The Fickle Face of Fuel and Feedstocks

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

graham@/lipinski@ssrllc.com

Novemmber 20th, 2012

The Fickle Face of Fuel and Feedstocks

Never put your trust in an energy commodity and certainly never let it hold on to your money while you go away for a few days.

One thing that we have learned over the last 40 years is that energy markets can at times be very volatile and unpredictable, even though at other times there can be extended periods of relative calm. These patterns are not simply a reflection of supply/demand dynamics, as the energy markets are also impacted by policy, speculative trading and security of supply.

We would argue that the price anomalies between different energy products are predictable over the long term as new investments and technologies help return the pricing levels to the “normal” level based on the energy value inherent in each product. However, the length of the “long term” is very unpredictable.

It is the steady state that tends to drive behavior – I am only indifferent about a fuel/feedstock if there is no economic difference. Once there is a margin difference, I may not be able to change what I am doing today, but that does not mean that I am indifferent. I covet that which would give me a higher margin or lower cost and I work out how to get it. Moreover if I can get more money by producing one fuel/feedstock versus another, I will again become particular and strive to discover and produce more of the higher valued one, often at the expense of production of the lower valued one.

Not everyone can exercise their desire to be choosy at the same time so you do not get a fast demand reaction or a fast supply reaction to exploit the margin of opportunity. It creeps up on you. In the Exhibit we show the annual relative growth of crude oil and natural gas and the relative price. The data is taken from the BP Statistical Review of World Energy and is for the US. While the correlation is not great the message is there – relative price matters.

Today in the US energy market we see the effects of a couple of these pricing anomalies in the way companies are behaving. High oil prices are leading to increased development in the oil rich shale areas as well as in the investment to get the additional crude to market. Much of this crude has associated gas, and as we improve the logistics to move the crude (allowing for increased crude production) we also increase the volume of associated gas hitting the market. This leads to more methane, more ethane, more propane and more butane. At the same time, the “gas guys” are looking for wet gas as the co-products are worth more than the methane – net result, more propane, more butane and more ethane.

What we see as a result is a natural gas market that remains very well supplied despite a significant scaling back of “dry gas” drilling, but we are also seeing surpluses build of propane and butane. Propane, while retaining its seasonality, has effectively decoupled from crude oil over the last 12 months and the butane/crude relationship is breaking down also and should follow the same pattern seen in the chart for propane (butane has an alternative use in gasoline blending in winter and this may add some price support near-term). We talk about natural gas as a possible competitor for gasoline in trucks and cars but at current pricing propane also looks promising, and the logistics around using propane as a fuel are likely to be easier to solve than natural gas.

Propane now, and possibly butane later, become attractive feedstocks for basic chemical producers again. The result is that this will put downward demand pressure on alternatives that have other outlets in gasoline production, which ultimately backs off demand for crude oil. Furthermore, some of the imbalances that have been created in the basic chemical markets over the last two years because of the extreme attractiveness of ethane as a feed may be redressed if ethane is substituted by propane where possible. However, the ethane has no-where else to go, so its price will fall further. Other basic chemicals will increasingly be made directly from cheaper propane and butane – again at the marginal expense of crude oil.

At the margin the world is reacting to the high price of crude by using less of it and at the same time trying to find more of it. As we find more of it we are increasing the supply of NGL’s (in the US) and through lower prices we are encouraging higher demand for them. Without the security premium in the crude oil price it would likely be a lot cheaper today – how much cheaper is of course a big debate. One day (the question is when) we are likely to wake up to a world awash with crude oil and a US economy that this more dependent on natural gas and NGLs. The price gap will close – it’s just a question of when – so be careful about betting real money on a sustained high price/value difference.

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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