Easwaran Kanason

Co - founder of NrgEdge
Last Updated: July 7, 2021
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Business Trends
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In a ruling that could have interesting implications going forward, the US Supreme Court has ruled that the Environmental Protection Agency (EPA) has significant latitude in providing exemptions to federal biofuels mandates. The ruling will provide the current Biden administration with the power to compel more American refineries to meet annual biofuel quotas by withholding waivers. But, crucially, it will also provide future administrations with the power to do the opposite- increase waivers to reduce biofuel blending, which sets the country up for a push-pull battle between political affiliations and the oil/farm lobbies.

Why is this important? Under the Renewable Fuel Standard law, the EPA issues an annual biofuel mandate that compels oil refiners to blend a certain amount of renewable fuel into the American fuel mix. For 2020, that amount was 20.09 billion gallons of renewable fuel, including a sub-mandate of 15 billion gallons from conventional biofuels (like ethanol) and the rest including other forms of biofuels. Typically, the mandated amount increases each year, but recent levels were kept steady as the EPA accounted for weaker fuel demand due to the Covid-19 pandemic. Refiners that do not satisfy these annual biofuel quotas will be required to buy compliance credits from refiners that do. Given that US fuels consumption has retreated into slow growth, the evolution of EPA biofuel mandates has had the effect of reducing the amount of pure gasoline and diesel required in the American market. The original intent of the mandates was to reduce US dependence on oil imports while simultaneously boosting demand for American agriculture in the Midwest. For a long while, it was a win-win situation. Refiners got to claim that they were ‘Buying American’ by reducing crude supplies coming from countries like Saudi Arabia, Venezuela and Iran, while US farmers got a major boost in captive demand. Given that both industries were staunch Republican supporters also played a role.

But those dynamics have changed. The advent of the shale revolution flipped the equation, allowing the US to reduce its net import position. From a peak of 12.9 mmb/d in June 2006, the US net crude import position fell precipitously to 40 kb/d in September 2019. Since then, the US has during most months actually been a net exporter of crude, with US shale oil making inroads into markets as varied as Poland, India and Vietnam. For refiners, this means the issue of importing crude is now secondary, since there is plenty of supply both domestic and across the border from Canada. The capitalist impetus is therefore then to increase the profit position. Which flies in the face of the EPA biofuels mandates, since that is an enforced cost on a refiner that actively replaced its own products (gasoline and diesel) that is oftentimes expensive. Because the price of corn and soybeans – the principal sources of American ethanol for biofuels – is also driven by food demand. In China, for example, US soy is a major source of vegetable oil and soymeal for the meat industry. Soybean prices recently hit its all-time high in the Chicago Board of Trade, as recovering demand in China and adverse weather in the Midwest created a perfect storm of speculative trade. For American refiners that were already devastated by Covid-19, that added cost could be the difference between solvency and bankruptcy.

And so the EPA – under the Trump administration – used a tool in the law that allowed it to provide exemptions for refineries that face an ‘economic hardship’ from mandate compliance. These waivers surged under Trump’s tenure, bringing cheer to the oil industry but drawing backlash from biofuel manufacturers and, particularly, US farmers that were facing demand hurdles as a result of Trump’s trade wars with China and other major trading partners. This triggered lawsuits from biofuel advocates, which argued that the waivers were only intended to be short-term relief, not long-term arrangements. Refiners, of course, argued the opposite.

In a 6-3 ruling split across non-partisan lines, the US Supreme Court has now affirmed that the EPA’s power on the matter is broad, not limited. Under the Biden administration, this will like lead to fewer waivers to compel more refineries to meet mandates, but allow some flexibility and option to provide relief for independent refiners that are still struggling from Covid-19. Increased environmental scrutiny under Biden has already caused the Limetree Bay refinery in the US Virgin Islands to shutter. To allow a refinery operating in a swing-state like Monroe Energy’s Trainer site in Pennsylvania or Husky Energy’s Superior plant in Wisconsin to shutter over strict adherence could be politically dire. Especially in a hyper-partisan political climate.

