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Russia reemerging as military power possibly more important than pipelines, production disruptions
by None
Midland Reporter-Telegram
The big story this week in the energy markets was Russia and its conflict with the former Soviet republic of Georgia. Late last week, Georgian forces invaded a southern province called South Ossetia. The province was legally under the control of Georgia, but much of the population was sympathetic to Russia and wished for secession from Georgian rule. After the Georgian invasion, Russian military forces produced a very swift counter-attack, the speed of which was probably only possible if they had prior knowledge of Georgia's intent.
It took just 48 hours for Russian forces to drive the whole of the Georgian military out of South Ossetia. The next day Russia pushed its military into Georgian territory as a final gesture that it was once again a serious player on the military stage. Shortly thereafter, a ceasefire was negotiated and the conflict ground to a halt.
Why is this important to energy prices? First and foremost, Russia is a huge oil exporter and much of Europe depends on Russian oil. Any large scale attacks would certainly interrupt oil production or at the very least, oil transportation in the region. Thankfully, this initial conflict was quite small and quite contained. Second, there is a bevy of important pipelines that cross through Georgia. Any substantial damage to any of the major pipelines could have serious consequences to oil distribution throughout the region. As such, Russian military forces took special care not to severely damage any pipelines in the region.
Quite possibly the most important lesson from this conflict was not about pipelines or production disruptions, but about the reemergence of Russia as a military power. Russia has not mounted a serious military offensive outside of its own borders since the 1980s. It is possible that with the U.S. fighting two wars on stretched military resources and Europe being so dependant on Russian oil that Russia felt it could act with impunity in this situation. Also, because the conflict was so small and contained, it is possible that Russia felt this would be a good time to show the world how quickly and precisely it could mobilize its military for an attack without an overextension of its own resources.
Whatever the reason behind Georgia's initial invasion and Russia's overly strong response, the impetus for more military activity in the region should have been bullish for energy prices. Strangely, energy prices fell sharply on Friday of last week and both Monday and Tuesday this week. Clearly, the momentum for energy prices remains to the downside and even conflicts in regions that were previously thought of as calm will not be enough to push prices higher in the short run.
On the domestic front this week, energy data released from the Department of Energy on Wednesday sparked a rally in the entire commodity sector. Most striking in the report was the larger than expected drop in gasoline inventories and the surprise drop in distillate inventories. On its face, the drop of 6.4 million barrels of gasoline inventories seems like a bullish event, but the data may not have been as bullish as some traders thought. Gasoline inventories as reported on Wednesdays are arrived at by adding production and imports to the previous weeks inventories and then subtracting usage. This week, we saw huge drops in both gasoline production and imports. Those two aspects went mostly overlooked in the hours immediately following the energy report. It wasn't until late Wednesday and Thursday that the sellers finally took control of the market.
The drop in gasoline production is easy to explain. Refiners lowered their capacity utilization ratio to a staggeringly low level of 85.9 percent this week. This is a level mostly associated with the spring and fall maintenance seasons. It is also a trick that refiners can use to temporarily boost crude oil inventories while causing refined product inventories to fall. They do this with the hope that product prices will rise in response to the inventory drop while they hope that crude prices will fall due to the inventory builds. In effect, they try to artificially widen the crack spread.
The drop in imports is another interesting piece. Over the past four weeks, gasoline imports have fallen by almost 400,000 barrels per day or just shy of 3 million barrels per week. That accounts for nearly half of the inventory drop in gasoline. Again, the reasoning behind the cut in imports is also an attempt to widen crack spreads for the refiners. Also this week, after-effects from Hurricane Edouard are undoubtedly showing up in the import data as the storm did cause some disruptions to deliveries in the Gulf.
Demand, the piece that makes the most sense to focus on, continues to show weakness. On a year over year basis, demand is still lower by more than 1 percent this week. This marks the 16th consecutive week of year over year declines in demand -- an unprecedented feat not seen in more than a decade. As long as demand remains weak, refiners have little incentive to make more gasoline and therefore little incentive to import finished gasoline. As it has been since the beginning of July, fundamental weakness in energy demand both in the U.S. and abroad are going to continue to be the most important data to watch. As we exit the summer driving season, every analyst will be looking for evidence that the demand destruction that we've seen this summer is due to some permanent changes in consumption habits and not the temporary effects of foregone summer vacations.
