[ihc-hide-content ihc_mb_type="show" ihc_mb_who="10,13,14,16,18,19" ihc_mb_template="1"] By Mark Rossano Summary Suez Canal UpdateU.S. Activity UpdatePhysical Crude UpdateChina Economic ImpactsEmerging Market RecapChina-U.S. Alaska MeetingBig Oil’s Split on Path Back From a Recovery Won’t Help ActivityHow big of a threat is Iran? Suez Canal Update The Suez Canal has been making headlines as the ship Ever Green remains lodged in the canal wall blocking traffic on both ends. The importance of the route is being felt across the shipping supply chain, as it forces more boats around the Horn of Africa- the longer and more dangerous path. It also adds additional fuel costs that typically outweigh the cost of fees/tolls to utilize the canal. The backlog is increasing the longer the ship is trapped and causing more delays on both sides of the canal. For example: Ship moving 12 knots From Saudi Arabia Rotterdam (days) Suez: 22 Good Hope: 38 NY S: 28 GH: 40 Houston S: 40 GH: 43 On average: “The 193-kilometer-long (120 miles) Suez Canal is among the most trafficked waterways in the world, used by tankers shipping crude from the Middle East to Europe and North America. About 12% of global trade and 8% of liquefied natural gas pass through the canal, as do around 1 million barrels of oil each day.” As of 3/25, there are about 237 ships waiting to traverse as some ships have already started to avoid the backlogs. We will reach about 500 quickly given the length of time it is taking to clear the problem. The insurance company for Ever Green will be on the hook for damages to the boat and salvage to get it “unstuck” as well as damages to the ships caught in the delay. The early estimates are for another 5 days of it being stuck as operations continue to dig it out and lessen the load to free the 200k ton boat. The impact on global trade isn’t small as in the first day about $9.6B worth of marine traffic was halted, and the figures just grow based on the length of delay and additional ships added to the backlog. The delays will also persist because it this remains a choke point, so you don’t just unplug it and see a huge surge of activity. There is still a queue to be honored and slow and arduous process to get the ships to the other side of the canal. Here is an interesting graphic highlighting how this could happen, and points to more problems we face as larger ships look to traverse our water ways. The shift in trade routes will create a headache for planning around crews, fuel, port rotations, and other impacts hitting the supply chain while it is already down and struggling. The impacts to the oil and gas industry will be fairly muted as there is more than enough crude/ product in tanks at the various locations. About 1M barrels a day goes through the canal, so in terms of “normal” operations it won’t have any impact on refining activity. It will (and already has) pushed up shipping costs in specific regions and trade routes, but all of these issues will be transitory. It just helps highlight how fragile our shipping lanes are at key choke points. The chock points around the world are the points to watch as any type of issue can reverberate through the system and impact the total flow of goods. They are a means of not only global trade but security as we have talked about countless times with the various Straits and most recently the Strait of Malacca. U.S. Activity Update Activity in the U.S. is maintaining its upward momentum with another big leg up to a national total of 195 spreads. The biggest increases have been in the Permian, Western Gulf, and Appalachia. We have been expecting to get to 100 spreads in the Permian by the end of March, and we got there a bit earlier with more upward movements likely. I thought the additions over the next few weeks would be a bit “smaller” with a steady build of 3-5, but we just had a nice pop of another big increase of 13 spreads. We should start to see a steady increase from here as the next leg of additions will take longer given the limitations on available equipment and employment. The trend will remain positive, but the pace of activity will cool off as the market digests the increase in activity. The Bakken is trending in a positive direction with a steady rise of 1 or 2 spreads a week as the spring thaw brings more activity back to the region. In some key areas such as the Eagle Ford and Bakken, we will need to see an increase in drilling activity to replace the backlog of DUCs that have been consumed over the last 12+ months. The Permian still has more than enough running room, but new rigs are being added to optimize programs which will find support at the current strip. The additions in the Permian will slow as we get some other activity in fringe basins, which we have already started to see in the Uinta, “Other”, Powder River and some coming one-offs in the smaller areas. Even after a big draw down in crude pricing, we are still sitting with WTI at about $58- which is still supportive of activity in the U.S.- especially given the strength that remains across the liquids market. Texas in general will see activity plateau a bit at these levels, but the trend will remain strong with a national target of about 215 spreads as we go into the end of April/ beginning of May. We have been discussing the tightness in equipment as we approach 250 spreads, but the conversations accelerate as we horsepower gets pulled out of the yard. As 215 spreads become active, pumpers and E&Ps will have to assess what is the demand going forward and start planning appropriately for spare parts to bring the next 25 spreads online. There will be horsepower available, but there could very well be transmission, fluid ends, and other parts that were stripped to keep other spreads working. The inventory assessment will increase as we hit 215, and the conversations will surround new capacity, replacements, and what costs/contracts will need to be signed. Attracting talent back to the oil patch will also require signing bonuses and other types of stage completion bonuses if they are executed in an agreed upon time. The last slug will most likely require CAPEX so a pumper will look for a 6 month or at least a well count guarantee to make the investment, which will also come with a higher price point. Our early estimate is for about 275 spreads active this year with an exit crude rate of 11.3M barrels a day. We could hit an upside of 11.5M, but at the current activity rate it is unlikely to see that number either hit and if it is- sustained at just 275 spreads. The pressure on equipment starts at about 230 because the difference between 230-250 will be replacement parts and more personnel and the move from 250 -275 replacement equipment. The new equipment will take a 6-month lead time so decisions will need to be made soon on ordering to ensure horsepower is ready for a back-end push. Either way- 250 spreads are a very doable number based on available capacity. U.S. crude exports have come under pressure with the weakness in the physical market and fairly tight spreads against the global grades. Just as using our normal bellwether: Brent vs LLS at $1.47 and Brent vs MEH at $2.97 is keeping spot cargoes low given the current market dynamics. The Atlantic basin crude grades are trading at some steep discounts with Urals about $2.45 less dated Brent, Libya OSPs starting at $-2, and other grades trading at discounts to dated Brent. The increase in lockdowns in the region: Germany, Italy, Belgium, France, Netherlands (just to name a few) will keep refined product storage elevated and reduce the total demand for U.S. crudes. North Sea spreads have softened with China limiting new purchases, which have pulled down diffs and those will remain under pressure in the next few weeks. The strength in the paper markets opened up the ability for hedging- especially at the private level given where the curve was pricing. This