Author: Brynne Kelly 7/24/2022
The narrative over the last few weeks in oil markets is that 'Demand Destruction Outweighs Supply Concerns' which has put enough pressure on oil to drive prices below $100. Oil is lower, selling has won the day; Inflation is tamed! Then a news item came across the tapes which hit home on the selloff's fragility.
Russia Strikes Odessa Port After Signing Deal to Unblock Ukrainian Grain Exports
Russia launched a missile attack on Ukraine’s key grain-exporting port of Odessa hours after signing an international agreement to lift its blockade of the Black Sea coastline and allow for the transport of grain and other foodstuffs necessary to alleviate a looming global food crisis.- Source
The headline above that got our attention is related to grains, yet why do we think oil markets will be any different?
If Russia and the West can't keep the peace on a needed grain shipment (wheat opened 3% higher on the news as we write this) what right do we have to trust any current oil "fixes" done on the fly? How reliable are the short-term supply-side mechanisms hurriedly cobbled together. Event risk is still decidedly to the upside here. Complacency may be the enemy.
So how are we doing catching up on the commercial inventory ( supply) part of the equation? It turns out we are still running in place.
The Net Effect of SPR Releases on Commercial Inventory is Underwhelming...
We had previously discussed at length the US Strategic Petroleum Reserve release and witnessed their minuscule impact thus far on commercial inventory levels. To summarize: SPR releases are either consumed locally immediately, or alternatively they are being exported for consumption elsewhere. Their effect is practically nil on increasing supply for the coming winter season. What makes us uneasy about these two things taken together is:
The grain problem exposes the fragility of the energy situation.
Not only would a price cap risk a complete cutoff of energy to the west by Russia, and make more likely the potential for $350 oil as mentioned by JPM and Co, but a Russian military action like the one that may (or may not) have affected the wheat delivery puts all ability to trust further in doubt.
What private company would insure energy transports let alone grain given the recent Odessa actions?
We are no better in securing supply going into the fall than we were a month ago.
There is nothing concrete out there that suggests the 'supply-side' of the equation is being resolved despite a $10 drop in the last month
The SPR is still slated to end in September, just in time for Winter demand.
Is there precedent for a comeback in the short time we have assuming no further "help" from our middle east friends? The answer is yes, but the context is different.
The Previous Supply Crunch Recovery
Using history as our guide, we can of course see that there have been key moments in history when consumer-facing product inventories have been at similarly low, or lower levels only to resolve themselves in short periods of time.
The Shale Era of Supply Meant Oil on Tap...
What is tough to reconcile is that historical conditions that helped ease supply/demand imbalances do not seem replicable today. Take the 'shale era'; a time when sky-rocketing prices intersected with technology. The industry had a breakthrough in drilling that was actually unlocked by high prices. What ensued was one of the greatest growth expansions in US oil production in modern history. The marketplace responded to higher prices with fresh unseen supply that became economical.
Shale Had Us Covered Then.....
The impact was half a decade of low oil prices, not only in the US but also globally. Even as prices sold off, producers continued to pour money into shale development, stopping only briefly to renegotiate drilling contracts and related costs as newly unlocked supply hit the market and depressed prices and margins. "Drill baby Drill" was the mantra.
The Aftermath of the Shale Era
That was then followed up with one of the greatest global hits to oil demand in modern history. JUST as the market had seemingly overcome the hit to oil prices and the US began to flex it's export muscles on the global stage, the pandemic hit.
Covid killed demand which disincentivized new supply...
This was so jarring to demand that prices briefly collapsed below zero in an epic selloff that made news around the world. Since then, the world has been putting the pieces of normalcy back together. Prices were being carefully brought back into reason through coordinated and (some not so coordinated) governance on output (supply). Yet before the paint had even dried on that story, Russia invaded Ukraine and turned the entire complex on its head.
To summarize:
Shale: Changing regulations and technology advancements helped unlock new oil supply
Covid: Global cooperation helped keep a governor on supply during the pandemic
War: Traditional supply routes are now being upended by the war in Ukraine causing prices to soar, unchecked
And now here we are, again in a situation that demands a quick supply recovery. But it would seem that there are no more technological tail winds to help us get to where we need to be.
Exit Shale Technology Tailwinds, Enter Cash and Political Headwinds
In addition to rising prices, interest rates are increasing. This makes it costlier to invest in and hold inventories for long periods of time. Is it a coincidence that the US government is selling it's Strategic Petroleum Reserves in this environment, aside from the obvious need to try and cap runaway prices?
