Strikingly these days, no one seems to have any clue what the **** is going on with oil's relationship to risk premia or expectations. The suggestion of a potential Saudi output cut in September reminded the market that spare capacity is tight and the fate of any deal between the US and Iran unknown. Then a few days later, Saudi Aramco is now signaling its marking down prices for October deliveries to Asian consumers. The eruption of protests and fighting in Baghdad's green zone after the cleric Moqtadar Al-Sadr announced his retirement from politics (again) and next thing you know, Brent's trading $5+ dollar a barrel lower and every trader-come-lately on Twitter is retweeting Saudi-backed news outlets that funnel information on any Iran deal out to justify calling the US weak. Brent's back around $100 a barrel once more despite a brief bout of speculation from commentators and others that exports from Iraq might take a huge hit:
So what's the beef? Like love (if Richard Hell is to be believed), market movers come in spurts, in dangerous flirts. Discerning a technical correction driven primarily by financial repositioning vs. a shift in fundamentals is always messy. Note that Aug. 30 is excluded from the following chart, but WTI – the West Texas Intermediate crude benchmark for you non-commodity nerds – has corrected downwards a bit but is still trading at a similar price point:
Before diving into a few ideas on what to follow more broadly, it's worth revisiting the bizarre attack lines on US/Western sanctions policy referring to Russia 'recapturing its oil riches'. Motivated reasoning is a dangerous thing, not that the Wall Street Journal or other outlets in need of a critical lede particularly care.
First off, the loss of access to USD and Euros de facto means that whatever these 'riches' are, they cannot be easily spent on imports. As I often say, the USD-denominated value of key exports like crude oil inflates Russia's GDP because of how it's accounted for. The actual purchasing power of any given US dollar or Euro is not represented by the official exchange rate, but rather by either offshore USD/ruble exchange rates or which companies are willing to risk taking payment in the first place. Money is social after all, not an objective construct on a balance sheet divorced from the complexities of human behavior and daily exchange. What has somehow been lost by a focus on the USD value of Russia's current account surplus is how a combination of a stronger ruble linked to mandated currency conversions, production declines (which will continue despite the shorter-term recovery), and the Ministry of Finance's neo-Soviet obsessions avoiding a ruble considered to be "too weak" feed into the fiscal system. Thanks to Janis Kluge for doing the lord's work pulling stuff out from the CBR. I took a quick look at their response to MinFin's newly proposed budget rule and he immediately spotted the crux of the problem:
As prices and output fall, so do revenues. The usual budget rule is fixed at about $42 a barrel + an annual inflation adjustment from when it was adopted (it was initially worked out in 2015-2016). Revenues collected from taxation above that level are parked aside mirroring the sterilization measures taken by Kudrin in the early 2000s to avoid an over-valued ruble. By setting aside said revenues, the budget rule acts as a hard brake on spending since MinFin always wants to minimize the deficit as well. The figures above are nominal. Imagine a real terms adjustment after 2-3 years of inflation in the range of 7-15% in annualized terms. This is disastrous to reimpose given that tax revenues from consumption will continue to fall alongside incomes, compounding the budgetary constraint. Worse, MinFin is looking at using money parked aside as tools to manage the exchange rate at a time when it'd be far more effective to reconsider the construction of Russian trade policy in light of the sanctions regime. The ruble's exchange rate is 'real,' but the liquidity of the market for rubles has collapsed.
So in light of that, what's happening on the oil market is quite interesting to track. The will they, won't they of an Iran deal continues to haunt all of us. I'm a lot more bearish at the moment because of the degree to which efforts are being made to muddy the communications context by anti-deal lobbies and the frankly unprecedented step being taken by Israel of appealing to a friendly congress with an intelligence briefing that I suspect will lay out what they will do regardless of any deal if it's agreed. As of last week, Russian crude flows to Asia had fallen to 5-month lows at a total of 1.59 million barrels per day. In practical terms, Europe is still grabbing volumes of Urals blend before the embargo takes effect at the end of the year followed by the EU's refined products embargo on Russia. Turkey is stepping in to absorb more imports as European importers redirect purchases away. Other buyers are clearly there, but Middle Eastern exporters want to grab European market share for diesel now while the getting's good and may well look to grab more of China's market in the months ahead into next year as Russian output falls. They will defend prices at $90 a barrel with talk of output cuts. The supply side is a mess with uncertainty. Iran will also be able to quickly release something over 90 million barrels of oil in storage in the event of sanctions relief. Call that at least 500k in output up to 1 million bpd over a 3-6 month ramp up to offset what I suspect will be a similar decline in Russian output because of EU policy, especially the diesel ban which will hammer Russian refiners and reduce domestic throughput since they won't have markets to serve anymore.