But more crucially, the ruling might be a long-term win for American refiners. Since the EPA, under a different administration, could use its position as affirmed by the Supreme Court to reduce mandates instead. It certainly sets up an interesting dynamic for the biofuels industry that has many shades of political influence. The focus at the moment is to ensure that US refineries in critical condition have their burdens eased, with the American Fuel and Petrochemical Manufacturers Association president stating that he hoped the EPA would ‘move swiftly to provide critical relief to those small refineries that have demonstrated disproportionate economic harm resulting from the Renewable Fuel Standard’. In response to the ruling, the EPA is now also re-analysing its slate of proposals for 2021/2022 mandates.

Why does this matter? Refineries in the US are currently operating at near-maximum levels as economic recovery gathers pace, especially with the summer driving season coming up. With US crude output still far below pre-Covid levels, due to shale discipline and investment shyness in the face of climate change conversations, that has bid WTI prices up to its highest level in nearly 3 years. In fact, the WTI-Bent spread has narrowed so much because American fuels demand is far outstripping its supply. Continued exemptions from biofuels waivers would increase that demand, since corn-based ethanol would be displacing less volumes of gasoline, potentially driving prices even higher. The spillover effects on US grain prices and associated impact on food prices may also see a change. But all that could be reversed by a future administration with a different direction, potentially upending price dynamics again. The US Supreme Court has handed the EPA a potent weapon. May it be used wisely.

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Saudi Aramco Moves Into Russia’s Backyard

International expansions for Saudi Aramco – the largest oil company in the world – are not uncommon. But up to this point, those expansions have followed a certain logic: to create entrenched demand for Saudi crude in the world’s largest consuming markets. But Saudi champion’s latest expansion move defies, or perhaps, changes that logic, as Aramco returns to Europe. And not just any part of Europe, but Eastern Europe – an area of the world dominated by Russia – as Saudi Aramco acquires downstream assets from Poland’s PKN Orlen and signs quite a significant crude supply deal. How is this important? Let us examine.

First, the deal itself and its history. As part of the current Polish government’s plan to strengthen its national ‘crown jewels’ in line with its more nationalistic stance, state energy firm PKN Orlen announced plans to purchase its fellow Polish rival (and also state-owned) Grupa Lotos. The outright purchase fell afoul of EU anti-competition rules, which meant that PKN Orlen had to divest some Lotos assets in order to win approval of the deal. Some of the Lotos assets – including 417 fuel stations – are being sold to Hungary’s MOL, which will also sign a long-term fuel supply agreement with PKN Orlen for the newly-acquired sites, while PKN Orlen will gain fuel retail assets in Hungary and Slovakia as part of the deal. But, more interestingly, PKN Orlen has chosen to sell a 30% stake in the Lotos Gdansk refinery in Poland (with a crude processing capacity of 210,000 bd) to Saudi Aramco, alongside a stake in a fuel logistic subsidiary and jet fuel joint venture supply arrangement between Lotos and BP. In return, PKN Orlen will also sign a long-term contract to purchase between 200,000-337,000 b/d of crude from Aramco, which is an addition to the current contract for 100,000 b/d of Saudi crude that already exists. At a maximum, that figure will cover more than half of Poland’s crude oil requirements, but PKN Orlen has also said that it plans to direct some of that new supply to several of its other refineries elsewhere in Lithuania and the Czech Republic.

For Saudi Aramco, this is very interesting. While Aramco has always been a presence in Europe as a major crude supplier, its expansion plans over the past decade have been focused elsewhere. In the US, where it acquired full ownership of the Motiva joint venture from Shell in 2017. In doing so, it acquired control of Port Arthur, the largest refinery in North America, and has been on a petrochemicals-focused expansion since. In Asia, where Aramco has been busy creating significant nodes for its crude – in China, in India and in Malaysia (to serve the Southeast Asia and facilitate trade). And at home, where the focus has on expanding refining and petrochemical capacity, and strengthen its natural gas position. So this expansion in Europe – a mature market with a low ceiling for growth, even in Eastern Europe, is interesting. Why Poland, and not East or southern Africa? The answer seems fairly obvious: Russia.