provided an avenue for swaps, outright puts, and collars at fairly attractive levels to protect against downside risk. The liquids market doesn’t have the same volume and hedge potential typically dries up 6 months out. The U.S. curve is still holding above $55 through Aug 2022 with only a dip below $50 further down the curve (in 2024-2025). The later months are no where near as important as current pricing or at least 2 years out for U.S. producers. This opens up hedging optionality and provides incentivizes to keep production moving forward. WTI Crude Curve The private market remains strong with activity accelerating in key Texas as opportunities remain open for hedging to protect cash flow and refiners in the process of increasing operation. Refiners will still remain well off normal throughput, but we will see national operations sitting around 83% with some acceleration into the summer months closer to 87%. The saturated gasoline market will keep operations local (US crude is good for gasoline) as the US market will remain the strongest from a product consumption standpoint. This will also hinder exports and keep imports strong, which will also keep a steady flow of U.S. crude moving into the system. The limited U.S. crude exports will create some headaches as storage also increases, which means our spreads will have to start trading at steeper discounts in order to pull more crude into the international markets. Without Europe starting back up, the U.S. crude markets will face some headwinds that will remain problematic if Asia (China) still remain limited buyers. The growth of work from home or flex schedules will remain a big overhang in the market as we see limited travel on the weekdays even as the weekends see growth as we emerge from COVID19. “A majority of businesses in five countries are considering a flexible remote model because of the successful use of video conferencing during the pandemic, according to a new report commissioned by Zoom Video Communications Inc. Its findings follow a recent Microsoft Corp. survey that found 73% of workers want remote options to continue.” We are seeing a demand for more work from home options or flexible schedules. Headwinds remain in mobility and general US activity as the weekday remains well below seasonal norms. We expect the weekends to move to about 7% above normal as we get above 20%-25% below normal on the weekday norms. Physical Crude Update India threatened Saudi Arabia that they would look elsewhere for crude, and gave their companies directive to shift into other markets. Nigeria, Angola, and WAF in general cut their OSPs and lowered pricing on current offerings that attracted some additional Indian purchases. West African oil exports to Asia this month are poised to rise to the highest level since December, as monthly flows to India and Indonesia both jump to the highest since 2019. Shipments to the biggest customer, China, are set to hold near steady. Total of 2.18m b/d is scheduled to leave for Asia this month, in 73 shipments, according to Bloomberg estimates compiled from a survey of traders, loading programs and vessel-tracking dataThat’s up from a revised 2.13m b/d for February, made up of 63 cargoes West Africa Bonny Light Crude OSP West Africa Qua Iboe Crude Nigeria OSP The increase is being driven by India and not China at this point, which will help keep WAF floating storage low, but more cargoes will be stuck in the Middle East. KSA is talking about keeping the production cuts for another month and based on the physical market makes sense- but they are losing market share to other nations that are willing to cut OSPs. It would be wise to see KSA maintain the production cut (they have largely maintained exports) and get more aggressive on pricing in order to incentivize additional purchases. By cutting OSPs, you provide additional margin to the refiner with some of that being pushed downstream. India is facing additional COVID cases and record diesel/gasoline prices that is hindering the purchase of products because they are more sensitive to pricing vs other nations. The price of refined products needs to come down to cool inflation talks and help pull through more demand. The level of subsidize in India and China limits additional support, and caps demand growth as the local populace struggles on several fronts. The market has caught up to what we have been highlighting with demand concerns in Europe and Asia being pulled to center stage. The issues being described were prevalent across the physical market as some differentials remained at 11-month lows and others quickly came under pressure to sell additional cargoes. 20-25 cargoes of Nigerian crude for April-loading are unsold 4-7 cargoes of Angolan crude for April-loading available as well as 3-4 consignments for loading some re- ffers 2 Djeno still available (Congo Grade)20 ESPO cargoes in March and April remain unsold. Nobody bidding for them. Virtually the shortest distance for crude oil to China.The US is taking advantage with 3 cargoes purchased for May loading into PADD5. We should see more activity as US and others take advantage of available cargoes.Angola has now cut May loadings to the lowest level since 2008 and cut pricing to a $1 below dated brent. These are West African cargoes that are the first to post their loading schedules and help to project Asian demand appetite and setting the stage for broader differentials. We are already starting to see some deferrals on cargoes into April/May has the cargoes can’t clear. This also points to more pressure on U.S. exports because our grades compete into Europe and Asia against the WAF market. The discounts coming across will limit new flow into Asia- especially with China cutting back (our largest importer). South Koreas has started to increase some buying, but the demand into Asia still remains a bit light. European demand will also remain slow as lockdowns persist and refinery throughput stays well off pace. CPC blends also remain slow as local refiners and Asian buyers aren’t showing up to take down the cargoes. This is putting the most recent bid at $2.90 discount vs dated brent (the lowest in almost a year). According to Bloomberg: “Only about three Suezmax cargoes for April loading were bought by Asian buyers, compared with more than six cargoes a month ago.” European flows in the U.S. remain elevated for diesel and gasoline as local demand remains weak, and the Texas freeze/ Easter-Spring Break demand has kept the arbitrage wide open. European imports of clean products from the Middle East have shifted to an 11-month low as demand remains low, which will keep pressure on U.S. distillate exports as Europe is our biggest market. The rise of COVID cases in Lat Am resulting in slowing activity and strong demand in the U.S. will keep gasoline exports low (our biggest export market for gasoline). Europe has also been exporting more gasoline not just to the US, but also Latin America and Africa- which will keep our ability to push more into the market limited. US Imports of Gasoline US Imports of Distillate The U.S. is importing at well over 5-year highs, while storage levels are elevated on a global level. The levels remain elevated around the world, and as the US provides the “best” opportunity more cargoes will come our way. Even as Europe exports gasoline matching seasonal records, builds are at 2021 highs and just off the highs achieved in 2020 during peak lockdowns. The problem is we have some recovering demand in the US but global cargoes chasing the arbitrage that will keep our imports elevated and exports depressed. All the while- U.S. refiners finally recover what was lost during the Texas blackout. PJK International ARA Gasoline Inventory K Tonnes International Enterprise Singapore Light Distillates Singapore Stock Data There has been some acceleration out of Singapore as some product is released into PADD5- but flows are