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Resource Nationalism

In the perennial struggle between resources owners and resource exploiters, Mexico’s latest move surrounding its largest private oil discovery ever has echoes of many past battles. There are only a few countries in the world that have both the physical energy assets and the technological know-how to exploit it, such as the US, UK and Norway. Even other major producers such as Saudi Arabia, Russia, Iran and Venezuela had plenty of outside help before nationalisation took over; to say nothing of the new players to hydrocarbons such as Guyana or Ghana. So Mexico’s decision to designate its state oil firm Pemex as the sole operator of the Zama field over the private consortium (led by Houston-based Talos Energy) that made the discovery has plenty of precedent. And is also a chilling reminder that the battle between national pride and international experience will always play out.

The Zama field, located in Block 7 of the Sureste Basin in the Gulf of Mexico, was discovered in July 2017 from the first exploration well to be drilled by the private sector in the country. The Zama-1 well struck oil at a depth of nearly 170m, and subsequent appraisal wells estimate the total recoverable reserves at nearly a billion barrels. Talos Energy, which holds a 35% stake in the block, is the current operator, sharing it with consortium partners Sierra Oil and Gas (40%) and Premier Oil (25%). First oil is expected by 2022 and peak production should stand at around 100,000 b/d. In many ways, Zama was a game changer for the Mexican upstream industry. At the point of discovery, Mexican oil production had been waning and discoveries lacking; Zama was proof that there was still significant amounts of oil left to be found.

The fact that Zama was the result of the first private sector exploration ever (well, at least for in over 80 years) was key. The fact that it was a huge resource was icing on the cake. Because in 2013, the Energy Reform allowed private and foreign investor across the entire energy value chain in Mexico for the first time since 1938, breaking Pemex’s monopoly in an effort to combat what was seen then as a chronic decline in Mexican energy. On the downstream side, international fuel brands penetrated the market for the first time, setting up what are now lucrative fuel station networks. But the biggest impact was on the upstream side. In the years following the 2013 Energy Reform, the Mexican National Hydrocarbons Commission awarded 107 oil and gas exploration and production contracts to over 73 companies from 20 countries.

The Zama discovery was born out of this de-monopolisation drive, and the companies currently drilling wells and making discoveries across Mexico include those from as far as Thailand and Malaysia. The string of new discoveries that have followed Zama’s are the fruits of this labour. Pemex still plays a vital role in the country – including running one of the world’s largest crude hedging programmes – but its loss of relevance has rankled some nationalists. Which is why in 2018, when new President Andrés Manual López Obrador (AMLO) took office on a nationalist platform, issuance of new E&P contracts have slowed down to a near trickle and new crude auctions have been suspended, as AMLO’s administration tries to assert domestic interests. His stated goal is to return Pemex to glory, which will mean rolling back the energy reforms that (briefly) made Mexico an upstream investment darling between 2014 and 2018.

Zama – as the most high-profile of all the private-led discoveries so far – has been at the centre of this tug-of-war. There is some basis to the government’s decision to hand over Zama to Pemex; this is not just some flimsy asset-grab attempt. Since the Zama field shares the same reservoir as one belonging to Pemex, the dispute has raged over whether Talos or Pemex has operational rights. A unification process to establish a joint area has been underway since 2018, with a study commissioned by both parties concluding that Pemex has a slight majority share with 50.4% of the shared reservoir. That ordinarily should have led to a new joint venture recognising the shared resource, but instead Mexico has decided to name Pemex as sole operator. It is a decision that should send chills down the spine of other international firms.

