Author: Brynne Kelly 10/31/2022
Last week's news cycle for us solidified the economic opposition between OPEC+ and G7 nations regarding energy prices:
OPEC+: The price is too low. We must protect the value of these finite resources and not give them away simply to garner market share.
G7: The price is too high. We must protect the purchasing power of the Consumer and ensure that prices are low enough to foster robust consumption in other areas of the economy.
The Russia/Ukraine conflict brought this all to light, even though it was years in the making. Competing for market share by oil producers ( US or OPEC+) is no longer straight-forward as sanctions and regulatory burdens hinder free- market flows of product to high price/high demand areas.
Why do we bring this up? Because the back and forth of news headlines last week between OPEC+ and G7 countries suggests there won't be any real organic pressure on prices any time soon.
Wildly Diverging Headlines
Saudi Arabia believes that it is 'taking steps to stabilize the energy market'.
*Saudi Arabia’s Energy Minister has warned countries against misusing their crude oil stockpiles to manipulate the oil markets. According to the Kingdom’s Energy Minister, Prince Abdulaziz bin Salman, who has been sparring with U.S. President Joe Biden in recent weeks, strategic crude oil stockpiles are designed to be used to manage supply shortages, not to bring down prices. “It is my profound duty to make clear to the world that losing (releasing) emergency stocks may be painful in the months to come,” the Energy Minister said at the Future Initiative Investment conference in Riyadh. (aka, we will not be giving our product away...). In addition, Putin stated that 'Excessive reliance on green energy is against Russia's interests and that Russia is ready to strengthen it's relations with China at all levels.
Conversely, The G7 alliance remains staunch in it's message: Energy producers need to bring down prices.
*The comment was quickly interpreted as a barb aimed specifically at President Biden, who lashed out at OPEC+ over its recent decision to lower its crude oil production targets by 2 million barrels per day after the United States spent months releasing more than a hundred million barrels of crude oil from its Strategic Petroleum Reserves to alleviate high prices at the pump ahead of midterm elections. The warning is just the latest in the tiff between Saudi Arabia and President Biden, after the U.S. President said there would be consequences for Saudi Arabia’s decision—with Russia—to lower crude oil production.
What stood out in the administration's side was the lack of policy response threatening more domestic oil creation to get those prices down (as we had done in the past), but instead scolding producers of excess profits coupled with a policy response to spend more saved SPR oil. This is not a revelation after a year of this type political behavior, but the intractable-ness of it all seemed to fly in the face of worsening economic reality. Both sides are further apart even as the risk grows.
In this new 'high priced' environment, profiting from fossil fuels is 'bad' and that can be rectified by reallocating said profits to more worthy causes like subsidies to keep consumer purchasing power intact so as not to derail the overall economy as upward price pressures threaten to just that.
Replacement costs are going up at a time when inventory reserves are at historical lows and production growth is anemic. If we didn't know better it is almost like the G7 leaders actually want all Oil production to stop overnight even while complaining of high prices and throwing gasoline (only environmentally sound eco-friendly hi-ethanol blend mind you!) on the fire they started.
Further, there is no guarantee that market-share garnered over the years as part of a loss-leader strategy can't be taken away via sanctions and/or policy. The threat of government intervention inhibits operation of business as a going concern.
Economics Inhibited
Therefore, put yourself (business-wise) in OPEC's economic position (or any producer for that matter)- if you can't fight for market share you might as well fight for price while your product is still in the majority. Among other things, this new environment has made for strange economic bedfellows in the face of ideologically driven (economically unsound?) Net-Zero opposition.
On the G7 side, the commitment to change the mix of energy supply to favor renewable sources is viewed as an absolute goal. If this leads to high energy prices, they employ fiscal price lowering measures rather than output-building tactics locally. The behavioral reactions tell you the motivations are not economical, but idealistic in pursuit of some net zero agenda and therefore not practical in relation to the problem at hand. This is especially true compared to past reactions to Saudi stubbornness.
The Past: The Cure For High Prices Last Time
A little over a decade ago, soaring oil prices motivated US producers to increase supply by employing more expensive drilling techniques whose margins were now positive. This was the discovery of the next 'marginal barrel' via fracking.
Ultimately oil prices collapsed as OPEC stubbornly refused to cut production to make room for this new supply. Some believe that OPEC did this deliberately to drive these new shale producers into bankruptcy. And in fact, several did succumb to bankruptcy and their assets were purchased by stronger fiscal players at lower values. High prices cured high prices because of economic reasons, not the pursuit of some ideal beyond becoming less reliant on foreign oil.
Regardless, the consumer enjoyed lower oil prices, happy to be the recipient of the loss-leader, market-share obsessed producer mentality. At least everyone was on the same page as they awaited a rebound in prices. It was, after all in the spirit of becoming energy independent, wasn't it?
Those low oil prices lasted longer than anticipated and destroyed a lot of investment capital in the process. Low oil prices also allowed economies to explore the impact of fossil fuels on the climate with little repercussion. When staples are cheap, it leaves room for more idealized purchases like 'green credits' and climate responsibility.
