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Trader's Corner - Presented by LP Gas. Propane Market Insights from Cost Management Solutions
Higher crude prices may elevate propane prices through winter
Any attempt to forecast where propane prices will be in the future begins by trying to establish where crude’s price will be in the future. That may not seem correct given that about 85 percent of propane supply comes from natural gas processing. One would think that the price of propane would be more closely related to the value of natural gas. We can accept that the prices of gasoline and diesel are strongly influenced by crude because refining a barrel of crude produces those products. Processing crude produces only about 15 percent of propane supply.

Despite this seeming contradiction, propane and other natural gas liquids are valued relative to crude. Once the methane is separated out at the natural gas processing plant, the ethane and heavier natural gas liquids values are related to crude, not natural gas. We believe this practice comes from the fact that much of the butanes and most of the natural gasoline become blending components for gasoline production. Regardless of the reason, the value of crude has a very strong influence on the value of propane.
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Propane’s own fundamentals, such as how propane supply, demand and inventory are running at any given moment, also influence propane’s price, but its base value is established by crude. Imagine going to a sports complex that has three football fields where the pricing game of propane is played. There is the low-priced field, the normal-priced field and the high-priced field. The field on which today’s propane pricing game will be played is determined by the price of crude. Once the field is determined, then propane’s own fundamentals will determine where on the field its price is positioned. We report propane’s value relative to crude a lot in our analysis. That is a measure of where propane is positioned on the pricing field, but again, it was the price of crude that determined the pricing field the game is being played upon.

Right now, the pricing game is being played on the high-priced field, with crude above $90 per barrel. There is a lot of worry about crude supply due to the war in Ukraine. Those worries drove crude to $123.68 per barrel in June, and it is those worries that keep the game being played on the high-priced field. But there are some traders that believe the venue needs to be changed to the normal-priced field. Their argument is that crude demand is going to drop because of a global recession making the current price too high.

Their arguments have actually been the primary driver of crude prices since June 9. Thus, we have seen WTI crude fall to as low as $85.73. If the price falls below $80, we would say we are playing on the normal-priced field. At the same time, there are plenty of reasons to believe that the game is going to remain on the high-priced field. So, before we fold up our lawn chairs and head over to the normal-priced field, let’s consider the possibility that a venue change is unlikely.
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1) Lack of global spare crude production capacity: OPEC+ members have recently revealed that they have essentially no spare production capacity. In the past, they are the only ones with spare capacity as other nations produced at capacity. The United Arab Emirates (UAE) and Saudi Arabia generally held what spare capacity the world had available. The UAE now says it is producing at capacity. At the same time, Saudi Arabia said that what spare capacity it has is not readily usable. It would take some time to bring it online. A lack of spare production capacity to deal with unforeseen events makes traders very nervous and puts upward pressure on prices.

2) End of petroleum reserves releases: The U.S. has been releasing 180 million barrels of crude from reserves at the rate of 1 million barrels per day (bpd). Those releases were originally scheduled to end next month, but another 20 million barrels added to the total recently. We might point out that would take the releases to just past the midterm elections in November. Coincidence? No. Other consumer nations have been releasing crude from reserves, as well. These reserves releases provide a false sense of supply. The releases were done to offset expected supply losses from Russia. Yet Russia’s production has largely continued to flow. One would have hoped that the U.S., and others dependent on Russian crude supplies, would have spent the six months these reserves releases gave them to increase their own production. We have seen little development in that arena, with the focus remaining on much longer-term replacements for crude. U.S. producers have increased production at best about 600,000 bpd since the reserve releases began – and that may be an optimistic estimate. We have seen little to suggest the European Union (EU) has increased its hydrocarbon production.

3) EU sanctions on Russian crude should become more effective: As we have mentioned, Russia’s crude has mostly continued to flow since the EU put an embargo on it. However, the embargo has not been fully implemented yet. We have seen estimates that Russian crude exports could decrease by 1.2 to 1.6 million bpd when the embargo is fully implemented. At least one estimate believes the export decline will be 2 million bpd in 2023. If these estimates turn out to be true, crude supply will likely be at a deficit to demand. That should put upward pressure on prices unless the worries about demand destruction do turn out to be legitimate. Just as the reserves releases run out, the world could be dealing with a real reduction in Russian crude supply.
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The above list has a reasonable degree of certainty, which would suggest that the pricing game is likely to remain on the high-priced field. A change in venue to the normal-priced field would likely come from events that are much less certain, including the following scenarios:

1) War ends: Russia ends its invasion of Ukraine and withdraws its troops. The EU quickly removes sanctions, providing more supply certainty. There are those who believe Putin’s time is near its end unless there are successes in Ukraine soon. It is awfully hard to make business decisions based on the potential for a coup d’état that would quickly change the political landscape in Russia. Otherwise, its hard to see Putin ending the war in any manner that would be acceptable to the Ukrainians.

2) Global recession that kills demand: This may be more likely, especially if the war doesn’t end. Central banks, especially the U.S. Federal Reserve, are absolutely committed to lowering inflation. The Fed has admitted that it is willing to slow the economy to achieve that aim. But one thing we have seen over the years is that it is very hard to kill energy demand. In fact, U.S. total petroleum products supplied is higher now than before the war began despite extremely high prices. Part of that we believe is increased energy exports, so domestic demand is probably down some. But have you also seen that more companies are requiring employees to return to offices and no longer work from home? Companies, especially tech, are dealing with a major drop in productivity and want employees back in the office. Schools are opening back up, as well. Airline and other forms of travel are increasing. This is going to increase energy consumption. U.S. unemployment is at 3.5 percent, so there are still plenty of folks going to work. Economic activity has slowed over the last two quarters, which is technically a recession, but that flies in the face of the high employment rate. We do have to consider that the employment rate is a little misleading given an increase in those who are no longer seeking employment, but its not like economic activity has completely collapsed. The world’s second largest economy and leading energy importer, China, is seeing its economy slow, but we are still seeing estimates of 4 percent growth. Slow growth is not quite the same as contraction that would lower energy demand.
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We wish we could say with certainty where crude will be priced in the future. With that knowledge, we could give you a much better estimate on where propane prices will be in the future. Based on the above and some other considerations not discussed, we would lean toward crude prices remaining elevated, meaning the game is going to continue to be played on the high-priced field. Given propane’s relatively low inventory levels at the moment and good export demand, we would expect its value to crude to remain around 50 percent, which is about where it is now. The educated guess is that we remain in the current pricing environment through this winter. The risk to higher prices seems more likely than the risk to lower prices. A weak winter could drive propane’s value relative to crude down, but again, it’s hard to make predictions based on weather forecasts. It seems every time we have tried to do so we have gotten surprised.

During the recent dip in propane prices, we saw more hedging activity. We believe those were good, smart, educated buys. We said months ago that we believed that buys anywhere around a dollar in this environment are more likely to be an asset than a liability. That still appears to be the case. Remember, retail propane suppliers are traditionally slow to respond to rising prices, which eats into margin. We tend to manage pricing in a falling market better. So, if we are going to error, it is better to do so trying to manage the risk to higher prices.
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About Cost Management Solutions
Cost Management Solutions LLC (CMS) is a firm dedicated to the analysis of the energy markets for the propane marketplace. Since we are not a supplier of propane, you can be assured our focus is to provide an unbiased analysis.
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