expected to rise again as India increases lockdowns and Chinese exports accelerate. China is maintaining a record amount of exports of refined products with early indications of accelerating in April as March closes above Feb. China has a big turnaround season, which will keep crude building- but right now they would be purchasing for after turn arounds. Yet- they have left a significant number of cargoes in the water as key grades are left unsold. It is resulting in some of the lowest diffs on record and more pressure in the physical market. China Export Commodity Volume - Gasoline China Export Commodity Volume - Diesel Europe’s crude imports from the U.S. Gulf are likely to be stable this month from February but well below the year-ago level after an unprecedented cold freeze triggered a sharp drop in crude production in the U.S. 17 tankers carrying about 10.6m bbl have arrived in Europe so far in March after loading crude from terminals in the U.S. Gulf, according to tanker-tracking data compiled by Bloomberg, port agent and fixture reportsAnother 18 tankers hauling 10.8m bbl are expected to arrive by the end of this monthTotal volume for March will be 21.4m bbl, or 690k b/d compared with 686k b/d in February U.S. imports of European diesel jumped to a three-month high in the week through March 18, while gasoline arrivals slipped w/w, according to bills of lading and ship-tracking data compiled by Bloomberg Diesel inflows from Europe surged to 221k b/d during the said period, highest since the week-ended Dec. 17Six tankers arrived with total 1.55m bbl in U.S. East Coast or PADD 1 Weekly gasoline arrivals from Europe dropped to 317k b/d, compares with 510k in previous week, which was the most since Oct. 1 Still, YTD average imports climbed to 241k b/d, vs 237k in 2020Eight tankers discharged about 2.2m bbl in U.S. Atlantic Coast Europe will stay under pressure with the slow rollout of vaccines and extension of lockdowns across key demand centers: Germany, France, Italy, Netherlands- just to name a few. The region consumes about 15M barrels a day, so the extension is meaningful when we consider their already elevated level of crude and refined product in storage. It will also reduce the purchase of U.S. crude capping export capacity into the global market. India is also another problem as they experience some record number of new cases in key states (most recently Mumbai). China Economic Impacts China is also targeting a reduction in credit according to the Fiver Year Plan, Communist Congress, comments from high level government and financial entities. This is resulting in a roll over of credit impulses, which is a leading indicator for where commodity prices go over a 6–12-month period. The country is facing record debt levels (and rising) as rates push higher and they face a big year of refinancing as a large slug of debt is set to mature. The headwinds presented by declining credit will result in a reduction in commodity demand, which will help cool off or at least pause the rise in commodity prices. The shift higher in grains and raw materials are facing a supply crunch, which will counter the pressure on some pricing. The credit issues aren’t new, but they have continued to grow as some provincies and cities finance their “Special Purpose Bonds” with 90% of tax revenue. The interest expense has become a huge headwind for some areas, and in a rising rates market the pressure will only mount. This will limit the amount of fresh capital that can be thrown at the economy to generate growth. The below graphic helps to depict regions with the most risk as refinancing ratios come into focus as defaults are rising on Chinese debt. The amount of debt increased with more offered in response to the pandemic and trying to minimize economic damages. China came into 2020 on a “weaker” footing as the focus on debt is nothing new, but with the onslaught of COVID19 some policies and debt reductions were rolled back. “Local governments were under pressure to increase infrastructure investment and shore up growth through the pandemic, leading to a 6% rise in off-budget borrowing from a recent low of 13.9 billion yuan in the third quarter of 2019, according to Liu Lei, a senior researcher at the National Institution for Finance and Development.” Special Purpose Bonds and General Bonds were accelerated in 2020 to counter the impacts, but the growth of SPBs was already a huge balance sheet overhang. Many of the investments have struggled to break even let alone generate revenue. This has left governments overstretched to finance interest expense while also trying to stimulate the economy. The issues required PBoC and Federal Government support, but now: “China has vowed to stabilize its macro leverage ratio and lower the government debt ratio this year to rein in risks.”[1] Right now- China is holding firm with their targets, but as pressure mounts with PPI rising, exports under pressure, and slow local demand may make them shift course (again). I believe it is “different” this time because rates are going higher, and just the sheer size of the debt bubble within China has grown to almost 300% of GDP. This will act as a weight on growth levels, which also promoted China to be “conservative” on their target growth parameters. They also face mounting sanctions and external pressures that will impact exports- but more importantly underlying prices. Some debt has been pulled from the system on the developers’ side as bond sales slowed and we so some rolling maturities. This is a good start and continues the start of retirements in 2019 that paused during COVID19. The Communist Congress has been addressing the importance of countering the elevated real estate prices, and trying to balance the debt levels at the developer end of the spectrum. It has also slowed buildouts, which has also increased pressure on real estate prices. The 5 year plan addresses these concerns by increasing “Rural Revitalization” by moving people or rather incentivizing them to move into less populated regions. This will allow for prices to flatten in urban settings and help diversify the economy into a broader setting as the CCP looks to spur more agriculture and manufacturing. The shift is also meant to support struggling provinces that face a heavy debt burden and struggling regional economy that is laden with debt. The Chinese household has seen their total loan size grow exponentially- especially after the pressure from COVID19 struck. There has been a steady growth in short term debt levels, but as 2020 progressed more medium-long term debt was ladened onto the household. The Chinese consumer has seen their debt levels steadily rise over the last decade, and now it is accelerating as government support (subsidies) were pared back. Some of those benefits were returned with VAT tax cuts and other incentivizes to ease the pain of the US-China Trade War and the impacts of COVID19. As Xi pushes the “Dual Circulation Strategy”- it calls for a rise in domestic consumption, but it is off to a very slow start. The headwinds only increase when we layer in the amount of debt at the household level. The problems grow when we look at the below chart for interest payments. This is where we get the overhang as interest expense limits investments on growth that is already coming off of a weak base. Total Interest Payments The contribution from the industrial and service sector have been the drivers of the economy, but the industrial segment started to struggle as we came into 2017 with services picking up the slack. Services started to soften in 2019, but was quickly followed by the industrial side as pressure mounted in the global economy (another reason we were bearish in the back half of 2019). The “recovery” is set at about the level of 2019, which seems low- but when we look at the global economic weakness persisting into the start of Q2 (at least)- it starts to make