Portions of this article were produced on 8/15/08 by Nathan Golz, Futures Researcher. Its publication is a collaborative effort and the information is obtained from sources considered reliable, however accuracy is not guaranteed by A.G. Edwards. Past performance is not a guarantee of future results and additional information is available upon request (432)684-7335. A.G. Edwards is a division of Wachovia Securities, LLC.
It took just 48 hours for Russian forces to drive the whole of the Georgian military out of South Ossetia. The next day Russia pushed its military into Georgian territory as a final gesture that it was once again a serious player on the military stage. Shortly thereafter, a ceasefire was negotiated and the conflict ground to a halt.
Why is this important to energy prices? First and foremost, Russia is a huge oil exporter and much of Europe depends on Russian oil. Any large scale attacks would certainly interrupt oil production or at the very least, oil transportation in the region. Thankfully, this initial conflict was quite small and quite contained. Second, there is a bevy of important pipelines that cross through Georgia. Any substantial damage to any of the major pipelines could have serious consequences to oil distribution throughout the region. As such, Russian military forces took special care not to severely damage any pipelines in the region.
Quite possibly the most important lesson from this conflict was not about pipelines or production disruptions, but about the reemergence of Russia as a military power. Russia has not mounted a serious military offensive outside of its own borders since the 1980s. It is possible that with the U.S. fighting two wars on stretched military resources and Europe being so dependant on Russian oil that Russia felt it could act with impunity in this situation. Also, because the conflict was so small and contained, it is possible that Russia felt this would be a good time to show the world how quickly and precisely it could mobilize its military for an attack without an overextension of its own resources.
Whatever the reason behind Georgia's initial invasion and Russia's overly strong response, the impetus for more military activity in the region should have been bullish for energy prices. Strangely, energy prices fell sharply on Friday of last week and both Monday and Tuesday this week. Clearly, the momentum for energy prices remains to the downside and even conflicts in regions that were previously thought of as calm will not be enough to push prices higher in the short run.
On the domestic front this week, energy data released from the Department of Energy on Wednesday sparked a rally in the entire commodity sector. Most striking in the report was the larger than expected drop in gasoline inventories and the surprise drop in distillate inventories. On its face, the drop of 6.4 million barrels of gasoline inventories seems like a bullish event, but the data may not have been as bullish as some traders thought. Gasoline inventories as reported on Wednesdays are arrived at by adding production and imports to the previous weeks inventories and then subtracting usage. This week, we saw huge drops in both gasoline production and imports. Those two aspects went mostly overlooked in the hours immediately following the energy report. It wasn't until late Wednesday and Thursday that the sellers finally took control of the market.
The drop in gasoline production is easy to explain. Refiners lowered their capacity utilization ratio to a staggeringly low level of 85.9 percent this week. This is a level mostly associated with the spring and fall maintenance seasons. It is also a trick that refiners can use to temporarily boost crude oil inventories while causing refined product inventories to fall. They do this with the hope that product prices will rise in response to the inventory drop while they hope that crude prices will fall due to the inventory builds. In effect, they try to artificially widen the crack spread.
The drop in imports is another interesting piece. Over the past four weeks, gasoline imports have fallen by almost 400,000 barrels per day or just shy of 3 million barrels per week. That accounts for nearly half of the inventory drop in gasoline. Again, the reasoning behind the cut in imports is also an attempt to widen crack spreads for the refiners. Also this week, after-effects from Hurricane Edouard are undoubtedly showing up in the import data as the storm did cause some disruptions to deliveries in the Gulf.
Demand, the piece that makes the most sense to focus on, continues to show weakness. On a year over year basis, demand is still lower by more than 1 percent this week. This marks the 16th consecutive week of year over year declines in demand -- an unprecedented feat not seen in more than a decade. As long as demand remains weak, refiners have little incentive to make more gasoline and therefore little incentive to import finished gasoline. As it has been since the beginning of July, fundamental weakness in energy demand both in the U.S. and abroad are going to continue to be the most important data to watch. As we exit the summer driving season, every analyst will be looking for evidence that the demand destruction that we've seen this summer is due to some permanent changes in consumption habits and not the temporary effects of foregone summer vacations.
Portions of this article were produced on 8/15/08 by Nathan Golz, Futures Researcher. Its publication is a collaborative effort and the information is obtained from sources considered reliable, however accuracy is not guaranteed by A.G. Edwards. Past performance is not a guarantee of future results and additional information is available upon request (432)684-7335. A.G. Edwards is a division of Wachovia Securities, LLC.
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