Then there's Venezuela. Quiet talks are ostensibly ongoing for a potential Chevron return to the country, touting promises to up output over 1 million bpd within 18 months. That's entirely up the Biden administration with no discernible movement, yet a sort of inevitable gravity that something has to change. Then you have hard constraints on US output from finding enough workers, access to steel pipe and other metallurgical inputs, and the slow roll effect of rising interest rates driven by Fed policy. Outside the Permian, output isn't rising. This data's dated back to May but tells the story:
Maybe plummeting construction demand in China frees up more steel, even with the incoming output curbs from power shortages. Maybe a slowing US labor market makes it a little easier to source talent for oil firms (I'm quite skeptical of that though). Finally add to all this uncertainty about what modeling demand looks like in a world where WFH is taking off:
Cards on the table, I've been bearish on oil demand growth since 2018-2019. EVs have accounted for roughly 25% of total sales in China this year. That's the world's largest single automotive market with likely surges in sales, production, and grid investment in North America by 2025 catching up to levels more similar to the EU faster than anticipated.
Bottom line is no one has any clue how to make heads or tails of the current environment with much certainty, but we know this. The economy (China) responsible for over a third of demand growth in the last two decades is electrifying its vehicle fleet quickly and seeing its growth model collapse and the United States no longer looks like such a laggard on the electrification front. Prices will remain elevated in nominal terms from existing supply constraints with a lot of potential for downwards movement from shifts in US sanctions policy and the obsolescene of past demand assumptions. Not for nothing that OPEC is predicting the market's surplus to rise from 600k bpd in October to 1.4 million bpd in November. With inflation adjustments, the degree to which prices are elevated is also not so impressive, nor will it provide any respite for the Russian budget as production declines overtake the benefits of higher price levels in no small part thanks to MinFin's budget rule obsession. The times, they are a-changin'. Traders will moan that the futures market is broken. It's not so much broken – it's doing the best it can – but it's incapable of incorporating all the moving parts at the moment to produce a reliable price signal. Prices aren't lying, they're reflecting just how complicated the situation has become. Oil markets have never had so many things to juggle in recent memory. Global growth is clearly weakening with often dollar-indebted emerging markets + China/India – a majority of global consumption since 2013 – slowing down from a strong dollar and their own structural imbalances. My guess is a $10 move in a day isn't so crazy when you look at the macro picture.
- Despite Luttwak's pretensions, it turns out Russia is not self-sufficient. The government has released a new strategy to ensure adequate access to strategic minerals. It covers all the hits – lithium, molybdenum, helium, nickel, graphite, and more. Reality is that Russia likely has reserves of everything it needs. That doesn't make them commercially viable and doesn't solve the fact that there's a huge capex push needed to refine inputs like graphite, a process made more difficult still by Russia's limited access to foreign tech doing just that right now.
- State aviation companies employing the nation's body of air traffic controllers are warning that the sector is about to get hit with wage arrears. In the current climate, Mishustin can't pretend he's Reagan and break a strike. They have to pay them or risk industrial action interrupting increasingly frail transport systems. Things are way worse than the topline GDP data is showing and the upwards revisions are mostly bunk.
- According to the Audit Chamber, the share of budget expenditures considered classified in H1 2022 rose from 15.2% in 2021 to 18.6%. There's every reason to expect that figure to rise a bit more in H2, though we'll see. That means about 2.35 trillion rubles of spending is secret from any public scrutiny over that period. The figure peaked over 21% in 2016 when the government paid down a bunch of defense sector debts – watch that space given the renegotiation of credit terms and rolling over debts from 2020 to prop it up during the pandemic.
- Consumer spending is not recovering no matter what officials say. Over the last year, the nominal value of the average check for a one-time purchase has risen 3.6% with annualized inflation at or above 14%. 40% of consumers polled by FOM have noticed meat and fish getting more expensive the last month despite Rosstat recording deflation. Current estimates from MinEkon, the Bank of Russia, and MinFin expect around a 4.2% annualized decline in consumer spending/consumption for the year. Not sure that's holding up well...
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