‘The Great Oil Deflation’ — The Energy Ties That Bind

It’s axiomatic that crude oil prices influence propane prices. So it follows that lower crude values are impacting propane, not only its price, but also its attractiveness as a petrochemical feedstock versus ethane and naphtha. Those realities were underscored at the National Propane Gas Association’s (NPGA) winter board meeting Feb. 8-10 in San Diego, Calif. With crude oil hovering near $50/bbl, off more than 50% from last summer’s highs, Debnil Chowdhury of IHS reported to NPGA’s Supply and Logistics Committee, laying out the reasons behind, and the response to, what the consultancy is referring to as “the great oil deflation.”

Oil market focus in 2014 shifted from geopolitical risks to weak market fundamentals as crude prices fell more than 50% since mid-June 2014. Libya’s production return triggered the oil price decline, and the underlying strength of U.S. and non-OPEC supply amid relatively weak global demand exacerbated the effect. OPEC—for now—is letting markets decide the clearing price for oil, keeping markets oversupplied. However, this decision by OPEC should not be viewed as permanent. Chowdhury, director of the downstream energy group at IHS, emphasized that the pace and scope of U.S. production response to low prices is the most critical factor in determining the depth and duration of the price decline.

The result is the U.S. tight oil investment will slow in 2015 by an estimated 40%, he said, bringing month-to-month production growth to a halt by the end of the year. This cut in investment lays the foundation for a rapid escalation in prices toward the end of the decade as demand growth outstrips supply growth, resulting in a new higher oil price environment, which is necessary to support new high-cost development on an accelerated basis. Under this scenario, demand remains relatively weak. Lower prices may allow an upside surprise in demand, but that alone will be insufficient to balance the market. Volatility ramped up in 2014 and is not expected to abate in 2015. This in turn can have a chilling effect on investments. Finally, IHS is calling for the international crude benchmark, Brent, to average $48/bbl this year, rising to $65/bbl in 2016 as the market tightens.

But what that means right now is that there is pain in the oil patch. “There’s a lot of distress as companies gear up for lower production, and there have been layoffs,” Chowdhury acknowledged. “Steel mills are cutting back as there has been less demand from drilling equipment manufacturers and pipeline companies.” He noted that the fall in crude prices has been as swift as it has been sizable. However, most of the drivers that underpin it have been firmly structural, with the current decline the culmination of two years of artificial stability.

He characterized the freefall this way. “The collapse of prices in 2014 may look like a perfect storm, but lack of short-term adjustment mechanisms mean it will rather be akin to a prolonged monsoon. Global supply disruptions, much higher than historical levels since 2011, maintained supply in check for 2012 and 2013. However, the fact that the return of 500,000 bbld from Libya alone tipped the global balance tells you how fragile stability actually was.” He added that there is limited upside for global disruptions. “Even if Libya production were to fall again, other geopolitically stranded barrels are already reentering the market in northern Iraq and potentially from Iran going forward.”

Chowdhury outlined that geopolitical factors formerly kept about 3 MMbbld off the market, which held off price declines—until 2014. Through mid-2014, this off-the-market oil counterbalanced the rise in supply from North America. Then Libyan factions reached agreements that returned 500,000 bbld to the market quickly, causing the first downdraft in prices. In addition, Baghdad and Irbil reached agreement in December 2014 that allowed 400,000 bbld to flow from Iraq’s Kurdistan region this year. “Markets suddenly realized the structural market imbalance,” he said. Meanwhile, the pace of global demand growth continued to slow. Demand growth slowed in 2014 as China’s economic rebalancing weighed on growth.

The IHS director recounted that world oil supply growth has come mostly from North America since 2008. And OPEC’s recent announcement of no production cuts will keep its output level at 30 MMbbld, with the intent of retaining market share and force higher cost non-OPEC production to be shut in. The move is viewed as being directed at U.S. tight oil, Canadian oil sands, Brazil pre-salt, and Russian Arctic development. But despite the OPEC balancing action, and with less non-OPEC supply growth, OPEC production is still expected to exceed market demand, implying a build in global inventories. Furthermore, current OPEC fiscal budgets are stressed at $50/bbl.