The Present: Implications for Now
Fast forward to today. These idealized pursuits weaved their way into policy at a time when the stress and cost of doing so was low. The opportunity cost of doing so wasn't that great because a cheap, reliable form of energy was there to support the deviation. The Net-zero crowd was lulled into complacency when oil prices were low, now they have increased their sense of urgency. Making idealist but inflexible choices during times of economic crisis is now very expensive.
Oil producers and many G7 countries are facing what they view as existential threats for different reasons. OPEC + ( and Western producers) fear extinction of their business, and many EU G7 countries fear a cold winter and Russian invasion. Conversely US Governmental reactions to these events (sanctions, regulatory penalties, etc.) are more inflexible in nature even as the economic/existential fear grows.
Today's marginal production decisions are encumbered by future regulatory liability risk. Economic decisions to not allocate CAPEX for future production are being made because of these regulatory policies designed with Net-Zero ideals in mind. And all if it affects the future supply metric.
The Future
G7 Policy seems unwilling to fairly back any new fossil fuel production alongside energy transition goals. Meanwhile OPEC+ countries are showing their disdain for lower energy prices for the sake of lower energy prices. Thus, the previously mentioned lack of Capex allocations.
Technology gains are what this century have been all about, yet investment aimed at efficiency gains in the fossil fuel space are now being sidelined as an unworthy use of capital for very uneconomic reasons. The old oil economy is neglected and the new economy is subsidized. Worse, taxes on the "old economy" are being used to grow the new economy at a time when we need oil the most. What should have been done when oil was plentiful is now being done in spite of supply crises.
Absent policy commitments to fairly back fossil fuel production alongside an energy transition, it seems that US energy infrastructure will get less competitive and more expensive to operate. Profits earned from energy exports will be rerouted away from carbon in the form of subsidies or 'greener' investments.
It's already happening tactically:
EPA Casts Shadow over Future of Shuttered St. Croix Refinery. Inspection found corrosion, safety hazards at Limetree Bay
Strategically the G7 are pursuing Net-Zero ideals undaunted by current crises as well:
As part of its major renewable energy plans to tackle climate change, the U.S. government is investing heavily in the future of tidal power. Meanwhile, Europe is also funding the development of tidal energy technology to help advance the renewable energy sector. This initial funding period in research and development is expected to contribute to the widescale rollout of tidal energy projects worldwide within the next decade.
Low inventory levels do not seem to be a long-term concern for G7 nations. They are being handled as a temporary "inconvenience" actively dealt with by subsidizing supply costs (stimmies and inflationary handouts) at the retail level, not supply solutions at the production level.
The Supply Past is not Prologue to Future Production
US inventories of crude oil and refined products are at historical lows, especially if you factor in the SPR. This is happening at the end of a decade marked by the most rapid growth in US production in history.
After almost a decade of production growth in the US, inventory levels are depleted...
If you look at what has materially moved the dial on crucial oil reserves, you will note that is has been neither recessions nor pandemics, rather production growth (or decline).
Shale era production was impervious to price, Covid changed that...
The above charts tell us that current price levels are not leading to production growth as rapidly as they have in the past. Shale era supply has been accessed and is now nothing more than a supply lever that can be turned off when needed. Possessing an On/Off switch is nice, but it is not a solution to current/future supply shortages.
The Future Supply Outlook
Additionally, there are no new technological solutions or policy changes on the horizon to incentivize more production. Prices are high enough to sustain a production recovery, but not high enough to change the landscape of production growth going forward, given the misalignment of objectives.
Right now the only way to make more oil is to drill baby drill using existing technology for operating leverage. Yet, producers are reluctant to undertake such endeavors given the lack of partnership being shown by policy makers towards fossil fuel producers. As the commitment to an energy supply transition grows in G7 countries, the commitment to traditional energy sources declines.
This digital (all or none) approach to Net-Zero energy has economic risks on its own. But in combination with global unrest it is more than uneconomical, it is potentially reckless. We are pressing Net-Zero bets at a time when the safety-net to do so is very fragile.
The War on Economic Common Sense
The fact is that when oil prices were low we took our time transitioning to a net zero environment. Now that prices are high the Net-Zero idealist side has grown in its resolve to push ahead. That may be the correct thing from an ideological/ idealist's standpoint. But economically and practically, no so much. Germans cannot heat their apartments with ideological energy. They need mmbtu's.
Carbon based energy is not a vice like big tobacco to be demonized. It is the most important resource for the whole global economy and the health of its citizenry. The economics tell you that. Transition to green, sure, but transitioning is not abandoning current needs.
Fossil fuels are an integral part of daily life. Yet this fungible, non-renewing, finite resource is being starved of investment capital to modernize it's facilities and increase productivity. Policy shift has materially moved away from economic energy independence for its people towards economic energy subservience under its adversarial control.
There was a time when our government was all about producing oil to weaken OPEC's hold on the market. Now we are merely releasing (printing it like the Fed makes dollars?) oil from reserves to try and balance rising prices with lack of investment. This lack of investment is seemingly going parabolic in terms of prices. Price caps are being seen as an opportunity for 'neutral' parties to get their hands on a deal.