little more sense. The pressure will grow as PPI within China is moving higher due to supply chain delays and commodity prices that remain elevated. The pressure will remain in place as additional pricing is passed through to the consumer and the buying business. These are issues that won’t be alleviated quickly or easily- especially as supply chains have already shifted from China over the last few years. The pivot has only accelerated with little standing in the way of additional moves to try to create more redundancy and protect costs. China is facing a slow down in local demand in some of the key areas of focus outlined in the 5-year plan and recent congress meeting. When we normalize activity for COVID19, retail sales and fixed asset investment fell well below pre-Covid levels. The CCP is pushing the Dual Circulation Strategy in an attempt to increase local consumption (retail sales) and investments in the local economy (fixed asset investment). The problem is the country is choking on debt at all levels of the economy, which is why delivering new local investment will take time as they work off current debt levels. China property investment also came in at 38.3% (est of 53.4%), which is a good and bad thing for what the government is trying to achieve. They want to take out some of the debt overhang (as we showed in the debt retirement chart), but they also need investment in new housing in the rural communities. Instead, we are seeing a straight slow down in activity as prices rise across the board hindering new activity and increasing prices to the consumer. Development activity will pick up again, but it will take additional government support and clearing of some debt loads in order to see the acceleration in activity. The PBoC is offering a debt swap for perpetual bank debt to keep the appetite in the market healthy for the bank debt. It is also a way to diversify holdings for banks because the assets are already so interconnected so owning each other’s perpetual increases the chance of contagion. But, the banks need financing to help protect balance sheets in an attempt to de-lever, and they have found success with the perpetual bonds. The PBoC will take this on and swap them with 10 year government nots (and some other options) at a premium to provide some near term liquidity while also trying to reduce balance sheet interconnection. This all sounds great, but it also just increases the risk at the federal level as the PBoC takes down more debt. The PBoC is also extending some programs to the end of the year: Pay an incentive – 1% of a loan's outstanding principal – to commercial banks that exercise forbearance on loans to small companies that mature in 2021Provide 40% of the principal for unsecured loans that commercial banks make to small firms The Chinese government is also maintaining tax cuts, which is why the fiscal deficit has outpaced estimates. The market assumed some reduction in tax cuts, but they have all been pushed through for another year- especially on the small business front. This will keep a lid on total tax receipts and keep the deficit expanding. Emerging Market Recap Issues are rising around the world as U.S. 10-year yields push prices higher- especially at the Emerging Market level. Following the ongoing Turkey debacle, Russia pulled a bond offering and raised their bank rate to help stave off a run on the Ruble and keep inflation capped. Mexico announced keeping rates flat, but had hawkish statements highlighting how they will be limited (read unable) to cut rates further and will be quick to raise rates to keep inflation in check. The use of monetary policy is being adjusted around the world as inflation and financing costs are going up rapidly. We are still at very low rates, but the rate of change is a growing problem as U.S. breakeven numbers press higher. Inflation in Russia has already pushed above the central bank threshold, which prompted a quick increase in rates. India is already seeing inflation push back to the top end of the range of 6% with the most recent reading of 5.1%. Based on the underlying fundamentals of commodities, PPI, and corporate costs, pressure remains to the upside on inflation metrics that will keep monetary policy hawkish around the world. Russia Central Bank Rates ASEAN countries are seeing additional pressure on the back end of rising pressure from inflation, slow vaccinations, and rising COVID cases. Global trade also remains under pressure with rising costs and supply chain issues, which are only made worse by the Suez backlog (talked about at the top). India is facing pressure at home with the rise in COVID cases (discussed above), which already started showing up in the industrial data. We have been saying the market was far to lofty with their GDP estimates in the region- especially in India. Headwinds have only increased in recent weeks on account of a rise in active virus cases, renewed local lockdowns in some states, rising input costs for firms, including higher oil prices, and surging borrowing costs. The rise in prices across India will keep showing up in their export costs and put additional pressure on the local populous already facing inflation pressures. This will keep a lid on total activity within the country and hurt net crude consumption over the next 2 or so months (at least). Pressure remains across most input costs that will keep costs elevated, and with the level of fiscal spending coming will keep inflation fears well bid. The below chart helps drive home the pressure on aggregate tightening on economic growth. The rise in interest expanse limits total growth potential with rising interest expense and shrinking economic expansion. This will prolong the downturn in the internal markets, but more so in the Emerging Market theatre. Fiscal stimulus continues to move in the developed world, but as it is going to replenish savings and cover the rising cost of essentials- additional growth is going to be limited. The amount of money being spend on interest payments is going up year over year, and based on estimates on new spending patterns- the numbers will only get worse over the next 24 months. The pressure will mount as U.S. yields press higher across the board. Inflation expectations continue to push higher in the U.S. that is driving up costs around the world. The twin deficits being run around the world will hurt long term growth potential. Rates are still at the early stages of reacting to the changes in the market, and it will keep put pressure on additional borrowing as monetary policy is forced to tighten up. China-U.S. Alaska Meeting The Alaska ended with a bang as both sides came out swinging to lay out the issues each side has with the other. The spin team was in full effect: State media has struck a uniformly positive note in describing talks: “Chinese and U.S. officials concluded…[a] dialogue that both sides believe was timely and helpful and deepened mutual understanding.” (Xinhua)“[The dialogue] was constructive, helped bolster mutual understanding and…yield[ed] fresh consensus.” (China Daily) The U.S. and EU issued more sanctions against China, and they responded by issuing new sanctions on the EU as the tit-for-tat continues to escalate. The pressure is increasing on China as they face more headwinds internally and externally. Taiwan recently started discussing long range missiles that are currently being developed with one already deployed in the region. This fits with the shift in U.S. focus on deploying more forward-facing missiles vs the defensive THAAD system. The U.S. met with South Korea, Japan, and Australia recently to discuss the importance of joint cooperation in the region, which resulted in North Korea sending 2 missiles into the ocean. The above chart gives a breakdown of where we sit in deployment of forward assets in the region. This comes at a time where we face the “Spring Thaw”, which typically