[ihc-hide-content ihc_mb_type="show" ihc_mb_who="10,13,14,16,18,19" ihc_mb_template="1"] By Mark Rossano SUMMARY Quick OPEC+ SummaryU.S. Completions UpdateU.S. Crude ExportsAsian Crude DemandIndia Economic Round-upOPEC+ Meeting and Physical Market Deep DiveBrazil and Latin America Deep DiveGlobal High Frequency Data, Employment, and Inflation Expectations Quick OPEC+ Summary OPEC+ delivered another win to the U.S. energy space by rolling over most of the cuts especially with Saudi Arabia maintaining the 1M barrel a day voluntary cut. There was a small increase of 150k barrels a day in April, but most of the reduction was maintained heading into shoulder season. It will either help draw down the excess supply or be a timely drop alongside extended turn arounds this year. It is always important to factor in exports vs production because even with a 1M barrel a day reduction, KSA only saw exports drop by 38k barrels in Feb vs Jan. Russia will be allowed to increase production by 130k barrels in April with Kazakhstan adding 20k barrels- based on the chart below: it equates to 225k barrel a day increase over Feb levels. The below numbers don’t include Libya, Iran, or Venezuela- Libya is now producing at a steady 1.3M barrels a day- which will support exports of 1.2M barrels a day. Because these three countries are excluded from the deal, the total increase in April is 325k barrels when we factor in Libya’s loading schedule. I will discuss this in more detail in the OPEC+ section, but their action today will be supportive of drilling and completion activity in the U.S. We will see spreads push towards 200 spreads with the WTI Crude Curve now above $60 through all of 2021. U.S. Completions Update The oil patch has started to recover from the freeze off that took down most of Texas and the surrounding area. The frac spreads in the region aren’t built to handle that kind of cold, so as temperatures approach freezing (let alone sub-zero) activity comes to a halt. Completion activity can happen in any temperature, but the equipment must be prepared to handle the extreme weather… I mean- we do drill and complete in the Artic Circle. The equipment in Canada, Russia, North Dakota, and other cold climates are outfitted with tracers, insulation, heaters, and other key assets to keep water and products warm. In Texas, the inclement weather resulted in frozen water and freeze offs at the well head. To protect equipment, everything had to come to a standstill to limit damage across the equipment, pipes, valves, and all key pieces to rilling/completions. If any of this is done improperly, pipes will crack, transmissions damaged, and other impacts that will require repairs and delay up time. This resulted in a near all stop across the Permian, TX-LA-SALT, and Western Gulf. We have seen about an 80%-85% recovery in activity with the remaining spreads back online over the next week or two. About 10% will be back online by the first week of March, but the rest could take another 10-14 days to get the parts installed and tested. But, the increase in crude pricing will pull more equipment into the market and overshadow the remaining 5% or so still offline. We will be able to overtake 170 spreads in the first week of March and continue the trend higher as we approach 100 spreads in the Permian heading into April. Private operators have picked up activity in the region, which will help support general completion activity even as some of the larger operators look to manage growth. According to Bloomberg, “Take the case of little known, closely held DoublePoint Energy. It’s now running more rigs in the Permian Basin than giant Chevron Corp. Meanwhile, family-owned Mewbourne Oil Co. has about the same number of rigs as Exxon Mobil Corp.” The rally in crude prices across the curve has helped private companies hedge across the curve, and lock in pricing that will be supportive even if there is a correction in pricing. The below map of the U.S. gives a breakdown of where activity is split between private and public entities. The decisions become a bit easier when you don’t have to worry about shareholders or reported earnings. This could keep assets more active vs what would be accepted by the overall market, but as the crude curve rallies- it becomes easier for public companies to promote an increase in activity. The hope has been for operators to focus more on cash flow and strengthening balance sheets vs growth, but as prices hold around $60 and over $55 throughout the curve it becomes easier to support more activity and deliver cash flow. March is historically when we start to see an acceleration in activity as the weather becomes more accommodative across the U.S. It is possible to drill/complete in cold weather, but it costs more money- so we normally start to see a pick-up in activity as spring rolls around. The rig positioning below just opens running room for completion crews because it builds on the DUC (Drilled but Uncompleted Wells) profile that can be turned to production over the next few months. The strength across the liquids complex (condensate and natural gas liquids-NGLs) also provides running room for