Fed-Engineered Recessions Worsen Throughput
A run-of-the mill Recession won't be enough to significantly move the needle on the state of the oil industry (inventory) or prices for that matter. Recessions slow demand growth rather than eliminate it, which at-best, leads to a slight build-up in inventories.
Recessions may not have as favorable impact on the supply/demand balance as history implies. A more likely outcome in this new policy world is fed-engineered lower demand will cause refiners to cut back on throughput as they have done before, causing producers to cut back on supply. Refiners have become increasingly reactionary to demand slow-downs. So too, have producers. Both are now incredibly sensitive to the impact of supply build-ups. Therefore: Recession plus more reactive production equals less supply build up. Factor in no CAPEX for supply growth and you have a recipe for big post recession supply problems.
If that's the case oil demand may be weakened due to the next recession, but it should still see annual growth. Oil prices may drop, but they likely won’t collapse. Meanwhile, CAPEX will avoid asset investment and the next economic cycle will be worse for supply.
With neither a shale boom nor a resurgent pandemic on the horizon, there are a growing number of bids beneath the surface for future barrels with little clarity on where they will come from.
So we ask non rhetorically: How is the market handling all this? Is it pricing things appropriately given these concepts as implied by the divergent stubbornness of all parties involved?
Market Impact
We have posited that Fossil Fuels are a consumable, non-renewing finite resource that is being made even more finite by politics and climate policy. This finite resource has become even more 'scarce' in the short-term.
It may be obvious to those of us in the field or even with a basic economic common sense, but to many this must be said:
Until there are material and concrete gains in the use of alternate clean energy sources, fossil fuel should be valued as a high-demand resource with a diminishing ability to replenish reserves under today's price/regulatory regime.
The market prices the above dynamics in two key ways: Flat price and calendar spreads.
Flat Price
It took at least a decade for the existing energy infrastructure to regroup and reorganize to accommodate US exports as production grew. That was a small step-change in comparison to what is on the horizon today.
Therefore, it seems like the only thing that is truly undervalued today is the back of the energy curve. That which falls into the replacement cycle of today's consumption. G7 countries have no realistic short-term, intermediate or macro economic policy advantages in this right now.
The back of the Oil Curve attempts to 'mean revert' while the 'mean' may be losing its relevance....
We are looking at a market facing severe underinvestment. Because we are not spending more money on long term production and/or solutions to bring more supply to market, increased volatility will persist. The lack of above-ground supply to meet short-term problems will keep us in rolling backwardation until motivated investors capitulate and put long-term capital to work in futures markets, given the lack of lower-cost alternatives.
This will persist until the energy intensity and availability of alternative supplies rivals that of fossil fuel. Tapping in to inventory reserves can only stave off inevitable shortages and keep a lid on prices for so long.
Calendar Spreads
Calendar spreads, and for that matter many traditional relationships across the complex are beginning to reach limits not easily explained away by short-term supply disruptions. In fact, today's backwardation is rooted in the ideology that the cure for high prices is high prices. Meaning that today's supply crisis will be cured by increased production and/or lower demand.
However, demand has already taken one of the most severe hits in history brought on by the Covid pandemic. We are in demand recovery mode that disregards price and favors open economies.
Backwardation suggests current supply deficits are seen as short-lived...
When in fact, they really represent the vulnerability of the system to short-term shocks due to low inventory levels and access to reserves. Neither of which appear to have short-term resolutions other than recessionary pressure.
We even see this in one-month calendar spreads which remain elevated in the front and muted in the back.....
One-Month Calendar spreads are off their highs even though supply remains tight....
Some might view the relative weakness in future calendar spreads as a sign that the market is loosening. We view it as a sign that the issues are systemic, long-lasting and that future market prices will find equilibrium at higher prices.
Bottom Line
From all this info we can infer:
Oil Prices are high, but not prohibitively so. Refined products however are in high demand and short supply.
The East represented by OPEC+ and the West represented by G7 and domestically the Biden Administration are no closer now than they were a year ago geo-politically
OPEC+ has become even more vocally defiant of Western policy
The currently united West has responded by doubling down on policy and showing zero flexibility for short or long term oil supply solutions
The US has/will opt only to drain more SPR, admonish foreign producers for not producing, and scold domestic refiners for not refining more at lower prices
The bad economics of this behavior are becoming increasingly evident as a sign of Net-Zero ideals driving policy and ignoring signs of emerging problems
Bets are being pressed on both sides.
Futures term structure may seem steep given current price, but current price may in fact be too low given the intractability on both sides. Which indicator is "wrong" may be determined by who wins this war of wills.
For more charts, see our Cutting Room floor...
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EIA Inventory Recap - Week Ending 10/21/2022
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 2.10 for the week ending October 21, 2022. Of this, Commercial inventories posted a weekly BUILD of 2.60 while SPR inventories DREW by (3.40).
YTD Changes
YTD total petroleum EIA inventory changes show a DRAW of (215.10) through the week ending October 21, 2022. The bulk of this is due to drawdowns in SPR inventories.
Inventory Levels
Gasoline and Distillate inventory levels remain decidedly below their 5-year average for this time of year.