starts an increase in attacks and terrorist attacks in the region. India and Pakistan had a high-level military meeting to discuss the current agreement between both sides and mechanisms embedded in it. India-China-Pakistan remain in a very close standoff in key areas in Ladakh and Kashmir, while India-China remain at friction points in Sikkim and Bhutan on the other side of the Himalayas. Big Oil’s Split on Path Back From a Recovery Won’t Help Activity Big Oil is splintering into several camps as it charts a way to attract investors back to the sector amid the effects of the pandemic and oil price war. That division will have substantial impact on oil supply over the next decade and the future of the industry. From the aspirational (and perhaps unfounded) goals from BP and Royal Dutch Shell, to the tried and true mega-project strategy for ExxonMobil, there will be a marked shift on capital allocation within the largest players in the world. There are two critical drivers behind recent strategy decisions – debt and ESG. European players are ESG constrained, but their actions have varied from Total’s move nuanced approach to BP’s reinvention of itself (third-time is the charm?). U.S. majors are further split, with debt-constrained players like Exxon and Occidental sticking to their tried and true, while nimbler peers, Chevron and ConocoPhillips, are adapting their strategy to free cash over asset-building. Conoco took a decisive step in exiting deepwater and Chevron is following behind, expecting up to 75% of its upstream investments to be in shale by 2025. There are three factors that we believe will decide the ultimate success of these strategies: Government intervention – Decisions to increase the burden on the industry will continue to shift capital away from high-cost jurisdictions. There’s a chance the U.S. will join those ranks, but Canada, the U.K. and continental Europe are already firmly there; Global Interest rates – We long believed that shale would suffer from a rise in rates, due to its short-term investment cycle. But with the healthies balance sheets in the land shifting towards shale, this may no longer be the case. Mega-projects like Tengiz, Gorgon LNG, Brazil pre=salt, and even Kashagan (gasp!) will probably see a boost if real rates and inflation rise, as variable costs are low. But the lack of investments in new projects means shale would still attract capital, even if long-term economic profit remains near zero; Technology breakthroughs – the hardest one to predict, but fair to say at the current pace of changes it would taken something from left-field. The light-vehicle fleet is evolving slowly with less than 2% of global vehicle sales. The heavy-vehicle fleet has barely budged and would need a substantial change of pace to have an impact on demand in the next ten years. ESG and debt constrained companies need to rely on one of the three for their ultimate success, while those that are Free and Clear can continue their business as usual and sift capital back to shareholders. Balance sheet flexibility allows Total and Equinor to invest more heavily in renewables, which one can argue will keep their cost of capital lower than if it resisted mounting ESG pressures in Europe. BP and Shell, which are both ESG and debt constrained, have to rely on government intervention, technology breakthroughs within their portfolio or higher oil prices to navigate the transition and lower debt. In the U.S., Chevron and ConocoPhillips are positioning themselves for greater flexibility to protect against government intervention and technology breakthroughs in renewables. While the short-term investment cycle of shale leaves them more exposed to rising interest rates, they are still net beneficiaries and can gain from that scenario. Exxon and Oxy both need to root against greater government intervention. Exxon’s relatively low debt and dividend makes them root for inflation to take hold, so it can grow its returns base at a faster pace than its dividend, while Oxy’s highly-leveraged structure needs to rely on asset sales and higher oil prices. Big Oil’s Return on Invested Capital Still Suffering ESG-Constrained – IOC to IEC v2 BP (BP/ LN $24.28/ADR) – Poster Child of Woke Oil BP’s claim to be transitioning from International Oil Company (IOC) to an Integrated Energy Company (IEC) sounds eerily familiar to their “Beyond Petroleum” rebrand in 2000. There is more action than in the prior shift, with new CEO Bernard Looney implementing a brisk shift towards renewables and letting oil & gas production drop by as much as 40% by 2030. The shift was very sudden, with BP having just spent $10 billion to acquire BHP Billiton’s U.S. shale portfolio in July of 2018. The ESG push has been much stronger in Europe, so it’s no surprise that BP and Shell are leading the way. Most interesting has been the push to convince investors that returns on capital don’t matter in the long-run. BP cut its dividend to reflect its new investment proposition because its investments can’t sustain it. It is likely that its oil & gas returns on capital will rise over the next decade, as the segment is starved of capital, but overall cash generation will likely be weak and preclude any real increase in distributions and slowdown debt reductions. But more stringent government policies could drive higher returns in its green energy push, although that would likely mean higher energy prices for consumers, something not easily digestible. Royal Dutch Shell (RDSA $39.40/ADR) – Not to Be Outdone by BP Shell is following BP’s shift to renewables closely, but while BP had to sell a lot of legacy oil & gas assets in the wake of the Macondo disaster. Its acquisition of BG underpinned the move towards “integrated gas”, which is meant to augment utility-level returns. Still, CEO Ben van Beurden is asking for more government intervention to “level the playing field” globally, as his company feels a larger pinch than most from stringer ESG regulations, including the early closing of Shell’s Groningen field in the Netherlands in 2022. While not quite beyond petroleum, Shell will also let its production decline at a faster pace. It will continue to invest in LNG as part of its integrated gas platform and to a lesser extent in its Brazilian pre-salt acreage, although most of its exposure is maturing over the next five years. The dividend cut, the first since World War II, has changed the shareholder profile slightly. But the biggest concern are European funds looking to divest from fossil fuels altogether, which prompted the strategy shift. Shell’s strategy will succeed if it can garner more government support. With little new investment in oil & gas, it will rely on growing subsidies and a higher carbon tax to compete with its Big Oil peers. LNG is also vital in Shell’s success, but its poor performing greenfield investments, Prelude has been a disaster, will hamper return on capital metrics. Total (TOT.FP €38.48/share) – Measured Approach to Renewables Total underwent a massive turnaround in strategies under Patrick Pouyanne. Gone are the days of chasing peak-oil and buying high-cost projects like Fort Hills oil sands, in favor of buying deeply discounted assets like Petrobras and Oxy’s fire sales in the past few years and sometimes hairy situations, such as Iran natural gas. There is a large dose of renewable investments, especially in generation, but it will continue to invest in its legacy business, as opposed to BP and Shell, which are likely to let declines set in. Total faces similar ESG pressures to BP an Shell, but it has flown the radar slightly with its investments and managed to continue its legacy business investments in a similar note to Equinor. Its highly-centralized structure also prevented Total from making deep, out-of-the money acquisitions in U.S. shale, while its peers were burning cash. It’s lone position in the Haynesville was partly acquired