The current era of relatively peaceful cooperation between Saudi Arabia and Russia in the oil sphere is recent. Very recent. It was not too long ago that Saudi Arabia and Russia were locked in a crude price war, which had devastating consequences, and ultimately led to the détente through OPEC+ that presaged an unprecedented supply control deal. That was through necessity, as the world faced the far ranging impact of the Covid-19 pandemic. But remove that lens of cooperation, and Saudi Arabia and Russia are actual rivals. With the current supply easing strategy through OPEC+ gradually coming to an end, this could remove the need for the that club (by say 2H 2022). And with Russia not being part of OPEC itself – where Saudi Arabia is the kingpin – cooperation is no longer necessary once the world returns to normality.

So the Polish deal is canny. In a statement, Aramco stated that ‘the investments will widen (our) presence in the European downstream sector and further expand (our) crude imports into Poland, which aligns with PKN Orlen’s strategy of diversifying its energy supplies’. Which hints at the other geopolitical aspect in play. Europe’s major reliance on Russia for its crude and natural gas has been a minefield – see the recent price chaos in the European natural gas markets – and countries that were formally under the Soviet sphere of influence have been trying to wean themselves off reliance from a politically unpredictable neighbour. Poland’s current disillusion with EU membership (at least from the ruling party) are well-documented, but its entanglement with Russia is existential. The Cold War is not more than 30 years gone.

For Saudi Aramco, the move aligns with its desire to optimise export sales from its Red Sea-facing terminals Yanbu, Jeddah, Shuqaiq and Rabigh, which have closer access to Europe through the Suez Canal. It is for the same reason that Aramco’s trading subsidiary ATC recently signed a deal with German refiner/trader Klesch Group for a 3-year supply of 110,000 b/d crude. It would seem that Saudi Arabia is anticipating an eventual end to the OPEC+ era of cooperative and a return to rivalry. And in a rivalry, that means having to make power moves. The PKN Orlen deal is a power move, since it brings Aramco squarely in Russia’s backyard, directly displacing Russian market share. Not just in Poland, but in other markets as well. And with a geopolitical situation that is fragile – see the recent tensions about Russian military build-up at the Ukrainian borders – that plays into Aramco’s hands. European sales make up only a fraction of the daily flotilla of Saudi crude to enters international markets, but even though European consumption is in structural decline, there are still volumes required.

How will Russia react? Politically, it is on the backfoot, but its entrenched positions in Europe allows it to hold plenty of sway. European reservations about the Putin administration and climate change goals do not detract from commercial reality that Europe needs energy now. The debate of the Nord Stream 2 pipeline is proof of that. Russian crude freed up from being directed to Eastern Europe means a surplus to sell elsewhere. Which means that Russia will be looking at deals with other countries and refiners, possibly in markets with Aramco is dominant. That level of tension won’t be seen for a while – these deals takes months and years to complete – but we can certainly expect that agitation to be reflected in upcoming OPEC+ discussions. The club recently endorsed another expected 400,000 b/d of supply easing for January. Reading the tea leaves – of which the PKN Orlen is one – makes it sound like there will not be much more cooperation beyond April, once the supply deal is anticipated to end.

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Market Outlook:

-       Crude price trading range: Brent – US$86-88/b, WTI – US$84-86/b

-       Crude oil benchmarks globally continue their gain streak for a fifth week, as the market bounces back from the lows seen in early December as the threat of the Omicron virus variant fades and signs point to tightening balances on strong consumption

-       This could set the stage for US$100/b oil by midyear – as predicted by several key analysts – as consumption rebounds ahead of summer travel and OPEC+ remains locked into its gradual consumption easing schedule 

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