basins that have lighter crude or generally a larger liquids base. The Delaware, for example, is a “light crude” play, but the support in the naphtha market (especially in Asia) will help support pricing and activity. DUC inventory has been drawn down since 2020 with completion crews out pacing rig activity drawing on inventory. The Permian still has more than enough running room to support a ramp in activity, but we will need to see a pickup in drilling across the Eagle Ford and Bakken over the next 6 months to replenish inventories. We need to see frac spreads increasing activity in the Williston (currently at 7) to around 15-20 to see production start to stabilize. Based on the seasonality chart below, we will see some increases throughout March with another 7-10 activations over the month. The biggest headwind to accelerating activity will be the DAPL pipeline decision because if the pipe is decommissioned differentials will blow out and limit new capacity. A shutdown of the pipeline would result in spreads widening by another $5-$7 in order to cover the cost of additional rail and competition for other pipe capacity. Until this is clarified, the pace of completions will remain subdued, but companies will at least look to stem declines in the near term. This will put completion crew activity at 12 quickly, but the remaining 7 or so will take a bit more time and clarity on DAPL. DUC Inventory in the U.S. Bakken Seasonally Adjusted Frac Activity We normally see an increase in general activity that picks up in the spring and accelerates to about the middle of the summer. The U.S. is starting from a much lower base given the fallout from COVID19, but we will approach 200 spreads by the time we get to the early April given the ability to hedge and private companies operating in different regions. Even at 200, we will be well off the normal pace and while there is support at this current price deck- many E&Ps are still cautious on the recovery prospects and OPEC+ production/export levels. Growth will continue from Texas (Permian and Eagle Ford) while Appalachia and Haynesville remain constant over the next few months. Given the current pricing, we will see some increases in the Mid-continent as NGLs/condensate prices support activity over the next 6 months- especially with propane pricing at current levels. National Seasonally Adjusted Frac Activity U.S. Crude Exports U.S. crude exports have come under pressure the last few weeks as pricing has been sluggish to support additional purchases. As of 3/2- Brent vs LLS is $.62 and Brent vs MEH at $1.55- which will limit total purchases. As of 3/5, things have widened out a bit with Brent vs LLS at $1.35 and Brent vs MEH at $1.92. The differential is still tight but as it widens it is going to help promote more exports from the U.S. According to Bloomberg, “crude exports from Louisiana’s offshore supertanker port tumbled to zero as Asian buyers limited purchases to manage high inventories that threaten to overwhelm storage facilities.” This is the first time since 2019 that we didn’t record an export within a specific month, which is being driven by a slowdown in Asian demand (specifically China): “Demand from Asia, and more specifically China, for U.S. crude has slowed because of high inventories in that region after recent heavy buying,” said Yuntao Liu, a London-based analyst at Energy Aspects Ltd. Purchases were also likely postponed as U.S. shipments in February would reach Chinese buyers in April, the peak of the country’s refinery maintenance season, he said.” India has been under pressure as gasoline prices reached a record price and diesel just off the historical high. Modi’s government has increased their fiscal stimulus and will have to borrow more money, so every piece of tax revenue is important. Gasoline/diesel taxes (depending on rovince) account for 53%-70% of the price- so Modi has discussed reducing some of the taxes by 3%-5% but it will be difficult to cut it by much more given the stress on the fiscal backdrop. “GST tax collections growth eased to 7.4% year on year from 8.1% in January. The slowdown in the recovery may simply reflect the leap year effect of one less working day in February this year. Adjusted for that, the recovery is likely to have picked up in February.” Tax collection within India will be something to watch as their balance sheet comes under pressure. Gasoline sales last month fell 2% from a year earlier, according to people familiar with preliminary data from the country’s three biggest retailers. This is the first decline since August.The sale of diesel -- the country’s most-used fuel and a proxy for economic health -- dropped 8.6% in February from a year earlier, according to the people. China is also sitting on over 100 days of crude in storage, which will keep pressure on new purchases in the near term. Asian floating storage is on the rise as new shipments are signaling the region, which will keep physical pricing soft out of West Africa and other regions. These headwinds will limit new purchases from the U.S., and the spreads remaining tight will add more pressure to exports. In the meantime, the OPEC+ announcement drove up the crude curve with all of 2021 now pricing above $60, and the whole curve now holding above $51. By Saudi Arabia sending a signal of restraint, the crude markets responded in a spike higher across the curve-which provides a great entry point for companies (especially private entities) to hedge some of their downside risk. There are also two ways to interpret the move: 1) The physical market remains soft and with coming refinery turn arounds in Asia- KSA wanted to hold barrels back. 2) KSA and OPEC+ are seeing tightness and want to sit back and let crude balances adjust. A bigger underlying issue is inflation that is only going higher with crude prices pulling the cost of gasoline and diesel up around the world. We have already seen a big increase across India, and the U.S. is on track to see $3 gasoline by the beginning of Summer driving season. There remains a hope of an increase in consumer activity, but as jobs remain well below pre-pandemic levels (though rising) and wage compression continues- spending will be limited. Between Fed activity and commodity prices surging, inflation will hit the consumer hard this time around. We have been jaded by low inflation, which has been higher vs official data but still low vs historic levels. The shift higher across the commodity complex and bubbles being pushed by central banks will cause a big problem. WTI Crude Curve Asian Crude Demand China saw a big slowdown over the Lunar New Year as travel underwhelmed vs 2019 and 2020. This has left more product in storage, while also building their crude storage. The tankers flagging China have started to slow but remain well over seasonal norms. The local ports have seen most of the bottlenecks loosen, which is also helping normalize the offloading of cargoes. This is putting more crude into onshore storage even as floating capacity remains over seasonal norms- but not at the levels we saw last year. Crude storage in Shandong at the Independent refiners (teapots) is at seasonally adjusted all-time highs, and due to continued slow demand on the product side- it will push more into the export market and limit runs at the local refiners. “Diesel and gasoline stockpiles held by China’s fuel-sales unit, traders and independent refiners rose to about 52% of capacity in the week ended Feb. 25, the highest this year, according OilChem. Inventories of diesel were at 23.4 million tons, while gasoline stocks were at 18.21 million tons.” Based on the below traffic chart, China never saw a “spike” in demand as people drove home- instead it was a steady decline once the Lunar New Year started. There has been a bounce off the lows, but China has been very slow to see a recovery in driving activity. Pressure is mounting on their underlying economic health, which we will talk about later in this report. Flight activity has been added back, but not back to the level it was prior to the holiday season. Driving Activity Around the World Shandong capacity and floating storage will be important to watch, because we are sitting at the highs of 2021 in crude as well as national highs in gasoline and diesel. This is being reflected in Chinese exports increasing as well as current storage data. “China’s diesel exports have surged to the highest in more than three years, with shipments at 537,000 barrels a day so far this month, Serena Huang, an analyst at Vortexa, said in an email interview. Feb. exports are 19% higher on a y/y basis and 63% more than Jan. “China is sitting on a diesel glut right now” with the recent resurgence of Covid-19 in the country exacerbating the situation, Huang said. Gasoline exports are at 389k b/d so far this month, 8% higher than last year and 5% higher than in Jan.” China Shandong Crude Stock Shandong Weekly China Supertanker Crude Imports China Shandong Fuel Oil Stock Weekly China and India aren’t the only places seeing limited demand as South Korea and Japan also see reductions in total utilization. South Korea crude imports fell 14.7% in February from a year ago- falling to 73mb from 88mb a year earlier. This keeps the country well below the 9 year average, and with COVID pressure still remaining- activity and demand will stay below normal. Some traffic is starting to pick back up, but the unemployment rate spiked back to a high not seen since 1999 limiting total activity. COVID cases still remain in the area with some increases in cases over the last few weeks, which will keep the stringency index elevated. The lockdown index remains elevated in Japan, which will cause a similar headwind as South Korea. South Korea Imports-Crude oil India Economic Round-up India has been facing a mixed recovery with some provinces seeing a drop in COVID cases and others a small uptick slowing down the reopening process. The general trend remains positive across the country, but the recent rise in rates (will cover that more broadly at the end of this report). Many emerging markets price their debt off of the US 10-year treasury, and with rates spiking higher- the cost of borrowing will edge higher. India has done a good job of reigning in some of their inflation issues, but with the recent