after Chesapeake’s bankruptcy, after its midstream provider, Williams Co. negotiated much improved terms, but Total exercised its preferential rights. Its success hinges less on government intervention than BP and Shell and more on its execution of projects and eventual success in its battery-technology investments. The legacy business is performing well and has few moving parts to create problems. Total is one of the few that is also still investing, although very little, in exploration and could see fruits from its efforts over the coming years. Equinor (EQRN.NO NOK$164.50/share) – Do as I Say, Not as I Do The rebrand to Equinor from Statoil was supposed to be accompanied by a shift in strategy, which has not entirely materialized. Equnor is far more measured on its shift to renewables than BP and Shell, despite being an early adopter. It has exited U.S. shale after a disastrous entry into the Bakken and Eagle Ford at the peak of the cycle (wonder if they see any similarities…), and will focus its future E&P investments in the NCS and Brazilian pre-salt, where it has built a sizeable stake. Excess cash flow will continue to flow to the Norwegian sovereign fund, which ironically refuses to invest in oil & gas. Equinor’s strategy is a hedge of the ESG-Constrained and the Free and Clear. It is investing in some of the best projects globally, Johan Sverdrup is perhaps the best non-OPEC field out there, but also utilizing some of its capex dollars to go into offshore wind. Its invested capital in renewable is less than 5% of its overall capital stack as of the end of 2020, growing from 4.5% of invested capital at the end of 2019. Debt-Constrained – Everything Is Fine, If You Don’t Look at Our Balance Sheet ExxonMobil (XOM $55.25/share) – 91% Dividend Payout Is Totally Sustainable… Exxon’s massive dividend has been an albatross, dragging down its credit rating and ability to make deals needed to revamp a relatively poor portfolio. Exxon sees the dividend as paramount to their investment thesis, but in reality, their leadership in return on capital (thanks Qatargas!) was really what set it apart. Exxon is now trying to grow its invested capital and cash flow base into its dividend, rather than seeing its payout as an outcome. It has averaged dividend payout of 55% of operating cash flow, pre-working capital, from 2015-20 vs. 23% in 2010-14 and 21% from 2000-10. Dividend accounted for 91% of 2020 pre-WC operating cash flow. Curiously, Exxon’s payout was higher in 2000-10, including share buybacks, but those seem a long way from returning at the current outlook. To ensure it can grow its earnings base to fit its $15 billion annual dividend, Exxon is prioritizing NPV and resource extraction over flexibility. It is still investing in mega-projects and trying to own the infrastructure and services around the well, harking back to good ol’ days of Big Oil. This strategy could work if inflation takes hold and Exxon can grow its dividend at negative real rates, but leaves it exposed to a lower-for-longer oil price scenario and prevents it from really building up the underlying earnings base. Its deals in 2016 were a step in the right direction, filling up the growth portfolio with high-quality assets. It added Permian acreage via Bopco, Brazil pre-salt, Papua New Guinea LNG and Mozambique LNG, but the real star have been the discoveries in offshore Guyana. Falling LNG prices, political struggles and capital-constrain put the LNG projects in the backburner. But Exxon will continue to fund deepwater projects and its Permian growth, albeit at a slower pace. With production down 15% of its peak, Exxon needs a lot of investment to get back to its perch. There are more opportunities than it is currently investing that would be accretive to its return on capital, but the dividend continues to take priority. It is also notable that Exxon has not made any deals since the pandemic hit, again likely due to the dividend, even if justified by their deal activity in 2016. Occidental Petroleum (OXY $26.17/share) – We Would Be Woke, But Have Too Much Debt Oxy wants to be the U.S. version of BP, promising to save the world with its CO2 program that boosts fairly low returns compared to the rest of its portfolio. But all the debt it took on to outbid Chevron for Anadarko has put the company on the back foot for the next decade. While it has certainly improved its metrics, the $10 billion to Berkshire Hathaway are going to be a long-term drain on cash, and everyone knows Warren Buffet will get his money back. Asset sales have helped shore-up the balance sheet, but the low-hanging fruit is done. Oxy must now focus on self-help to get to its debt-reduction targets or sell a prized-asset like Oxy Chemicals. There’s plenty on the cupboard for growth over the next decade, but not enough capital. Oxy will need oil prices to be north of $60-a-barrel in order to resume growth and make sense as a long-term investment. Otherwise, every extra dollar is just going back to bondholders and equity will languish. Free and Clear – Capital Flexibility Trumps NPV Chevron (CVX $102.86/share) – Slow and Steady, Thanks to Oxy! Chevron’s saving grace over the past decade has a name, Pat Yarrington, and even though she has since retired, the company is still benefiting from her stellar management of the balance sheet. Operations and acquisitions have been near peers of even subpar, with issues at Gorgon LNG, Big Foot in the Gulf of Mexico, Tengiz, Atlas, among others. But still, the California team managed to come out of the other side thanks to a slower dividend growth than Exxon and a tighter purse-string than its sister-company. Oxy’s $1 billion break-up fee on the Anadarko deal was a nice boost to the cash balance, but most importantly, it prevented a deal at the wrong time. The Noble deal made more sense and will add to Chevron’s free cash flow and, to a lesser degree, to its growth profile. There is still room for further additions, but Chevron seems to have learned its lesson and will bide its time before dipping back into the market. The March analyst day showed that Chevron is all in on shale and expects to invest the majority of its growth dollars in unconventionals in North America. The Argentina play, enticing as it may be, is likely dead in the water, as the country dips back into capital controls. There could be some more growth out of Israel, but for the most part, Chevron seems to be shying away from large capital projects. It is following a game plan similar to ConocoPhillips’ shift towards shale. Even in the Permian, it is not looking to extract every last drop of oil and maximize NPV by accelerating development. Targets are set around free cash flow over NPV, favoring flexibility and returns over total value-add, a shift in mindset from the traditional Big Oil role. ConocoPhillips (COP $52.13/share) – Got the Hottest E&P in the Game Wearing our Chain Conoco started the shift to flexibility long before the crisis. It spun-off Phillips 66 to become a pure E&P company in 2011 and then exited deepwater in 2016 after the first oil price shock of the decade. Getting a sweetheart deal from Cenovus for its oil sands JV certainly helped, as did cutting the dividend, but Conoco has been reducing invested capital and focusing on free cash flow generation for years. It’s prudent fiscal management and slow-development pace in shale paid dividends as it acquired Concho Resources, arguably the best independent that could be bought, near the lows. It is still running substantially fewer rigs in its acreage than peers. Its Permian position, roughly 700,000 net acres will see moderate growth in 2021 versus Exxon’s mammoth program. Contrast its Bakken position to Continental, which has a roughly overlapping position, and you can see Conoco has taken a much more measured approach. It produces 78kb/d in 2020 vs. Continental’s 183kb/d in the basin. The balance sheet is in great