Because if it could happen to Talos, then it could happen to Lukoil, which just agreed to acquire a 50% interest in the Area 4 Ichalkil and Pokoch fields in the Bay of Campeche from Fieldwood Energy. It could happen to Petronas, which has made a string of offshore discoveries including from the Polok-1 and Chinwol-1 wells in 2020. It could happen to Eni, which holds rights in six E&P blocks (six as the operator) in the Sureste Basin. It could happen to anyone, because the AMLO administration has indicated with this approach that it is ready to confront the frustration and concern of foreign investors in order to polish Pemex. This could bring Mexico in the crosshairs of the Biden administration, since Talos is an American firm and this could fly in the face of some terms in the new North American trade deal. And more concerning is whether Pemex even has the resources and skills to operate Zama. The energy reform in 2013 happened precisely because Pemex couldn’t deliver operationally. Six years on and not much has changed at Pemex, so will there be any difference beyond nationalistic pride? Talos has made the full investment at Zama so far, while Pemex has yet to drill a single well after cancelling plans in June at the reservoir. Indonesia attempted something similar; and despite grand ambitions, Pertamina is no Petronas and the Indonesian upstream sector has languished.

Time will tell if this is a one-off or a trend in Mexico. But odds are that it will be the latter, given the nationalist bent pursued by AMLO and his relatively high popularity. But this shouldn’t be a surprise to any international firm operating in the sector. It happens everywhere. It is currently happening in Guyana, which is currently debating new petroleum laws to give the state a greater share of oil revenue after ExxonMobil was attracted there on favourable terms to make blockbuster oil discoveries. It is at the heart of the crisis in Papua New Guinea where the new government is attempting to extricate better terms from ExxonMobil and Total after their LNG projects took off. It resulted in Eni being ordered by a Ghanian court to place 30% of the Sankofa field’s revenue in an escrow account after the Italian major defied Ghana’s request to combine its field with the neighbouring Afina field owned by Springfield. Competing national interests and commercial rights are reality in the upstream world. And if those signs coming out of Mexico are correct, then current private firms sitting on Mexican assets should be wary. At least until this attempt fails and a new politician initiates a U-turn.

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Market Outlook:

  • Crude price trading range: Brent – US$72-74/b, WTI – US$70-72/b
  • News that OPEC+ was on the verge of a new deal – after some concessions were offered to the UAE to entice it to support the extension of the club’s supply deal – provided some relief to the global crude markets, but the resulting incremental gains in supply over 2021 have seen benchmarks retreat down to the US$70/b level
  • Markets are also increasingly concerned about the global resurgence in Covid-19 infections that spiking cases even in vaccine success stories such as the US and the UK, both of which have seen daily cases return to high double-digits; although this is mainly among the unvaccinated and death rates are low, the chances are the renewed outbreak causing further mutation is dampening forecasts for mid and long-term crude demand

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Despite narrowing Brent–WTI spread and lower production, U.S. crude oil exports remain high

Following the rapid growth of U.S. crude oil production since 2010, the U.S. government lifted restrictions on crude oil exports in December 2015. Before the restrictions were lifted, exports were less than 0.5 million barrels per day (b/d), but subsequent U.S. production growth caused price spreads between international (Brent) and domestic (West Texas Intermediate, or WTI) crude oil benchmark prices to widen. WTI averaged $10 per barrel (b) less than Brent from 2011 to 2014. Since the policy change in 2015, U.S. crude oil exports have increased significantly and have averaged more than 3.0 million b/d since 2019, despite narrowing price spreads, significant price drops, reduced demand, and less production since early 2020, when the U.S. market began to react to the COVID-19 pandemic. Weekly export data from our Weekly Petroleum Status Report show a slight growth trend in crude oil exports since June 2021. As of the week of July 9, 2021, U.S. crude oil exports averaged 3.51 million b/d, and Brent and WTI spot prices averaged $76.13/b and $73.35/b, respectively (Figure 1).

Figure 1. Crude oil spot prices and four-week average U.S. crude oil exports

Since 2015, U.S. crude oil export infrastructure, including pipelines and terminals, has expanded rapidly in the Texas Gulf Coast, particularly at the ports in Corpus Christi and Houston. As a result of this infrastructure expansion and a significant increase in domestic production, crude oil exports grew rapidly when benchmark prices remained above $50/b in 2018 and 2019, and they declined only moderately when the market dropped sharply in 2020. Between March 20 and June 19, 2020, four-week average U.S. crude oil exports declined about 31% and refinery inputs declined 13%. Crude oil exports declined more than refinery inputs in the same time period. In early 2021, both Brent and WTI prices increased to 2019 levels, and the price spread between Brent and WTI had narrowed to less than $2/b as of June 25 from about $8/b at the end of 2019. Four-week average crude oil exports had increased to 3.5 million b/d during the same period. In addition, WTI prices higher than $70 will contribute to an increase in U.S. crude oil production, which in turn will likely contribute to growth in U.S. crude oil exports.