rise in crude prices and the increase in fiscal spending- we will start to see that reverse. Other countries are in a similar boat, but India is one of the few countries in the below list (outside Turkey) that has recently faced inflation above the stated central bank target. India High Frequency Data The inflation target for the central bank has been between 2%-6% with the end of 2019 thru 2020 tracking well above the range. This was driven by more aggressive monetary policy, which remains in place- but new measures haven’t been taken recently on the monetary side to right size the inflation push. The central bank was able to achieve the targeted 4%, but now with a renewed fiscal push and rising global rates- there will need to be some sort of reaction. It could be a reduced fiscal response or some hawkish measures out of the central bank to maintain the target. “The budget points to capex growth of 26.2% in fiscal 2020 after a projected 30% rise in fiscal 2021. As a proportion of total expenditures (excluding interest and subsidy payments), capex is projected to rise to 23.7% in fiscal 2022, up from 20.3% in fiscal 2021 and 18.2% in fiscal 2020.” Inflation is already perking up in food, energy, and goods after seeing a steady decline, which will limit total fiscal capacity- or increase the cost of the stimulus. Debt levels are set to grow and remain elevated through 2026, with the hope that the GDP recovers, and the country can “grow out of their debt.” The problem is the debt profile is going to push to 95% of GDP level- which will make it more difficult to grow into over the next few years. The below gives you an idea as to where the money will be going over the near term to support the economic recovery. So far, the economy has started to pick back up, but it has leveled off like many others over the last few weeks. The global economy remains in neutral as it hovers around 70%-80% of “normal” as we will discuss at the end of the report. OPEC+ Meeting and Physical Market Deep Dive OPEC+ have decided to keep oil output unchanged in April with Saudi Arabia maintaining their 1M barrel a day voluntary cut in April. Russia will be able to increase production by 130k barrels a day in April with Kazakhstan increasing by 20k barrels a day. Saudi has also said that the reduction of the voluntary cut will occur over the course of several months. The expectation coming into today was for an increase of about 500k-750k barrels a day to be added to the market. Instead- we only had 150k added, which is below even the lowest estimates of 250k coming to market. The below numbers don’t include Libya, Iran, or Venezuela- Libya is now producing at a steady 1.3M barrels a day- which will support exports of 1.2M barrels a day. Because these three countries are excluded from the deal, the total increase in April is 325k barrels when we factor in Libya’s loading schedule. Based on the backdrop in the physical market, I get the hesitancy- especially with Libya now producing at 1.3M barrels a day. Libya coming back at higher levels and much faster vs what the market expected. The physical market remains loose vs the paper market, so the best structure to help “ease” the futures market would be to cut OSPs (official selling prices). We have already seen Libya cut OSPs and some West African grades trade below stated pricing. The current yield backdrop with rising rates and inflation fears are heating up, and elevated crude pricing just pushes up the price for gasoline and diesel. As we discussed previously- India gasoline/diesel prices are at records with more pressure coming into the market. Inflation has been all around us for years, but now with the base effect and commodity prices kicking into overdrive- it can’t be ignored. We are coming out of a pandemic with activity still well below average, and as we start the long climb higher- slow job growth and wage compression will only be exacerbated by the rise in everyday pricing. The OPEC+ meeting will be more than enough to keep the good times rolling across the paper markets, and the pressure will remain at the refiner that faces elevated storage and rising feedstock costs. The issues will be hit on 2 fronts with crude prices going up as well as the USD catching a strong bid as US rates drive higher across the board. The pressure at the refining side will remain with cracks being pushed lower as demand is impacted with sluggish economic data and high prices. International Enterprise Singapore Total Singapore Stock Data International Enterprise Singapore Middle Distillates Singapore Stock Data International Enterprise Singapore Light Distillates Singapore Stock Data The below chart breaks down the stated levels of production from OPEC+ nations through April based on the meeting: Deputy Prime Minister Alexander Novask said “It’s very important for us as we have seasonal demand and we need to increase throughput volumes at refineries and supply growing demand for oil products in Russia.” It will be important to watch physical pricing that has softened over the last several weeks, and exports because they have outpaced the underlying production commentary. Iraq