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US Economy

The US Economy’s Energy-Security Blanket

By Elliott H. Gue, on Mar. 5, 2014

The potential fallout from Russia’s military incursion into Ukraine’s Crimean peninsula dominated headlines over the weekend and hit global markets hard on Monday.

Soviet leader Nikita Kruschev gave Crimea, located on the northern shores of the Black Sea, to Ukraine in 1954, even though most of its inhabitants were ethnically Russian.

And Russia has retained a strong military presence in the region. Sevastopol, located on the southwest coast of Crimea, is home to Russia’s Black Sea fleet.

Political relations between Russia and Ukraine have been strained for years, with a series of disputes over natural-gas prices ratcheting up tensions between the two neighbors. 

Russia supplies about half the Ukraine’s natural-gas needs, while Ukrainian pipelines transport natural gas from the neighboring energy giant to Europe.

On two occasions over the past decade, these disagreements resulted in fuel shortages for Russia’s European customers during the winter heating season, a period of peak demand.

More recently, tensions escalated rapidly after the ousting of Ukraine’s Moscow-backed President Victor Yanukovich in late February, following massive protests in Kiev spurred by his rejection of a proposed free-trade pact with the EU.

The rhetoric between the US, EU and Moscow has heated up, with several nations calling for economic sanctions against Russia until the country pulls its troops for the Ukraine.

Heightened tensions in Crimea should drive up global energy prices, at least in the near term.

The world’s second-largest producer of natural gas and No. 3 in liquid hydrocarbons (oil and natural gas liquids), Russia supplies about a quarter of Continental Europe’s gas and exports about one-third of these volumes through Ukrainian pipelines.

Source: Energy Information Administration

The start-up of the Nord Stream pipeline, which travels underneath the Baltic Sea and transports Russian natural gas to Germany, has reduced Gazprom’s (Moscow: GAZP, OTC: OGZPY) dependence on Ukrainian pipelines to deliver volumes to Continental Europe.

Nevertheless, the rapidly emerging crisis could still cause significant supply disruptions in European gas markets. And if the US and EU impose sanctions on Russia, the energy giant could curtail some of its exports in retaliation.

US Energy Security

In America’s Energy Advantage (available exclusively to Capitalist Times Premium subscribers), we explained how surging oil and gas production from North America’s vast shale fields has reduced US dependence on imported oil and natural gas, lowering costs for American consumers and revitalizing the nation’s manufacturing and industrial base.

But the upheaval in Crimea illustrates another huge advantage of America’s push for energy independence: insulation from the geopolitical risk premium in global oil and gas markets.

Much of the world’s oil supply comes from politically unstable regions that are prone to supply disruptions.

For example, periodic unrest and public protests continue to curtail Libyan oil production almost three years after the nation’s civil war ended. Meanwhile, hyperinflation in Venezuela has starved its national oil company of cash, making it difficult for the country to maintain its hydrocarbon output despite elevated oil prices.

As the US pushes toward energy liberty, a growing abundance of domestically produced oil and natural gas provides a degree of insulation against supply shocks in the global market.

Consider the difference in the 12-month strip price for UK- and US-traded natural gas. The strip averages the next 12 months of gas futures prices to smooth out short-term fluctuations and approximate what consumers likely will pay for gas over the course of a years

The Crimean conflict has sent London-traded natural-gas strip prices soaring to $10.60 per million British thermal units (mmBtu) over the past few days. Meanwhile, natural-gas futures that trade on the New York Mercantile Exchange have declined to about $4.75 per mmBtu. 

With North America producing more than enough natural gas to meet domestic demand, any disruption to Russia’s ability to export the fuel won’t affect the US one iota.

And major gas consumers in the EU likely will be keen to diversify their supply by eventually importing volumes from North America, once a slew of terminals to liquefy and export natural gas come onstream over the next several years.

Meanwhile, growing domestic production of light-sweet crude oil and limits on the volumes that the US refinery complex can process should ensure that West Texas Intermediate (WTI) and Light Louisiana Sweet (LLS) crude oil trade at a significant discount to Brent crude oil and other global benchmarks.

Although the recent rally in WTI has narrowed the price gap relative to Brent to about $5.70 per barrel, the near-term strength in the US benchmark reflects two temporary tailwinds: harsh winter weather that has driven demand for heating oil and the start-up of TransCanada Corp’s (NYSE: TRP) Keystone Gulf Coast pipeline on Jan. 22, 2014.

The Keystone Gulf Coast pipeline stretches from Cushing, Okla.–the delivery point for WTI–to Nederland, Texas, and has helped to alleviate the glut of crude oil that had built up in Cushing because of rising inland production and insufficient southbound takeaway capacity.   

Coupled with Enbridge (TSX: ENB, NYSE: ENB) and Enterprise Products Partners LP’s (NYSE: EPD) Seaway pipeline, the Keystone Gulf Coast pipe has shifted the glut of crude oil to the already well-supplied Gulf Coast.

Source: Bloomberg

And when the US winter heating season draws to a close this spring, expect reduced demand for heating oil to kick out the second leg supporting the recent rally in US oil prices.

With the US producing more than enough natural gas and light-sweet crude oil to meet internal demand, the domestic economy remains insulated against potential supply shocks in the global energy market.

US Economy Warms Up

In February, the Institute for Supply Management’s Purchasing Managers Index (PMI) for the US manufacturing sector rebounded to 53.2; the widely watched indicator had plummeted to 51.3 in January from 56.5 in December 2013.

PMI values greater than 50 indicate economic expansion, while readings above 55 historically have corresponded to annualized GDP growth of at least 3 percent.

The second half of February brought a welcome bit of break in the extremely cold weather, which fueled the better-than-expected improvement in PMI. And the new sales component of PMI–a leading indicator for the index as a whole–surged to 54.5 in February from a reading of 51.2 in January.

Against this backdrop, investors should regard any pullback in the stock market as an opportunity to add exposure to our favorite cyclical names. 

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