The growth in U.S. crude oil exports in the first half of 2021 has been predominantly sourced from oil produced in the Permian, Eagle Ford, and Bakken regions, but crude oil exports also increasingly contain Federal Offshore Gulf of Mexico crude oils such as Mars and Southern Green Canyon, based on export data from ClipperData (Figure 2). Because the Permian and Eagle Ford regions are close to the Texas Gulf Coast, crude oil produced in these regions is usually exported from the Gulf Coast region (PADD 3). Prior to pipeline networks expanding to connect to the shale regions in North Dakota and Texas, rail transportation was an important means of delivering crude oil, mainly from the Bakken region in the Midwest (PADD 2), to refineries and crude oil export terminals.

Figure 2. U.S. monthly crude oil exports by select production regions

Pipeline development continues to play an important role in the growth of U.S. crude oil exports. Historically, U.S. refiners imported crude oil to the Gulf Coast by marine vessels and then transported some of the imported crude oil to the Midwest through pipeline systems such as Seaway and Capline, which flowed north from the Gulf Coast to the Midwest.

With rapidly increasing crude oil production, the demand to move imported crude oil from the Gulf Coast to the Midwest declined. As a result, the volume of crude oil moving through the Seaway pipeline dropped, and the pipeline was reversed in June 2012 to flow south and transport growing domestic crude oil production from the Bakken to the Gulf Coast. The Houma-to-Houston (Ho-Ho) pipeline, renamed the Zydeco Oil Pipeline in 2014, was also reversed in December 2013 to transport crude oil from the Texas Gulf Coast to Louisiana Gulf Coast primarily for refinery processing.

Such structural changes diminished the flow of crude oil from the Gulf Coast to the Midwest and contributed to the rapid increase of crude oil exports (Figure 3). Most U.S. crude oil exports leave the country from Texas ports, but some leave from Louisiana ports. Based on estimates from ClipperData, crude oil exports from Texas have been as high as 1.9 million b/d at Corpus Christi in June 2021 and 0.9 million b/d at Houston in May 2019. In Louisiana, they have also been as high as 0.4 million b/d at Morgan City in April 2021 and 0.3 million barrels at Baton Rouge in July 2018.

Figure 3. Monthly crude oil pipeline movements

Crude oil exports could further expand as more infrastructure is modified. Recently, Marathon Pipeline (MPLX) announced Capline’s reversal proposal. The total Capline pipeline capacity of more than 1 million b/d from the Louisiana Gulf Coast to the Midwest has been idled for several years as domestic crude oil and crude oil from Canada displaced imported light crude oil. In the proposal, light crude oil produced in Bakken and heavy crude oil from Canada will be transported from Patoka, Illinois, to St. James, Louisiana, via the reversed Capline pipeline. The initial reversal project planned for light domestic oil to be transported from Cushing, Oklahoma, to Memphis, Tennessee, via the existing Diamond pipeline through an extension and a newly constructed connection to Capline (Byhalia Connection). The pipeline would then travel from Memphis, Tennessee, to St. James, Louisiana, via the reversed Capline (Figure 4). On July 2, 2021, however, project developers Plains All American and Valero announced they were canceling the Byhalia Connection project, which our pipeline database had expected to be in operation by the first quarter of 2022.