Despite the financial pain, OPEC shows no sign of supporting crude oil prices via a production cut, ignoring calls by member states Iran and Venezuela for a downward adjustment. Therefore, the U.S. becomes the swing producer, but other relatively high-cost supplies, such as Canadian oil sands, Brazil, and the Arctic are also in play. The unfolding realignment carries some significant risks, namely political strife in Libya, Nigeria, and Venezuela. Other factors that may unfold include higher Iraqi or other output, and weaker Asian demand.

In the longer term, IHS sees growth in regional refined product demand—except in Europe and North America. Its forecast calls for growth of just under 1% through 2020, with some regions, including Asia, growing at more than 2% a year through the forecast period. At the same time, U.S. crude production is expected to flatten in the second half of this year. In the shorter term, IHS expects crude oil prices to rebound as supply length is worked off the market.

Domestic propane supply factors unfolding under the new energy landscape, Chowdhury said, show gas processing margins falling as NGL prices fell, calling into question whether U.S. gas plant propane production, which has doubled to more than 1 MMbbld in only seven years, will continue to rise at a sustained rate. U.S. refinery production of propane, meanwhile, at about 600,000 bbld, is much lower than gas plant production, and is not changing appreciably. Propane imports from Canada, which were declining, have now stabilized at between 160,000 bbld and 175,000 bbld. In addition, U.S. waterborne imports had fallen to zero, until they were briefly needed last winter.

To sum up, the great oil deflation led to U.S. Lower 48 propane production from natural gas sources to decrease. But it’s not all gloom and doom out there. Chowdhury highlighted that even with the deflation, domestic propane production will continue to increase, albeit more modestly, due to rising production of natural gas, preferential production of wet gas, and attractive, though not as robust, gas processing margins. Refinery supplies of propane should remain fairly stable.

Furthermore, the need for Canadian imports will decline because of the rise in U.S. domestic supply. Regarding Canadian propane, Chowdhury pointed out that inventories there remain high and above the five-year average—at about 12 MMbbl as January 2015 rolled up. Those high stocks are not due to increased production, which has been stagnant, but rather to the U.S. not needing as much propane from its northern neighbor, although Canada needs the U.S. market due to a lack of an export outlet for its supply.

Also, the great oil deflation and its drag on propane prices is leading petrochemical cracker operators to review their feed slate options, Chowdhury said. The crude-to-gas ratio is becoming more favorable for crude-related feedstocks such as propane. He commented that the U.S. is one of the cheapest sources of ethylene in the world—third after the Middle East and western Canada, and that U.S. ethylene plants are running at high rates. Over the past few years, ethane has generally been a much cheaper feedstock, and cheap ethane has been displacing some propane use as cracker feed. But the large drop in propane prices has now led to its cash cost being favorable to ethane.

However, IHS expects propane prices will increase, with U.S. values remaining stable into 2015 and then slowly strengthening versus crude oil. At the same time, ethane prices are also expected to slowly rise as new ethane crackers and export terminals start up. Propane and butane are used internationally as feedstocks for ethylene production, and a weak petrochemical market tends to put downward pressure on LPG prices, whereas a strong market supports prices, Chowdhury said. A weak or strong global economy has the same effect.

U.S. propane exports have set new record highs every year since 2008, the IHS director observed, rising from about 50,000 bbld to more than 400,000 bbld in 2014. Those waterborne exports are expected to continue to increase as supply rises and domestic inventories remain high. While LPG export capacity is expanding rapidly, decisions to build terminals were based on higher price and supply forecasts. “Some new export terminal projects may not be as viable if they were based on $80 to $100 a barrel crude oil,” noted Chowdhury. Nonetheless, IHS is calling for likely North American export capacity to reach 840,877,000 bbld this year, up from 105,962,000 bbld in 2010.