has yet to hit a target stated while we have seen some reductions from Nigeria and Angola, but there is a mixture of market forces at play limiting underlying demand from WAF. The physical market remains weak with the North Sea the only bright spot, but that has started to soften over the last 7-10 days. The spreads remain tight coming from the U.S. limiting the underlying demand for US crude in the market. Typically, the U.S. sells into Europe and Asia (more specifically China- the largest by far, South Korea and Japan) but in Europe Urals, CPC, Nigerian, and Libyan barrels have displaced U.S. flow. Asia has been facing slowing demand, which is showing up in the way they are purchasing from the U.S. and typical customers such as Angola and Congo. Oil shipments from Gulf producers moved higher in February, even as Saudi Arabia cut production.Despite the reductions, shipments from KSA fell by just 35,000 barrels after increasing by 500k a day in the first half of the month. KSA had maintenance work at several refineries limiting internal demand and resulting in a limited impact on exports, with some crude also coming from storage. On the other hand, exports from the UAE dropped by 138,000 barrels a day, with the increase being driven by Iraq. Iraq’s crude exports rose by 83,000 barrels a day to a nine-month high, even after the country’s oil minister pledged that it would pump below its quota in February to make up for past overproduction. Iraq continues to produce and export well above their agreed upon target. Total shipments out of the Gulf states remained steady in Feb even as Saudi cut total outputs with less heading into the Asian markets. China has been reselling cargoes (Unipec reselling Sonangola) and taking the lowest amount contractually allowed. As China, South Korea, and Japan have limited buying- India has been looking to pick up more cargoes, but based on the data below- more has been originating from West Africa and Russia. India was pushing for an increase to the OPEC+ target (a cut in OSP would also suffice) to help slow the rise of petrol prices within the country. Some recent samples of OSPs and Platts window transactions showing some of the softness in the physical market. “At the same time, some pockets of physical oil market strength appear to be wobbling, with observe flows of North Sea crude grades to Asia dropping in February to the lowest in four months.” The North Sea was very strong heading into Asia, but we have seen it slow that has resulted in less cargoes being released and more being left in floating storage. Libya Cuts March OSP for Es Sider Crude to Dated -$2: List Libya set its OSP for Es Sider for March at a discount of $2/bbl to Dated Brent, compared with a discount of $1.40/bbl for FebruarySharara OSP at -95c for March, compared with -50c/bbl for February Urals traded at a 10-month low in late February on Platts The grade traded on Platts at a discount of $2.35/bbl to Dated Brent on Feb. 22Urals was offered at that level on March 1 Mitsui sold CPC Blend at fresh 10-month low in Platts window. Tupras bought CPC from Litasco via tender. Surgut offered five Urals cargoes in tender. Mitsui sold 90k tons of CPC Blend to Shell for March 9-13 delivery at $2.75/bbl less than Dated Brent, CIF Augusta: person monitoring Platts window Traded price is the lowest since end-April, compared with recent discounts of $2.45, $2.50 on Feb. 23 ESPO strengthened in February, after trading in January at the lowest premium to the Dubai benchmark in four months The grade sold on Feb. 19 at premium of $2-$2.20/bbl; that’s $1/bbl higher than the low on Jan. 19 ANGOLA ALLOCATIONS: Unipec Re-Offers April Angola Oil Cargoes Amid Weaker SalesUnipec has re-offered several (6) cargoes from its April term allocations of Angolan crude: tradersTotal number of re-offers, grades not knownUnipec was allocated six and 3 additional April cargoes by Sonangol; it also holds another four consignments of Sonangol- Sinopec International Angola (especially Unipec) very rarely resell 1 cargo let alone 6 out of 9 allocations. The Congo also typically sells their 9 or so cargoes very quickly, but only 1 cargo was able to move into the market with a cut in pricing. The physical market will be an important one to watch- especially as China goes into turn around and refined product pricing pushes higher to reflect the rise in crude prices. Libya has seen a steady rise of production hitting 1.3M barrels a day, which will support exports at 1.2M barrels- but the competition in the market has caused a cut in OSPs to make sure they can keep flow moving into market- especially Europe. U.S. Dollar Tipping Latin American Oil & Gas Perilous Equilibrium The rally in the U.S. dollar since mid-February is already creating ripple effects in Latin American economies and their relationship with National Oil Companies (NOCs). Argentina’s embattled economy was unsurprisingly the first to break, with price and capital controls put in place since 2019 and accelerating in late 2020. But Brazil is the latest, and largest, domino to fall. President Jair Bolsonaro will fire Petrobras’ CEO Roberto Castello Branco due to rising