Figure 4. Expected change in Capline pipeline flows

The Memphis Valero refinery owns an existing pipeline, the Collierville pipeline (not illustrated in Figure 4), connecting the refinery at Memphis and a terminal of Capline pipeline in Collierville, Tennessee. The Byhalia connection was proposed as an expansion of the Collierville pipeline. Because the Byhalia project was canceled, the future of the idling Collierville pipeline is uncertain. However, the pipeline could be an option to bridge not only the Memphis Valero refinery with Capline to source Canada’s and the Bakken’s crude oil but also allow WTI crude oil to flow to the Gulf Coast on the Capline pipeline.

Nonetheless, if Capline is fully reversed, it could transport light crude oil from the Bakken region and Canada to Louisiana for refinery processing and exports. In addition to increasing U.S. export capacity, such a reversal may continue to contribute to significant changes in the U.S. petroleum industry, particularly in heavy oil imports from Canada to the Gulf Coast, refinery inputs in the Gulf Coast and Midwest, and crude oil exports from the Gulf Coast.

U.S. average regular gasoline and diesel prices increase

The U.S. average regular gasoline retail price increased more than 1 cent to $3.13 per gallon on July 12, 94 cents higher than the same time last year. The Rocky Mountain price increased more than 5 cents to $3.49 per gallon, the Gulf Coast price increased 3 cents to $2.83 per gallon, the West Coast price increased nearly 3 cents to $3.87 per gallon, and the East Coast price increased nearly 1 cent, remaining virtually unchanged at $3.01 per gallon. The Midwest price decreased less than 1 cent to $3.02 per gallon.

The U.S. average diesel fuel price increased less than 1 cent to $3.34 per gallon on July 12, 90 cents higher than a year ago. The Rocky Mountain price increased nearly 8 cents to $3.59 per gallon, the West Coast price increased nearly 1 cent to $3.91 per gallon, and the Gulf Coast and East Coast prices each increased nearly 1 cent, remaining virtually unchanged at $3.08 per gallon and $3.31 per gallon, respectively. The Midwest price decreased less than 1 cent, remaining virtually unchanged at $3.26 per gallon.

Propane/propylene inventories rise

U.S. propane/propylene stocks increased by 1.6 million barrels last week to 59.6 million barrels as of July 9, 2021, 13.1 million barrels (18.0%) less than the five-year (2016-2020) average inventory levels for this same time of year. Midwest, East Coast, and Gulf Coast inventories increased by 0.7 million barrels, 0.6 million barrels, and 0.3 million barrels, respectively. Rocky Mountain/West Coast inventories decreased slightly, remaining virtually unchanged.

Divergence in #TeamSaudi

The history of OPEC – the cartel, of some of the world’s largest crude oil producers, has been one of historic co-operation or divergence. When OPEC acts in concert, it can awe the world in either direction; see the terrifying oil shocks of the 1970s or the unprecedented 2020 deal that removed nearly 10 mmb/d of supply to stabilise the market in response to Covid. The addition of Russia and other countries into the broader OPEC+ club bolstered the firepower of the group, but also ratcheted up the tensions within. Because when OPEC fails to agree, the results can also be spectacular, leading to unfettered production and devastating price wars. Typically, the instigators of a showdown tends to be Saudi Arabia (or Russia in OPEC+), or one of the more recalcitrant members like Iran, Iraq or Nigeria. But the latest rupture has come from an unlikely quarter. The previously pliant United Arab Emirates is now holding up OPEC+’s path forward as an unlikely source of drama.

It was supposed to have been easy. After several months of routine meetings followed more routine approval of cautious monthly eases of the group’s supply quotas, the July OPEC+ meeting was expected to be more of the same. Resurgent demand amid economic re-openings and accelerating vaccinations dampening the potency of new Covid-19 variants saw oil supply/demand balances tighten. OPEC+ discipline was key to this, allowing crude oil benchmark to rise to their highest levels in nearly 3 years, with US$70/b being a sweet spot that satisfies domestic budgets and consumption concerns. Ahead of the July 1 OPEC+ meeting, the ministerial panel had recommended that the group adds 400,000 b/d in volumes every month from August to December, and that the wider agreement itself should be extended in full to December 2022 (from its original end date of April 2022). This would be more cautious than required by the market but, the OPEC+ ministers argued, was necessary in case Covid resurgences turned into another series of devastating waves.