IHS pegged U.S. propane inventories as of the end of January as being 54% above average, adding that stocks soared from average levels in 2013 to very high volumes this year. And both regional and national stocks are all high versus 10-year averages. Propane stocks in the U.S. are expected to remain high during the first half of this year, but closer to average in the second half.

East Coast (PADD 1) propane stocks were reported at 14% above average, and in stark contrast to last winter, even Midwest (PADD 2) inventories were 35% above. Gulf Coast inventories were measured at 71% above average, and the Rocky Mountain/West Coast region (PADDs 4 and 5) came in at 93% above.

The consultancy concluded that primary propane stocks in every region have fluctuated wildly in the last three years, with record high inventories in winter 2012-2013, record low volumes in winter 2013-2014, and new, higher record supplies in 2014-2015. The fluctuations are explained as being the result of both new dynamics and short-term anomalies such as weather and supply outages in the U.S. market. New dynamics include rapid increases in propane supplies from gas processing due to shale gas production, reduced use of propane as ethylene plant feedstock in the first half of 2014, and the need to export surplus propane and build new export terminals. Additionally, although distribution and storage infrastructure has been added, the Cochin pipeline has been lost.

Moving forward, IHS calls for East Coast propane stocks to remain on the high side of the historical range as PADD 1 propane production from gas processing continues at high levels, despite the great deflation. Mid-continent inventories are expected to remain high, but could move lower, depending on Gulf Coast drivers. PADD 2 production growth is forecast to be lower than last year—5% versus 10%—due to the great deflation. “Even with the potential slowdown, we are at twice the production level of 2008,” said Chowdhury. “There’s a potential that [Midwest] stocks will be lower if demand pull from PADD 3 increases due to propane export terminal needs and cracking.”

It follows that U.S. Gulf Coast propane stocks will be dependent on cracking rates and exports. Although PADD 3 is well stocked today, a drop to historical normal inventories could occur due to increased demand from export terminals and ethylene crackers switching to propane. “We have seen propane cracking demand increase from 250,000 bbld in October 2014 to 380,000 bbld in February 2015 for PADD 3,” Chowdhury said. “However, we still see high production in the first half of 2015, leading to stocks remaining high.”

Propane stocks in the Rocky Mountain region are expected to decline, but remain well above the typical range, although the great deflation will cause production to not grow as steeply as previously expected. Also, there is potential to draw down inventories back to historical levels in the second half of this year if PADD 3 exports and demand cause a pull on supplies in the region. IHS further notes that PADD 2 will have to compete with PADD 3 export terminals and crackers for PADD 4 supplies if there is a weather event. This scenario would cause Rocky Mountain inventories to fall to normal levels.

Propane stocks in the West Coast region are forecast to remain about average. Around 80% of PADD 5 propane supply is from refining. The great deflation will not change production much this year, and fairly average inventory levels should be maintained. In addition, IHS emphasizes there are no propane-based crackers in PADD 5, making cracking economics and chemical demand irrelevant.

Chowdhury concluded that IHS forecasts are subject to higher or lower crude oil prices, which affect global LPG prices. Substantially higher or lower oil prices would also affect propane production. U.S. propane inventories need to be robust because if volumes fall too low, propane prices would ultimately rise, deterring exports. Further, rising U.S. natural gas production will continue to generate large, but lower than previously seen, propane volumes. The great deflation will slow the pace of export growth, but nonetheless there will still be strong growth and increased exports. Propane production under the great deflation will be less affected than U.S. crude production, but the propane impact will be significant and will vary regionally.

On the demand side, feedstock demand for ethylene and propane dehydrogenation (PDH) will absorb some North American propane, but surplus propane will still have to be exported from the U.S., with most going to Asia. At the same time, propane inventories are growing and will need to be cleared by exports and cracking. But North American prices must be lower than in other regions to incentivize exports. Finally, gas processing economics are enhancing propane recovery, and propane will remain an attractive cracker feedstock versus naphtha in most parts of the world.