diesel prices and its impact in the country’s consumer price inflation, setting off what could be a major shift in oil & gas markets over the next five years. Brazil’s massive pre-salt fields are expected to be the main growth driver for non-OPEC production, surpassing U.S. shale after its recent struggles. Bolsonaro’s move and his dwindling popularity in Brazil are paving the way to renewed populist and interventionist approaches that could ultimately curtail pre-salt growth. Argentina’s failures at Vaca Muerta are the most egregious example of how government intervention can hamstring otherwise promising resources, but Brazil’s own recent past is an indication of what seems to be an increasingly likely destination for Petrobras. Brazilian Real Depreciating Fast Can Lead to Inflation Source: Bloomberg, BCB, C6 Research Argentina Went Through Fast Depreciation as Yields on Its 10-Year Exploded Source: Bloomberg, BRCA, C6 Research It is highly likely that Bolsonaro will succeed in replacing Petrobras’ CEO with Army General Joaquim Silva e Luna, the federal government is still its majority shareholder and has seven out of eleven board members. If Petrobras’ management succeeds in selling four refineries before being replaced, they could stave off some of the risks for the company and the country, but they will have a very short timeline. The sale would essentially break Petrobras’ monopoly over refining and help establish a competitive fuel market in Brazil. With a fragmented congress, Bolsonaro is unlikely to be able to push through laws to control fuel prices. The Future of Brazil’s Pre-salt Hangs in the Balance Brazil’s pre-salt discovering were the largest offshore finds in the past 30 years, with over 35 billion barrels of oil equivalent (BOE) in potential resources. The region now accounts for over 70% of Brazil’s crude oil supply, with the majority of it owned and operated by Petrobras. Partners, including Equinor, Royal Dutch Shell, Repsol, Total and Galp are the current largest foreign producers in the pre-salt. Unlike U.S. shale, the pre-salt continued to grow in 2020, as its highly desirable, medium sweet crude is in demand from Asian refineries and Petrobras owes China crude-backed debt. Petrobras’ need to reduce financial leverage and low extraction costs, under $4 per BOE, were further incentives for Petrobras to continue development in the region. Rystad Expects Brazilian Production to Rise 15% To Start of 2025 Source: Bloomberg, Rystad, C6 Research Rystad expects Brazilian production to grow by 15% by 2025 from 2020 levels, adding almost 450,000 barrels of oil a day. There have been some COVID-19 related delays, as Chinese built Floating, Production, Storage and Offloading (FPSO) vessels have faced construction and supply-chai issues. The impact is minimal and most of those units are leased by Petrobras, meaning it will not incur the costs of the delay, other than opportunity costs from lost production. Petrobras Production Units Timeline Could Be Pushed Back Further Source: Petrobras Petrobras expects to add roughly 1.5 million BOE of daily capacity by 2025, nearly half of which will be in its 100%-owned Buzios supergiant field. With Brazilian refineries already operating near full capacity and running 93% domestic crude through its units, production growth will be 100% for exports. While short-term growth seems to be locked-in, disruptions to Petrobras’ governance could have an impact from 2024 and thereafter. Brazil started opening up to outside companies in 2016, after President Dilma Rousseff’s removal from office. That has brought in several new operators and partners to the pre-salt, including ExxonMobil, Chevron, Total, Ecopetrol and Qatar Petroleum. These partners are expected to contribute substantially to growth over the coming years, but that could be disrupted if populist sentiments resurface in the country. Under Rousseff and her predecessor, Lula da Silva, Brazil implemented several laws to restrict foreign companies from operating in Brazil. Local content requirements for exploration and development delayed and, in many cases, ceased activity in the pre-salt, even as oil prices topped $120 a barrel. The industry in Brazil is not yet developed and faces a significant lack of resources, human capital along with Brazil’s infamous high-costs to do business, from the most complex tax-system in the world, to bureaucratic and oft-shady licensing. Petrobras Lost Billions Under “Long-Term Fuel Pricing Policy” Source: Bloomberg, C6 Research A return to those policies, especially at a time of increasing competition for capital and abundant resources, would likely see capital flight from Brazil’s pre-salt and further delays in its development beyond 2024. At that time, the only major non-Petrobras operated fields would be Equinor’s Bacalhau (previously Carcara) and Total’s Lapa field, which it acquired already producing from Petrobras. Brazil’s Mounting US Dollar Debt and Artificially Low-Rate Can Trigger Pain The catalysts for disruptions in Brazil’s oil & gas industry likely lie far outside OPEC+ or Petrobras’ 3-miles deep reservoirs. The record amount of U.S. Dollar-denominated