The loggerheads over the recommendations was always expected to be between Saudi Arabia and Russia: the former representing the voice of caution and a need for discipline, while the latter argues that additional barrels can still be absorbed by the market as it attempts to flex its production prowess. But, as is turns out, all members of OPEC+ had reportedly signed up to the new recommendation. All except one.

The history of the UAE in OPEC is one of alliances. Along with Kuwait, the UAE has always been #TeamSaudi within the club, supporting the kingpin across the various heated discussions and decisions. In the realm of geopolitics, Saudi Arabia and the UAE are staunch allies. They did, after all, engineer a remarkable blockade of Qatar for nearly 4 years in response to alleged support of terrorism through links with Iran. But the strength of alliances ebb and flow. And in January this year, the break between the two allies was starting to show.

Key behind this is the UAE’s grievance that it had been handed an unfair baseline – the level which all OPEC+ countries are expected to measure their production cuts or increases against. The current level for the UAE is 3.2 mmb/d, and it argues that this should be raised to 3.8 mmb/d if it is to endorse any extension. And the logic behind that is the UAE has been investing heavily in output expansions and is itching to capitalise on that, particularly since it wants extra liquidity to boost its attempt to convert its Murban crude futures contract into a regional crude benchmark. Both Saudi Arabia and Russia have rejected the argument for re-calculating the output target, fearing that everyone else in OPEC+ will ask for the same treatment. This impasse – which is essentially UAE vs everyone else – could potentially unravel the deal that took several weeks of intense negotiation and the assistance of the White House to broker.

In the absence of a new deal, there is a fallback deal. And that is to maintain supply levels at July levels for the rest of the year. But that itself is a risk, since global oil supply is lagging behind demand, and the inflationary effects of elevated crude oil prices are starting to show. Keeping production flat – assuming there are no breaches of compliance – risks further price spikes, and other producers rushing in to fill the gap at the expense of OPEC+ market share. Which is the last thing OPEC+ wants, especially is the rush is from US shale producers.

But an even more dramatic scenario could see a full-scale rebellion of the UAE against its quotas and potentially its exit from the cartel, a possibility strategically ‘leaked’ to reporters back in January. This would break OPEC+ unity, risking a free-for-all situation that could crash prices is other producers follow suit and trigger a punishing price war. In a show of just how close this nightmare scenario is, Saudi Energy Minister Prince Abdulaziz bin Salman has publicly stated that he has not spoken to his counterpart in Abu Dhabi as the July 1 meeting stretched further and further with all parties attempting to come to a compromise. And a compromise is still the most likely resolution, since it is against all interests to jeopardise the stabilised crude oil situation with a price war now. The most likely result is that – after plenty of sound and fury – OPEC+ will endorsed the supply increases for August to December, but not extend the duration of the deal beyond April 2022.

How long and deep will this chasm grow between Saudi Arabia and the UAE? How will this fundamentally reshape the politics within OPEC+? On all evidence right now, it seems like it could be quite a while. Because this is bigger than just oil. Riyadh and Abu Dhabi have been on a crash course for a while now. The UAE has been developing its own foreign policy themes, which are increasingly independent of its Saudi ally – see its recognition of Israel and its position on Yemen. Saudi Arabia’s call for international firms operating in the Middle East to move their regional headquarters to Riyadh has also been interpreted as a threat to Dubai. And in a chilling reminder of the Qatar blockade, travel between the two countries has been restricted. The healing of this rift will be key, not just to the future of OPEC+ but the incendiary geopolitical dynamics of the regions, especially with the incoming return of Iran from the cold to the oil markets and the wider world. OPEC+ has just experienced an earthquake, and now it is time to see what the aftershocks are going to be.