In other business, Supply and Logistics Committee chairman George Koloroutis noted that the propane industry is currently experiencing “unpleasant times,” with inventories whipsawing from low to high and prices “whipping back and forth.” He reported that a joint project between NPGA and IHS to publish a U.S.- and PADD-level primary propane inventory trend report would soon be completed and distributed.

Contained in the project data will be trigger mechanisms to alert NPGA and the industry to launch emergency actions. Such actions, for instance, would be tripped when the Energy Information Administration reports propane inventories within states have fallen below the five-year average.

A highly spirited and lengthy debate ensued at the Feb. 9 marketer and state/district directors meeting in San Diego. Up on the agenda was a proposal by the CETP Certification Committee finalizing certificate renewal and skill evaluator training. Under a directive by NPGA’s Executive Committee, the committee has been working for considerable time with ITS (Industrial Training Services; Murray, Ky.) to develop and finalize all elements of CETP certificate renewal, including a three-year validation from date of issue and a three-year phase-in period to renew, which was to begin June 1, 2015. Skill evaluator training and registration was scheduled to become effective March 1, 2015. Similarly, proctor training requirements were to be modified so proctors would only need to renew every three years, rather than annually. But as the saying goes, the devil was in the details.

After exhaustive debate, with both proponents and opponents arguing passionately for and against an “expiration” of CETP certification, meeting participants, recognizing they could not reach consensus, voted unanimously to refer the matter back to the NPGA board of directors. Subsequently, the board moved to table implementation of any elements related to CETP certificate renewal, and referred the matter back to the Executive Committee so it could provide additional direction to the CETP Certification Committee.

Debate hinged on whether or not renewal requirements should be instituted by NPGA, and if so, in what form. Opponents generally objected to a mandate that superseded a company’s purview. Proponents called attention to the advice of legal counsel. Lawyers representing the propane industry have advised that proof of refresher training and continuing education is an effective defense tool before juries and judges considering incident claims.

The Governmental Affairs Committee reported that the 113th Congress was the most successful legislative session NPGA has ever experienced. Congress passed the Propane Education and Research Act of 2014 by unanimous voice vote in both the House and Senate, and President Obama signed the bill into law on Dec. 18. Two other laws related to winter 2013-2014 were also passed. The Home Heating Emergency Assistance Through Transportation Act of 2014, introduced on Feb. 25, 2014, was passed by Congress on March 13 and signed by President Obama on March 21, all in only 23 business days. Also enacted was the Reliable Home Heating Act of 2014.

“While conventional wisdom holds that the 113th Congress was among the least productive sessions in history, it was quite the opposite for the propane industry,” said NPGA president and CEO Rick Roldan. “Most notably, NPGA’s advocacy team was able to secure enactment of three industry-specific, stand-alone bills. Among them two hours-of-service relief/efficiency bills and H.R. 5705, which ultimately will eliminate the Department of Commerce restriction on PERC activities.”

He added that the advocacy team was also successful at reauthorizing the alternative fuels infrastructure and 50-cent-per-gallon fuel credits for 2014. The Section 179 expensing provision, which was recently elevated in priority by the Governmental Affairs Committee, was also reauthorized. Roldan pledged that in the 114th Congress, NPGA would endeavor to make the 179 provision permanent.

“Finally, our team, together with advocates from the trucking industry, won adoption of a statutory provision in the omnibus spending bill that will ease two recently imposed hours-of-service requirements. Our experts believe that these restrictions have reduced transportation efficiency by 10% to 15%. Roldan explained, “Specifically, the legislative language eliminates the requirement—through fiscal year 2015—for two consecutive 1 a.m. to 5 p.m. rest periods prior to restart. The provision under the current rules that allows only one restart per week was also eliminated. Staff is grateful to [NPGA] chairman David Lugar for initially raising this issue as a priority.

“I urge the board to recognize that such a level of accomplishment, in an environment of partisan rancor and procedural anarchy, can only be described as extraordinary. This is the same adjective that I would use to describe the team that produced these results.”