debt in Brazilian corporate balance sheets and Brazil’s artificially low target rate (SELIC) are an over-pressurized natural gas reservoir ready to blow. Brazilian corporates added $76 billion in total debt in 2020 for a total of $968 billion, 23% of that is denominated in U.S. dollars. Meanwhile, the Brazilian economy is expected to contract by 4.5% in 2020 due to effects from the pandemic, while the Real went from R$4.02 per US$ to R$5.44 as of February, 2021. That is good news for exporters like Klabin and Braskem, but a challenge for domestic retailers and consumers. Brazilian Corporate Debt Rising, US$ Portion Near 2016 Crisis High Source: Bloomberg data from company fillings, C6 Research Brazil’s greatest enemy, consumer price inflation, was weakened in 2020, despite a weak Real. But higher commodity prices and renewed demand outside Brazil can have an outsized impact for an economy that often teethers on the edge of undersupply. Thinking of Brazil as a purely commodity-based economy that benefits from the recent rally ignores the Brazilian consumer, who is often left out of the rise in commodity prices. Most of Brazil’s commodity businesses are owned by a small fraction of the population or the government to the benefit of its rent-seeking political class that consumes substantial resources. Brazil May Be Similar, But It’s Not Argentina Similarities to Argentina’s struggles are plentiful, but Brazil has a few key differentiators that make it unlikely to repeat Argentina’s cyclical default-restructure-hope-default pattern. First, the size of its population and economy makes Brazil a vital cog to global stability. First, the country is large exporter of soybeans, iron ore, paper products, meat products and soon, oil. Its domestic market can sustain a base level of spending and activity without relying on foreign direct investment, although growth is limited, especially as demographic dynamics worsen. Most importantly, politics in Brazil are notoriously fractured and its most charismatic populist leader, Lula da Silva, does not have a clear successor. Lastly, Brazil has a long history of respecting pre-established contracts that did not fracture even in the tenuous 2014-16 period. Still, Bolsonaro’s meteoric rise and fall show there is a leadership vacuum in the country, with ideological fractures similar to those in the U.S. Despite an approval rating of only 26%, Bolsonaro is still the leading candidate for 2022 presidential elections. There is a plethora of potential centrist candidates, from TV personality Luciano Huck, a center-left candidate, to Brazil’s most-admired personality, former Justice Minister and Federal Judge, Sergio Moro that could still challenge Bolsonaro. The Workers Party (PT) has lost some steam following Rousseff’s impeachment, but it is still a force to be reckoned with, as its last candidate Fernando Haddad nearly won the presidency from Bolsonaro in 2018. It lacks a clear leader that can unify the many leftist movements in the way Lula da Silva did in 2002. Its current leading candidate, Guilherme Boulos, leader of the PSOL party, was defeated in Sao Paulo mayoral elections, a typical bastion of centrist politicians. The incumbent mayor, Bruno Covas, would be a leading contender for presidential elections, were it not for his deteriorating physical health. Lessons From Oil Cycles – LatAm NOCs Need Goldilocks Oil and Dollar LatAm NOCs are typically looked at as a cheap way to get exposure to the oil cycle and Emerging Markets. But the lesson from several oil price and dollar cycles are that these companies need a very tight range for both oil and the Dollar in order to sustain long-term returns on capital. Government interference is rife from total control for Pemex and YPF to the still stern control of Colombia’s Ecopetrol and Petrobras. COVID-19 Took a Large Toll On Brazil’s Federal Budget/Deficit Source: Bloomberg, BCB, C6 Research That range will vary over time as inflation and domestic rates fluctuate, but it’s fair to say Brazil reached the upper-end of that range as Brent crossed US$62 a barrel at an exchange rate of R$5.30 per US$. Argentina’s situation may take years, if not a decade to restore, as its populist government returns to failed policies of capital and price controls. Colombia’s center-right’s government decision to merge Ecopetrol and electric-utility ISA may have been the least objectionable intervention, but it still diluted minorities on what is likely to become another unwieldly, centralized, state-owned bureaucracy. Selling Refineries Would Be a Big Step to Reducing Interference If Petrobras manages to sell its four refineries before Bolsonaro intervenes, it could go a long way towards reducing future interference in the company. Most of the intervention has come in pricing at refinery-gate, where Petrobras owns nearly 100% of Brazil’s operating capacity. The company sold gasoline and diesel below market values for over a decade under the guise of “long-term pricing”, creating a multi-billion-dollar debt burden. Gasoline in Latin America a Bigger Burden to Consumer Budgets Source: Bloomberg That started to change under CEO