It's no surprise then that given our current circumstances, it is not easy to see how the supply-side is resolved. Where once tailwinds helped get fresh supply to the market, we now have headwinds inhibiting new oil. Explosive production growth like before seems unachievable in today's environment. The political environment dictates that: No matter how many new supply contracts are drawn up in the short-term they will inevitably face scrutiny in the future due to Political Green New Deal issues.
The regulatory environment today favors anything BUT fossil fuel. This channels investment away from traditional energy sources towards more 'environmentally friendly' sources via regulatory incentives. Money chases the highest return with the least barriers to entry. The barriers to enter new fossil fuel production are growing as they continue to be laden with penalties. It seems like the current system is maxed out in terms of government permissibility.
All this is making it difficult imagining figuring out how the supply side is resolved as quickly as it was during the shale era barring another severe hit to demand. It is a sad state of affairs when we need to think of lockdowns as a potential option to lower the price of oil. Yet, that is where we are since Western governments aren't able to support traditional energy production growth without breaking any of their blessed covenants. There seems to be no room for tolerance when it comes to carbon energy.
To summarize. Here are some barriers to growing traditional energy supplies that were not present when Shale rescued us :
Replacement cost in real dollars is higher
Fossil fuels are a technologically mature industry right now
Reallocation of capital away from Oil/Gas due to policy
Supply chains are tenuous as relationships are shuffled
Insuring expensive cargoes traversing to/from unstable areas is risky, driving up costs.
There is simply nothing in the future that tells us that the government will get around to 'doing the right thing' to unlock long-term supply stability because they believe they are doing the right thing now by holding to their climate objectives.
Backwardation
The above narrative helps reinforce why backwardation has been so 'sticky' even as prices have sold off. The lack of good guaranteed collateral is making it risky to own anything outside of a short-term window, and in that short-term the market is undersupplied.
Prompt spreads remain steep even in the recent selloff...
Less collateral leads to less deals. Because of this there is less speculative activity. The market is overall less liquid than it needs to be for good price discovery. This makes it easier for headline risks like 'recession' to take hold on prices without making much of an impact on the bullish structure of the curve. The relationship between flat price and spreads remains in flux.
Over the last decade there have been significant forces that have stabilized prices at a globally affordable level:
Increased global cooperation- globalized supply-chain logistics
Decreased regulations and new technology that unlocked production
Both of these tailwinds have run their course making it difficult to predict where the next supply-side growth comes from. Any confidence that re-globalizing supply chains would be reliable may have gone down with that missile attack on Ukrainian ports over the weekend. As far as regulations go, there does not appear to be an appetite from those incumbent in office to abandon their climate commitments and their regulatory pursuits that follow.
This leaves the demand side. Recessionary fears from tight Fed policy have likely had an impact on prices. But their rate hike cycle is likely to end in late fall, right before heating oil season and right before the election. We may not even bank on a recession lasting long enough for supply to catch up. That leaves prices themselves and another lockdown as potential drivers of demand destruction.
Can we really count on high prices curing themselves given the geo-political situation, or global pandemics to 'rescue' us? Maybe. Even if they did, such impacts don't usually happen overnight. They happen in concert while slowly bleeding consumers dry.
Bottom Line
Looking back is becoming less relevant. The variables that squared up market balances in the past are not fitting nicely into the variables that will solve the equation going forward.
We don't want to make more oil, we want oil to be cheaper. In fact, not only do the flagship producers that subdued oil prices over the last decade NOT want to increase production, they can't. They simply can't deploy capital the way they have in the past and still retain investors.
Until the laws of supply and demand reassert themselves, we have to witness the disconnect between short term known supply and short to intermediate and seasonal demand not matching up. While policy makers celebrate the 'pullback' in oil prices, the rest of us wonder how sustainable it is.
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EIA Inventory Recap - Week Ending 7/15/2022
Weekly Changes
The EIA reported a total petroleum inventory DRAW of 3.20 for the week ending July 15, 2022. Commercial inventories posted a slight DRAW of 0.40.
YTD Changes
YTD total petroleum EIA inventory changes show a DRAW of 123.40 through the week ending July 15, 2022.
Inventory Levels
Commercial Inventory levels of Crude Oil (ex-SPR) compared to prior years are have gone from way above historical levels to surprisingly below historical levels and should continue to flounder while backwardation in the market persists.
