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Tighter Margins Spell Trouble For ConocoPhillips
- Russia plans to cut oil production which threatens more turmoil in the markets.
- Margins are getting tight as costs continue to creep higher with labor, steel, and other input costs shifting up again.
- This crude oil producer’s recent price runup provides a favorable entry point for a near-term downside scenario.
The crude markets remain volatile with another round of uncertainty thrown into the mix by Russia. Russia plans to cut its oil output by 500,000 barrels a day next month, following through on a threat to retaliate against western energy sanctions and sending oil prices sharply higher. The move threatens to renew turmoil in the oil market, which had so far taken disruption to Russian supplies in stride.
It further tightens supply constraints from OPEC+, which Saudi Arabia had already led into a 2 million barrel-a-day production cut last year in an effort to buoy prices. Delegates from the group signaled they won’t take any action to fill in the gap created by Russia. This may seem like Russia is getting aggressive against the West, but we have to look at flows because Russia may have no choice except to reduce production.
The EU rolled out its next round of sanctions on refined products (mostly diesel and gasoil) coming from Russia. The EU27 was the largest buyer of Russian product that is now displaced and must find a new home. The below chart puts into perspective the number of refined flows that make it into the export market. There has been a fairly steep drop off in exports as we approached the deadline for the price cap.
Russia has a finite amount of storage capacity, and there is a limit to the amount of exports that can happen at a given time. A port can only handle so much traffic at any given time, and there will have to be a choice on what product is loaded- crude or refined product. There may be some slips that can only handle one or the other, but the increase in inherent ship traffic will still limit underlying flows.
This just means that Russia cannot export the same level of crude and refined product that was being moved by both pipe and ship. As more oil and product moves to ship, Russia will have to make a decision. This will result in a reduction in crude production.
As diesel, gasoline, and gasoil get stuck at the coast, storage will build up and cause refiners to reduce utilization rates. As rates fall, it causes more crude to be left in the Russian markets and put into storage.
Russian crude is already struggling to maintain flows so the mixture of reduced run rates will result in an even bigger glut of crude left onshore. The additional level of crude caused by run cuts will overwhelm export infrastructure and storage. So, instead of letting the market drive production cuts, Russia can “claim” they are doing it to impact the crude markets.
The below chart puts into perspective the amount of product that has to be redirected to new markets. This is a sizeable chunk that will be pushed into the export markets, so it makes sense to see announced production cuts.
The important piece of information will be the number of crude exports vs production. There is a good chance that crude exports will remain stable even as production is reduced because oil no longer going into refiners will have to find a home. We don’t see an announced production cut reducing any volume in the broader market.
The global markets have seen builds accelerate faster than expected, and we are starting to see some adjustments to storage estimates. We have about 60 million barrels of crude and products inventory build in Europe and the US to date, which isn’t bullish at all vs the prevailing narrative.
China may be drawing somewhat (from high levels!), but these “China demand will rise by 1-3 mbpd” calls are grossly overstated. We have seen a very steady amount of Chinese buying that is still within a historical range of buying.
China Supertanker Crude Imports
There still remains a record number of gasoline/light distillates in storage in Asia and Europe that are keeping crack spreads compressed. As Russian product struggles to find a home, we have seen middle distillate (diesel) stocks begin to rise quickly in the same areas around the world.
As crude prices push back to the top of the range, we will see pressure to the downside as well, as valuations of E&Ps come under fire. Margins are getting tight as costs continue to creep higher with labor, steel, and other input costs shifting up again.
The below chart is just one example of how elevated prices are versus historic. We don’t see any near-term reduction in prices as companies try to pass on as much cost as possible. The inability to pass on much of the costs limits the signing of long-term OFS contracts and keeps people active on the spot market.
Here is a great quote from NOV earnings…
“But right now, there are two key constraints: money and supply chain. The freshly restructured offshore drilling contractor industry has little access to or appetite for external capital to rebuild itself.
Despite 30% headline project cost increases since 2020, E&Ps are becoming more confident in their economics in the energy-security-challenged new reality we are living in. But they are finding one more cost they need to dial in, and that’s a way to finance the refurbishment of offshore drilling rigs, through both higher day rates and mobilization fees. National oil companies and integrated majors, supplemented by shipyards offering bareboat charters and, importantly, Eastern Hemisphere sovereign wealth funds, are the emerging sources of capital that we foresee underwriting the Big Offshore Drilling Restart.
The second constraint is the supply chain, broadly. COVID-driven workforce disruptions, lack of critical components, and expensive, unreliable freight have injected new execution risk into all shipyard projects in Asia and elsewhere. And not just for offshore rigs, FPSOs also face higher execution costs and risks, as we hear from our Completions and Production Solutions customers.
Our consolidated revenues from North American land customers increased only 1% sequentially. After rising sharply in the first part of the year, the U.S. rig count has now found a near-term ceiling a touch below 800 rigs, constrained by, among other things, the availability of labor.
North American E&Ps are citing service availability as the biggest risk to the achievement of their production targets, but our oilfield service customers tell us that crew availability is the real root cause. U.S. oilfield wages in West Texas and North Dakota are up 20% to 50%, along with higher per diems, higher oil-based mud bonuses, higher overtime, as crews are chronically shorthanded, and they work extra hours to cover the unfilled positions. But new hires are hard to find. And the crews that are successful in hiring new green hands are less safe and demonstrably less efficient.
$4,000 per ton casing is another constraint, and it’s contributing to 40% higher costs per foot for E&Ps.”
Today’s Recommendation:
The best way to play these constraints resulting in tighter margins is by buying puts on ConocoPhillips Co. (NYSE: COP).
ConocoPhillips Company is an American multinational corporation based in the Energy Corridor district of Houston, Texas. It’s ranked 156th on the Fortune 500 list and has a market cap of $129 billion.
The company has operations in 15 countries and has production in the United States, Norway, Canada, Australia, Indonesia, Malaysia, Libya, China, and Qatar.
Approximately 1/3 of the company’s U.S. production is in Alaska.
The risks mentioned above are playing out across the energy patch, and we believe the recent run-up in pricing is a good entry point to short some overvalued names like Conoco.
We believe that COP provides the best near-term downside as costs increase and pressure mounts on more of their liquid-rich acreage.
***Action to take: “Buy to open” the COP January 19, 2024 $100 put option up to $10.75 per contract.
- The symbol is COP240119P00100000
- Search for options under the stock’s ticker: COP
- Make sure you choose the right option (expiring on Jan. 19, 2024)
- Choose the $100 strike price
- Select “put” option
- Select how many contracts to buy
- Once you have the right contract, click “buy to open”
- Choose “limit order.” This sets the price for the trade
- Use a limit of $10.75
- Click “buy” to transmit the order.
If you place a limit order near $10.75, your order should be filled.
Note on risk: Options plays can be volatile, and all involve plenty of risk. And although these ideas are well-researched, nothing is guaranteed. Don’t bet the mortgage money here. And remember, it’s up to you to decide how much you’d like to put into each play. Please be sure to diversify your risk, and don’t put all of your money into one play.
I am expecting great returns from this play over the several months.
Good luck with this trade!
Good Hunting,
Freedom Financial News