shape and can absorb price shocks and relatively flat efficiency gains. Our friends at FLOW may say Conoco’s acreage is not as great as they say it is, and they are right. But Conoco’s pace and fiscal management make the difference relative to peers that overdrill on an endless treadmill of debt and dividends. Saudi Aramco (ARAMCO SAR$32.80/share) – Not Much Debt, But Not Too Much New Aramco is certainly not taking the same path as the two companies above, it is sticking to its massive, low-cost fields in Saudi Arabia, mega-projects and large dividend that are more similar to Exxon than Chevron. But with a solid balance sheet, it does have a lot more flexibility, at least at the corporate level, than Exxon. The Saudi government is a different story, is it seeks to reduce its expenditures and improve its balance of payments. As a minority investor in Aramco, returns are likely secondary to the dividend yield. At 4%, it’s hardly something to write home about, but it’s still higher than the S&P 500 and you don’t have to worry that Elizabeth Warren and AOC will come in to dismantle your key components. Here was a recent article I did on Iran: How big of a threat is Iran? In mid-February, President Biden stated that the U.S. would be willing to return to the JCPOA (Joint Comprehensive Plan of Action) if Iran resumes compliance under the agreement. Iran struck back by saying they would only re-enter discussions if the U.S. and EU dropped the sanctions first—ahead of any initial talks. Iran announced in January that they would begin enriching uranium and restricting IAEA members into the country. In March, the U.S. and EU again tried to get Iran to cooperate with the International Atomic Energy Agency with regards to their nuclear activities. They followed the statement by launching a barrage of missiles, drones, and rockets against assets in the region—with the most recent one being against a U.S. military convoy supply. Iran is currently doing its best to stay relevant in the Middle East, but when looking at the full picture of the region, it’s clear that these attacks are not coming from a point of strength—rather, the opposite. Iran is facing a major internal conflict between the populace and the ruling party. When the JCPOA was first enacted, sanctions were removed from Iran, which provided a cash windfall. But they spent the money on proxy support instead of internally on the local economy, which created a great deal of strife within the country as locals didn’t see the economic or financial benefit of the deal. This has become a major point of contention and has increased the divide within the country as the populace believes the regime “squandered” the money. Iran continues to be impacted by sanctions squeezing the balance sheet and limiting crude production and total exports. The pressure is pushing the country closer to a regime change, with a presidential election coming on June 18th. Their political future is nearly impossible to predict, but a major shift will most likely happen over the next 24 months. It’s doubtful that any negotiations with Iran will take place ahead of the election, but to show strength and solidarity with their proxies, attacks will remain prevalent throughout the region. What is the JCPOA? In July 2015, Iran signed the JCPOA deal agreeing to dismantle most of their nuclear program and permit facilities to be inspected regularly in exchange for a lifting of sanctions—unlocking billions in frozen assets and allowing Iranian oil to be sold internationally. When the terms went into effect in January 2016, Iranian crude production went from 2.8M barrels a day to 3.83M barrels a day, and stayed at that level until President Trump removed the U.S. from the agreement and reinstituted sanctions on the country. The biggest controversy of the initial deal was that it failed to address the development and testing of ballistic missile systems. During Obama’s administration, Iran tested several ballistic missile systems, causing a growing call to expand the limitations put on the country or exit the deal altogether. When the U.S. officially withdrew from the JCPOA in May 2018, crude production in Iran dropped off quickly, but that doesn’t mean they stopped selling. They have always been very good at “clandestine” ways of moving crude through Iraq (shared fields/pipelines through Basra), ship to ship transfer, and utilizing their own tanker fleet. For these reasons, the below numbers are likely lower than what is making it to market since the sanctions were reinstated. But the additional risk of selling against sanctions also means that Iran sells their crude at steep discounts vs. the stated physical market. If a company or country is caught, the ships will lose their ability to sail, and governments, officials, and corporations will face sanctions and fines. Most shipping insurance in the world is denominated in U.S. dollars, and with Iran restricted from utilizing USD, they have to come up with other means to transact. They have created deals with countries that have the central banks posting the collateral on insurance and transacting in a different currency outside of the USD universe. The lack of USD in the Iranian markets and terrible balance sheet have pushed their unofficial inflation rate up to 67% on the year. This pressure impacts the local populace—it weakens their buying power and increases activity in the “black market,” bringing necessary goods to steep mark-ups. Regardless of how you look at it, the Iranian people lose on all fronts—and with many of them identifying more with reformist values and relations with long-term trade partners (like Europe and India), it means that those from the hardliners are losing significant support by the day. Iran Oil Production At the beginning of this week, Iran launched a barrage of missiles and drones at Saudi Arabian oil assets—this comes in the wake of a string of rocket attacks against U.S. and coalition forces within Iraq. While Iran seems to be putting on a show of strength, mounting internal pressure and the external noose tightening is actually putting them in a place of weakness. Israel has been striking Iranian assets and their proxies at will across Syria, while the U.S. has struck key structures in Syria and Iraq. Israel just struck another Iranian vessel carrying products to Syria, which is a tactic they use to disable ships importing illegal goods into the region. The pressure was ratcheted up again after Saudi Arabia responded by striking facilities in Yemen linked to the Iranian-backed Houthis. The regime is facing a growing crisis as protests have intensified in the Saravan, Sistan, and Baluchistan province. The Sistan-Baluchistan province is a semi-autonomous region along the Pakistan border, and has always been a problem for the Iranian government. It makes sense that as the regime appears to weaken, fringe areas will start to test boundaries—with the most recent uprising resulting in the destruction of police and IRGC facilities. Protests have continued to spread across all major cities and provinces as the country faces the fallout of economic sanctions. Employees are striking in greater frequency as wages and benefits either haven’t been paid or back pay is still “forthcoming.” As issues arise internally, the Iranian regime responds by projecting power and support of proxies, which takes money, equipment, and manpower. Iran needs to maintain their standing along the Shia Crescent, as Israel and the GCC (Gulf Cooperation Council) nations hit supply lines and embedded Iranian assets. But they will continue to be met with resistance. Just recently, the U.S. was accompanied by Israeli, Saudi Arabian, and Qatar aircraft as they flew B-52s across the region to show “solidarity” in deterring Iran. The below chart shows the “Shia Crescent” that is being squeezed as countries within the region unite against a common threat. Generational