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Market Outlook:

  • Crude price trading range: Brent – US$73-75/b, WTI – US$71-73/b
  • Global crude oil prices have given up some of its gains, as the market interprets the rupture in OPEC+ as a sign that supply discipline may be eased faster than expected as the UAE faces off against the rest of OPEC+ over the future of the supply deal
  • Rising Covid cases across the globe – especially the spread of the delta variety in countries that had managed successful containment such as the US and Europe – are also dampening expectations as the market worries that a new infection wave is building that will impact consumption beyond Q3

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U.S. fossil fuel consumption fell by 9% in 2020, the lowest level in nearly 30 years

In 2020, total consumption of fossil fuels in the United States, including petroleum, natural gas, and coal, fell to 72.9 quadrillion British thermal units (Btu), down 9% from 2019 and the lowest level since 1991, according to our Monthly Energy Review. Our new chart of U.S. fossil fuel consumption by source and sector shows how each sector consumes fossil fuels. The chart also shows fossil fuels used for industrial non-combustion or nonfuel purposes, for example, in making plastics and chemicals.

Last year marked the largest annual decrease in U.S. fossil fuel consumption in both absolute and percentage terms since at least 1949, the earliest year in our annual data series. Economic responses to the COVID-19 pandemic in 2020, including a 15% decrease in energy consumption in the U.S. transportation sector, drove much of the decline. The United States also had relatively warmer weather in 2020, which reduced demand for heating fuels.

We convert sources of energy to common units of heat, called British thermal units (Btu), to compare different types of energy that are usually measured in units that are not directly comparable.

U.S. annual fossil fuel consumption by source and sector

Source: U.S. Energy Information Administration, Monthly Energy Review

Petroleum products, including motor gasoline, distillate fuel oil (diesel), and hydrocarbon gas liquids (HGLs), accounted for 44% of U.S. fossil fuel consumption in 2020. Every sector consumes petroleum, but the transportation sector accounted for about 68% of total petroleum consumption in 2020. Overall, U.S. petroleum consumption fell 13% in 2020 from 2019.

Natural gas accounted for 43% of U.S. fossil fuel consumption in 2020, the largest annual share on record. Every sector consumes natural gas, but the electric power sector accounted for a record-high 38% of total natural gas consumption to generate electricity and heat in 2020. Over 80% of the fossil fuel energy directly consumed in the residential and commercial sectors is natural gas, and it is mostly used for space heating. Overall, U.S. natural gas consumption decreased 2% in 2020 from 2019.

Coal accounted for 13% of U.S. fossil fuel consumption in 2020, the lowest annual share since 1949. Overall, U.S. coal consumption fell 19% in 2020 from 2019, the largest annual decrease on record. The electric power sector consumed about 90% of total coal consumption to generate electricity and heat in 2020. Coal used for electricity generation has steadily declined over the past decade, although we expect it to increase this year, according to the June update of our Short-Term Energy Outlook.

Nonfuel use of fossil fuels accounted for about 8% of U.S. fossil fuel consumption in 2020. Fossil fuels can be consumed—and not combusted, or burned—when they are used directly as construction materials, chemical feedstocks, lubricants, solvents, and waxes. HGLs accounted for 48% of U.S. nonfuel use of fossil fuels in 2020.

U.S. annual non-combustion use of fossil fuels

Source: U.S. Energy Information Administration, Monthly Energy Review

The Return of Oil Prices

A year ago, Brent crude prices were trading at some US$40/b. With the world then coming off the first wave of Covid-19 infections, this was seen to be a decent price for crude oil. Several waves later, Brent prices reached US$50/b in January 2021, with the beginnings of a global vaccination drive promising recovery. And what a recovery it has been. As we reach the half year point, Brent crude prices are now trading at US$75/b. That’s a 50% jump in over 6 months, one of the best performances for crude prices ever and the highest level in over 2 years. The question on everyone’s minds right now is: what’s in store for the second half of the year?

In pure market terms, crude prices are now reflecting the rapid recovery in global economic activity matched against output levels that are still curtailed. Led by rapid vaccination progress in the US, Europe and China – with the rest of the world slowly catching up – fuel demand has recovered to the point where market analysts have commented that the massive glut built up by the collapse in consumption in 2020 has been virtually eliminated. Even the beleaguered airline industry is back on its feet; regional travel within Europe has opened up again and American Airlines made the headlines last week for cancelling up to 15% of its daily flights…. not because of empty planes, but because it did not have enough staff to man those planes.