Pedro Parente during Michel Temer’s lame-duck presidency, but a truckers strike over diesel prices forced Parente’s resignation in June 2018. Roberto Castello Branco took over for interim CEO Ivan Monteiro and continued a destatization plan, selling several of Petrobras’ non-core assets in power generation, ethanol, petrochemicals, fuel retail and natural gas distribution. The plan was to move towards an Equinor model, focused on developing its peer-leading pre-salt reserves and returning capital to the federal government through royalties and a formulaic dividend payout. Diesel Prices Took Down Parente and Now Castello Branco Source: Bloomberg, ANP, C6 Research Refineries were next on the list, with binding offers from Raizen (Cosan, Shell joint-venture), Ultrapar, Mubadala and others for four refineries in Brazil’s Southern region. Without a monopoly, the federal government would need to enact price-control legislations that are highly unpopular after Brazil’s bout with hyperinflation in the late 80s. Brazil is also an importer of diesel and, at times, gasoline, which means that without a monopoly the marginal price would be set at the import price, effective Petrobras’ current formula for retail prices. Petrobras Has Binding Offers for Four Refineries Plans to Sell More Source: Petrobras The threshold to control fuel prices would be substantially higher if other interests are involved, especially large corporates like Shell, Cosan and Ultrapar and a sovereign fund in Mubadala. It would likely be a step too far for Bolsonaro and his eventual successor to strip large players of their holdings or devalue their investments for a nation reliant on exports and balance of payments for its prosperity. Global High Frequency Data We look at high frequency data points to get a sense of where we sit on a global economic level. The data has had an upward trend since we exited the January spike in cases and vaccines have rolled out across many countries. Now that we pivot into the 2Q- we have to look at what will the next 3 months look like as inflation moves higher and jobs pressure remains in the market. Wage compression and inflation will be a focal point to look at the underlying strength of the recovery from the consumer perspective. The underlying strength has adjusted in China as we see a slow down in trade and underlying manufacturing pausing following the Lunar New Year. There is a mixture of the holiday overhang, but also limitations on exports as businesses have looked elsewhere for capacity as prices have risen. China is limited by the amount they can subsidize capacity given price increases within the country and pressure to stimulate local consumption. The prices paid vs prices received is a global issue, and resulting in inflation while also squeezing margins at the corporate level. Companies feeling pressure on the revenue/ margin side will be slow to higher back employees as cash is still tight on the balance sheet. This is a fundamental reason why the “leading indicators” for employment have faced headwinds. Another big issue is the lack of skill set available for the jobs open in the market. Yields have maintained a steady rise as inflation and lack of demand for US debt has increased. This has put upward momentum in the rates world with more pressure coming into the inflation world. Leading indicators are highlighting how we remain in the early stages in the drive higher of inflation. The pressure will remain as the government issues new debt and the Fed is limited in what they are able to purchase with inflation moving higher. The acceleration of borrowing will put more pressure on bond offerings and weigh on bid-to-cover rations over the next several months- the long end of the curve will be the one to watch: 5/ 10 / 20/ 30 year are the key rates and auctions to track in the near term. We have been discussing the wide divergence for jobs/ wages/ total compensation/ savings. The top 10%-20% have benefited the most over the last 20 years as the central banks opened up depressed rates for the foreseeable future (even when they raise them). This has created a big shift in the market with the lowest 3 quintiles living out of savings, while the top 2 tiers have been the driving force behind the savings increase. The pressure is growing with the divergence getting worse as wage compression remains the problem. More people are working part-time vs full-time and while job openings have risen many of them remain unfilled. The skill set isn’t available to match the position- so eventually the employer will have to hire someone and do more on the job training. There is also a lot of competition in the jobs market as more people are sitting on the sidelines and looking to get back to work. These people will accept lower wages because they want to get back to work and need training. The company will be “less efficient” until they get the worker up to speed, but will be paying less in wages to compensate. So as jobs remain depressed and wage compression continues: the below chart highlights how the inflation basket going vertical will only add to the pain at the consumer level. [/ihc-hide-content]