9 min read

Welcome to the Club

Welcome to the Club

Instead of a news roundup today – aside from the impending clampdown on The Bell, I've noticed the news drip has visibly slowed in recent weeks – I thought it best to react to a political and market development for oil that Yakov Feygin flagged to me yesterday. Vedomosti ran with the story too. "America asks China for Help with Oil" certainly has a ring to it in Moscow, but it speaks to a deeper strength of the Biden administration's approach despite the Twitter and media hits they're taking as well as a coordination problem embedded in the processes associated with emissions reduction and the energy transition. Speak to inflation hawks and fearmongers keen on talking up how we aren't going to diminish or need for various hydrocarbons anytime soon or else risk economic armageddon if we do so and you get a dark picture of what the energy transition and pie-in-the-sky ideals of progressive climate policies can cause. Underinvestment in new oil & gas supplies leads to massive price spikes, skyrocketing inflation, and a dramatically more expensive path to decarbonization leaving us all poorer and energy systems more fragile than ever.

I sympathize with part of this – constraints on supply are an ineffective policy approach unless you significantly ratchet up public spending and introduce new forms of redistributive instruments to offset rising energy costs including, but not limited to, some forms of carbon taxation and pricing. Anyone convinced that making oil & gas expensive is the best way to force changes in consumption patterns doesn't seem to have anything to say about the short-term inelasticity of demand i.e. people who need to drive to work are going to keep driving, for instance or else have nothing to say about the limits of battery deployments to provide backup capacity. There's also an almost intentional confusion among the most ardent proponents of extreme climate policy measures between oil and natural gas and how they're related.

Take the breakdown of oil use from the IEA based on 2018 data. It's mostly about transportation:

Combine that with the adoption of smart devices intended to more efficiently manage energy loads and distribution for a variety of purposes and we can see rapid growth gains that will support marginal efficiency improvements that add up over time:

But oil isn't a story about power generation whereas natural gas is. And oil and gas are often associated with each other and related industries when it comes to exploration, even if individual finds are "pure" plays and their respective markets differ. COVID has cracked open a host of old orthodoxies from the troublesome assumption that expectations drive inflation to shibboleths about debt burdens and the importance of the actual supply-side of economics in the form of physical production processes and logistics  systems. Those most bearish on the energy transition tend to obsess over the supply-side, though. Their critiques are ultimately about being unable to substitute existing sources of power with new ones and the exorbitant costs of quelching investment into new supply. There's just one problem with all the whining: there's actually very little legal enforcement or regulatory power internationally standing in the way of new oil & gas projects. This isn't some "woke" plot to underinvest. Investors are reacting to two successive price collapses that crushed expected returns and shattered any faith that the "drill baby, drill" approach taken by countless firms operating in US shale plays would end up turning a profit. That prospect made even less sense when investors began to question the viability of oil demand growth post-pandemic. For those who don't recall, Equinor's audit of its US operations heavily exposed to shale investments post-2010 last October was brutal:

That's over $20 billion in impairments before we even get to the COVID crisis. And conventional plays generally come to market on timelines closer to 5+ years from exploration to actual production, a prospect made more complicated by demand uncertainty after a period of assumed supply abundance because of US output growth. China's growth slowdown and the poor outlook for emerging markets next year and after should probably put a dent in a big chunk of the oil & gas bull story.

What I want to draw more attention to, however, is the latest entreaty from the Biden administration to China to coordinate releases of crude oil stocks from strategic reserves. Today, China's state reserve bureau announced that it was releasing stocks onto the market which drove down crude prices today. The announcement comes a few weeks after reports that the Biden administration had been reaching out to other major importers, including China, India, and Japan, to coordinate releases of strategic crude reserves in order to calm the market amid thus far fruitless attempts to get OPEC+ to increase output more quickly. As of now, this is all very informal and a bunch of actors making decisions in their own best interests. Inflation levels have spiked globally, largely driven by energy prices and specific supply chain frictions and labor market disruptions from the pandemic. Even informal arrangements can lead to new fora and forms of cooperation. OPEC+ gets all the ink cause producer cartels are assumed to hold all the cards when what they produce is so central to so many forms of economic activity and cannot be substituted. But buyers have plenty of agency to coordinate between each other and shape markets. What the transition catastrophists seem unwilling to accept is that oil & gas became poor investments for a lot of investors and firms after 2013 based on returns alone, the current rally not withstanding.