The acceleration in consumption recovery has some market observers predicting that crude oil prices could return to the prodigious US$100/b mark by the end of the year. And these are not just any market observers. This is the Bank of America, Goldman Sachs and the world’s second-largest independent oil trader Trafigura. The market, it is said, is hungry for oil. Even though demand has not yet fully recovered, it is far stronger than was predicted. But on the supply side, there is the continued supply quotas imposed by OPEC+ that is keeping prices high, as well as what Trafigura is calling ‘structural underinvestment in new production.’ By which he means that the shock of Covid has held back new upstream projects that could otherwise start producing now, which is also exacerbated by the furore around climate change that is scaring off investment by publicly-traded companies. And, unusually, the US shale patch has not responded to the strong price signals in the way they would previously. Where the mantra had been ‘drill, baby, drill’, US shale players are now practising unusual discipline, focusing on building shareholder value than chasing greater volumes and revenue. All of which means that crude supplies are unable to keep full pace with charged-up demand.

This is, of course, a recipe for OPEC+ to loosen its supply quotas. Following a nervous January, the OPEC+ club has been progressively allowing for higher output every month in 2021. This will continue when the group meets next to decide on its targets for August and beyond. Further relaxation of quotas is on the table – which will be cheered on by most club members, especially Russia, Kazakhstan, Iraq and Nigeria – but don’t expect quotas to be eliminated completely. Some form of supply control will be present well in 2022 at the very least. Because OPEC+ countries have an incentive to keep prices relatively high, to rebuild their battered fiscal budgets and recover from the Covid revenue disaster. The US$70-80/b sweet spot is just right to meet national budget requirements while also balancing consumption drivers. But any higher and demand destruction starts kicking in. Which, in combination with the climate change debate, could be a potent combination in demonising oil and gas even further. So, if the Bank of America is right that we are heading towards US$100/b oil, expect OPEC+ to start making concrete moves in the opposite direction to keep prices in an acceptable range.

The odd combination of discipline within OPEC+ and the US shale patch is having an interesting effect on prices. Specifically the Brent-WTI spread. At less than US$2/b, the spread is now at its narrowest in 8 months, and much lower than the US$4/b spread the last time oil prices were at this level. Why is this? Well, the spread is typically based on four factors – US crude production, US crude supply/demand balance, North Sea crude operations and geopolitical issues in international crude markets. The first and the last are of most interest right now. Since US onshore shale drillers aren’t rushing to restart rigs – only 470 rigs are currently operating in the US according to Baker Hughes – US crude production is more than 3 mmb/d off its pre-Covid peak. With US refineries now running at near-record utilisation rates to meet surging demand, refiners are bidding up US crude prices to secure domestic supplies rather than see them leave as exports. Which explains why the WTI is in a growing backwardation structure, where oil for prompt delivery is more expensive than futures contracts, because there is a demand for oil now.

On the flip side, OPEC+’s relative discipline has been instrumental is keeping prices high since any relaxation in supply quotas lags behind demand growth. But, crucially, there is also no geopolitical risk premium that is typically the main factor that blow out the Brent-WTI spread. Instead of an isolated Iran, world powers are now negotiating a return to the 2015 nuclear accord that could see Iran resume its status as a major crude exporter. The prospect of this has already kept Brent prices slightly subdued since May compared to WTI. Depending on how long the tightness in the US crude market lasts and how OPEC+ reacts with its supply relaxation programme, it is conceivable that WTI could close the gap with Brent even further. It could possibly even reach parity and exceed Brent – a situation that has only occurred a handful of times in the history of crude oil trading. We live in interesting times. The first half of 2021 was fascinating to observe as a crude market observer, being faster and brighter than anyone expected. The second half of 2021 could be similar. Let’s watch it play out.

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Emerging Biofuels Mandates in the US

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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