dynamics are at work in the GCC nations as the younger generations are more open with their beliefs and views, even opening relations with Israel (who have proven highly effective at striking Iran and their proxies). This is a key reason why geopolitics shift over the course of decades—because it is closely tied to the generational cycles that underpin countries, alliances, and enemies. Israel has formalized diplomatic relations with four Arab League countries: Bahrain, UAE, Sudan, and Morocco. (When I was in the UAE in 2010, if you had an Israeli stamp in your passport, you weren’t allowed into the country.) It is also important to notice that Israel flew with KSA and Qatar in the recent U.S. B-52 flyover, even though they don’t have “formal” diplomatic relations with them. This is something that would have been impossible even three years ago. Qatar was subject to GCC sanctions in 2017 over their relationship with Tehran, but the embargo has officially come to an end as of January 5, and diplomatic and economic relationships have been re-established. Qatar and Iran share several oil and gas fields in Persian Gulf, which created a need to work together to share royalties. Qatar has been looking to expand their liquified natural gas capacity, so they needed to work closer with Tehran to structure new deals. These conversations kept going even after the JCPOA was re-instated and led to additional pressure within the GCC, which has now been overcome. So now you have four entities (and one old friend of Iran) flying a saber-rattling mission . . . and we didn’t think Iran was going to try to respond? You may be asking, I thought Russia and Iran were allies in Syria? How can Israel strike in Syria given the anti-missile/aircraft barrages of S-200s, S-300s, and S-400s? The reason is: Russia doesn’t care if Israel hits Iranian-backed positions as long as they don’t touch Russian assets. According to reports, Russia was fully aware of the recent U.S. mission, and per the agreement, did nothing to stop the attacks. Russian soldiers operate the more advanced systems and allow Israel (and most recently, the U.S.) to hit assets within their “controlled” airspace. But why would Russia not protect Iran? Aren’t they on the same side in Syria? Yes and no. Yes, they have both been fighting alongside Al-Assad in Syria, but Russia wants to be the top dog, so why not let Israel and their OPEC+ allies hit Iranian targets. It helps weaken a potential political threat within Syria and the Middle East. The constant attacks and sanctions are causing the Iranian regime to run short on money (and time!) as the populace continues to turn against them. The death of Qasem Soleimani eliminated the head of the IRGC (Iranian Revolutionary Guard Corps) Quds Force who was a mastermind behind terrible (and HIGHLY successful) tactics within and outside their borders. He is responsible for the deaths of many U.S. soldiers and Iranian civilians while in power. Soleimani was an enemy to many, but his whereabouts and movements were typically clouded in mystery—the Quds Force is a clandestine unit. But intelligence has been leaking like a sieve from Iran as high-value targets continue to be eliminated. Most recently, Mohsen Fakhrizadeh (a top nuclear scientist) was killed by assassins using a remote machine gun. This is a man who has a constant security detail and whose movements are a state secret due to the importance of their nuclear program. There have been a barrage of similar “attacks” throughout last year (the map below highlights some of the more recent incidents). All of these attacks have attempted to minimize civilian casualties but hit at regime-owned and operated companies and facilities. It is clear that local Iranians are now emboldened to strike out against a repressive regime. The Iranian people have carried out many protests over the years, but they have always been met with violent suppression (many of them led by Soleimani). The brutal tactics have only built up more resentment across the region. The populace has been turning away from the regime over time, but the shooting down of the Ukraine flight in July 2020, the handling of COVID19, and the new deal with China have pushed people beyond their breaking point. Iran and India have been friends and allies for over a 1000 years, and part of the China deal stipulated that India had to be “expelled” from current and future deals with Iran. India has built refiners specifically for their crude and has deals in place to build roads, rails, ports, and oil and gas exploration that was temporarily paused (but not stopped) when the U.S. sanctions came back into play. The U.S. even turns a blind eye to some shipments of Iranian crude heading into India. After the Ukraine plane was shot down, the local Iranians stopped walking on Israeli and U.S. flags that were painted on the ground, with some even getting rid of them all together—symbolically showing that they were no longer eager to “trample on” and disrespect these countries. The U.S. also set up humanitarian aid through the Swiss Embassy during the COVID19 pandemic to show solidarity and support for the local populace. The mounting pressure internally has pushed the Iranian regime to lash out with the recent attacks on coalition forces in Iraq, KSA assets, and an Israeli ship. Iran’s balance sheet is under pressure, which pushed President Rouhani to sign a deal with China agreeing to inject $400B of Foreign Direct Investment over 25 years into Iranian O&G and petrochemical businesses. They also agreed to invest in their banking, telecommunications, ports, railways, and other projects (many of them already had deals with India). This new deal allows China to deepen their military cooperation through joint exercises, research, weapons development (ummm . . . JCOPA?), intelligence sharing, and other integration metrics. China has been increasing their purchase of Iranian crude at a steep discount, especially with new refiners and petrochemical facilities starting up within China that require the type of oil Iran produces. China has been given an opportunity to gain a footing in the Middle East, which is a place they have tried to increase influence through Belt and Road investments. Over the last several years, Iran has become an integral part of the BRI, and even after calls to shut down travel with China due to COVID19, Iran was the last country to react. This caused Iran to be one of the hardest hit nations at the outset of the pandemic, and created even more animosity between the regime and the local Iranians. The biggest concern now is the delivery of advanced ballistic missile capacity to Iran, which so far has been limited to older generation technology. This is just another (among many) point of contention between the U.S. and China, but we have already covered that extensively in two previous articles. President Biden must remain firm in deterring attacks against U.S. and allied assets in the Middle East. While it is important to strike back to show force, we must avoid any civilian casualties by not striking within Iran. It would be a huge error to deter the populace’s shift away from the regime, especially as intelligence is leaking out in the U.S.’s favor. They are losing influence as the noose tightens around their borders and protests increase throughout Iranian provinces. Geopolitical moves are measured in decades, not single years, with nothing ever moving in a straight line, but the hardliners don’t have the support of the locals or the international community. We have considered Iran a friend and ally in the past, and if the Iranians continue their current path, we will one day again soon. Those from the '79 revolution are old, dead, or losing influence—now is the time to press. [1] https://www.bloomberg.com/news/articles/2021-03-24/china-s-2-3-trillion-hidden-debt-is-seen-climbing-even-further?sref=9yOLp5hz [/ihc-hide-content]