The best way to avoid underinvestment is to manage demand and prices at some level in order to avoid periods of intense energy price inflation that are particularly salient in the United States because of its poor public transport infrastructure and middle and working class Americans' reliance on cars. If buyers start using strategic releases more often to manage price spikes, even if they may be of marginal long-term use, that's a very different market context to contend with. Here's US strategic and non-strategic crude stocks vs. gasoline and diesel prices that last two years:

US crude stocks are cumulatively equivalent to about 10 days of global crude oil demand at the moment. Based on the IEA data from August, Canada and Mexico are holding somewhere in the vicinity of 300ish million barrels in stocks so that's another 3 days of global demand. China's strategic stocks are around 400 million barrels – 4 days' demand – and doing a back of the napkin calculation including commercial stocks assuming they're now holding around 90-100 days' import cover as is the norm per post-73' energy security management schemes, then they'll have somewhere in the range of 900 million barrels in reserve – about 9 days' demand in total. That's about 3 weeks of global demand in the event we wake up in a world where every oil well stops producing. Europe's collective public and private stocks come out to the range of 900 million barrels – about 9 days cover. That brings us to 1 month. When you add in Japan and the Republic of Korea – somewhere in the range of 350 million barrels – you wring out another 3.5 days. India was selling crude from its strategic reserves back in August as an inflation management tactic. Take the OPEC data compiling what's out there on oil stocks and globally, it's about 80 days' cover:

On the one hand, being able to provide for a little over 1 month's worth of demand if we suddenly ceased all production doesn't exactly communicate a massive advantage for buyers. The 80-day cover period is a different metric insofar as it's about covering import needs so it doesn't correspond to quite the same hypothetical. But we don't live in a world where producers are going to up and stop entirely. Saudi Arabia may have the benefit of a cosy relationship with the US and no sanctions risks despite its hand in countless tragedies, but oil rents account for over a quarter of Saudi Arabia's national GDP, almost 90% of its budget revenues, and about 90% of its export earnings. Ignore Russia – oil matters because of its transfers domestically, not its net share, and it can't idle much capacity – Saudi Arabia is still the biggest mover and shaker on the market. They can idle wells, but they can't stop producing en masse, especially since any supply cut on their end might actually shift the investor outlook for some US projects so that non-Permian shale plays see more recovery. So let's say hypothetically that the world's largest buyers release a day's worth of demand onto the market – 100 million barrels of crude are sold at lightly regulated prices undercutting the export spot prices demanded by Saudi and other exporters and those supplies are released and sold over the course of a week. Will it fundamentally alter the supply/demand balance and price dynamics? Absolutely not. But it will take the psychological edge off further price increases for futures markets, particularly during a winter season in a place like the US where road fuel demand tends to dip and the executive branch has instruments available to formally or informally negotiate purchases. It also signals that governments will act when needed instead of the position of learned helplessness that tends to pervade whenever price rallies of this sort accompany broader inflationary pressures and forces trades made on the spot to react. If there's anything approaching a semi-regular stream of releases by government order, only an idiot wouldn't go for the cheaper barrel domestically. You can't ignore market prices when releasing supplies – any future releases will almost certainly adhere to market pricing – but crude markets are about marginal differences and even a marginal difference forces a response from exporters and other competitors.

If that approach becomes more regularized as a form of inflation control and price management, then OPEC+'s power to regulate prices through supply-side agreements would be blunted. Buyers are forced to eat the margins and price hikes enabled by OPEC+ as a result of consumer competition over barrels as much as supply/demand imbalances. The market's likely headed for some level of oversupply next year as well. Then consider expected deflation as most of the supply chain issues that have driven up prices on top of energy markets ease. This from Goldman Sachs, not exactly a bastion of inflation doves, suggests even Wall Street bankers that normally panic over inflation's negative effects for asset owners realizes the current environment isn't a "regime change" for price increases:

I'm pretty confident oil won't be that salient by 3Q next year, which also increases the relative importance of these overtures now because they open up lines of communication that will hopefully be there in the future. Biden should be lauded for introducing an element of oil diplomacy too often ignored by market participants or else dismissed out of hand as ineffective. It doesn't have to solve a problem to make an impact. A lone US release, for instance, does relatively little. A US release following a release in China followed by a release in Europe and state-to-state coordination setting shared conditions under which they intervene is far different. OPEC's November release also highlights the concern that China's slowdown, hidden for now by global low base effects and US stimulus, will weigh on the market more:

Buyers establishing a precedent to manage oil price levels and supply across what would otherwise be geopolitically sensitive lines is a big deal. Higher inflation in China is much more problematic for the government if growth appears to be slowing down, and these manufacturing figures don't speak to the problem of falling property prices. Prices fell in October by 0.2%, their largest decline since the financial turbulence of early 2015. Investments into the property market account, housing activity, and construction account for something like 29% of China's GDP, massively higher than the 10-20% on most developed markets given relative levels of income per capita and consumption. Marginal declines in property values create knock-on risks for consumption that will drag down China's oil demand growth trajectory. If you're an oil bull obsessed with the risks posed by the energy transition, you're taking the wrong lessons to heart if you think the problem is constraining supply. Coordinating demand and releases like this is what's needed to ensure investors realize steady returns and we avoid price crashes like 2014-2015 and, to the extent we can use COVID as a base case, 2020-2021. Rallies and price troughs create boom-bust cycles of supply-side investments that can't smooth out as they might once have done as we approach peak demand, creating short-run inflationary episodes that require active market management. Biden's laid some groundwork for that, even if haltingly and in a limited, improvisational form.

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