bigger issues. The biggest issue for the U.S. will be designating a way to “retaliate” and “measure” if the deal is broken or if things worsen on the bigger issues. There has already been a lot of questions if China could actually absorb that amount of new goods from the U.S. or is this just another Chinese tactic of “appease” with no real desire (or ability) to honor the agreement. China (on a state and corporate level) has always signed deals and blatantly ignored every piece of the terms if they were no longer in China’s favor. They have walked from countless contracts, joint ventures, and other agreements once it no longer suited their needs- regardless of the terms everyone signed on too. The official terms will be key as the devil will be in the details, and the above is purely the “leaked” or “scooped” terms that have been put forth by China and the U.S. Each side will try to pick the details that maximize the spin on why this is a good deal, but the full information will be needed for everyone to decide if this is positive for the market.

Headline risk will remain high across the trade deal as well as Middle East tension. Iran proxies will continue to launch rocket attacks against Iraqi bases that house coalition troops and equipment. As of this writing, a rocket and mortar attack is being carried out on the Taji Military Base North of Baghdad. These attacks will continue to occur throughout the region as Iran attempts to drum up support from their proxies, while they tackle rising domestic turmoil. Headline risk remains high, but the underlying fundamentals demonstrate headwinds for crude and refined product pricing and demand. The goal will be to find the signal in the noise and focus on the underlying market fundamentals.

[1] https://thefederalist.com/2020/01/07/media-coverage-of-iraq-is-a-case-study-of-ignorance-and-manipulation/#.XhVEjROM6JE.twitter