Risk Versus Uncertainty
The trajectory of oil prices seem less certain as a result of supply announcements and the Omicron variant
Author: Brynne Kelly 12/05/2021
In economics, the distinction between uncertainty and risk proposed by economist Frank Knight (1921) has become classic and hardly contested. In the case of risk, the outcome is unknown, but the probability distribution governing that outcome is known. Uncertainty, on the other hand, is characterized by both an unknown outcome and an unknown probability distribution. In both cases, preferences are defined across chance distributions of outcomes. For risk, these chances are taken to be objective, whereas for uncertainty, they are subjective. Consider betting with a friend by rolling a die. If one rolls at least a four, one wins 30 Euros (or Pounds, Dollars, Yen, Republic Dataries, Bitcoins, etc.). If one rolls lower, one loses. If the die is unbiased, one’s decision to accept the bet is taken with the knowledge that one has a 50 per cent chance of winning and losing. This situation is characterized by risk. However, if the die has an unknown bias, the situation is characterized by uncertainty. The latter applies to all situations in which one knows that there is a chance of winning and losing but has no information on the exact distribution of these chances.
Over the last week or so, we have clearly been made aware of the bias held by the US administration - to keep a lid on prices by drawing on reserve inventory. The long-term success of this action is yet to be determined. However, there is no denying the headwinds being thrown at oil markets recently. The list of uncertain variables is growing. What seemed like a rock-solid recovery trade has now become less certain in the short term.
When there are too many uncertain variables, markets tend to return to what it knows: long-term value or mean reversion. The chart below plots 12-month calendar strip prices since 2017. Note how quickly the calendar strips pulled back and clustered inside the $60-$65 range, which at the moment is being considered 'long-term value'.
What's interesting is that despite the recent selloff in oil prices, the long-term bullish sentiment seems to remains intact. You know, the sentiment that says 'capex' has been so severely damaged by the Coronavirus and the political environment that future supply growth is in question. This backstory gained momentum throughout oil's recovery in 2021, fueled by the constant rise in equity markets and the continued draw-down of petroleum inventories.
Yet, these long term predictions don't help much in the short run as the deck chairs are being shuffled.
Over the last three weeks some key assumptions, or variables, have become less certain. Specifically the following:
Supply and supply growth,
Regulatory guidelines around EPA RVO limits (Renewable Volume Obligations)
Future Supply - OPEC+ and US SPR
Last week we presented a detailed schedule of the estimated timing of the US SPR deliveries prior to the OPEC meeting. We now know the results of that meeting per the OPEC press release:
"The 23rd OPEC and non-OPEC Ministerial Meeting (ONOMM) reaffirmed the continued commitment of the Participating Countries in the Declaration of Cooperation (DoC) to ensure a stable and balanced oil market. In view of current oil market fundamentals, the Meeting resolved to:
Reaffirm the decision of the 10th ONOMM on April 12, 2020 and further endorsed in subsequent meetings including the 19th ONOMM on July 18, 2021.
Reconfirm the production adjustment plan and the monthly production adjustment mechanism approved at the 19th ONOMM and the decision to adjust upward the monthly overall production by 0.4 mb/d for the month of January 2022,
Agree that the meeting shall remain in session pending further developments of the pandemic and continue to monitor the market closely and make immediate adjustments if required.
Extend the compensation period until the end of June 2022 as requested by some underperforming countries and request that underperforming countries submit their plans by December 17, 2021. Compensation plans should be submitted in accordance with the statement of the 15th ONOMM.
Reiterate the critical importance of adhering to full conformity and to the compensation mechanism.
Hold the 24th OPEC and non-OPEC Ministerial Meeting on January 4, 2022."
Point number 3 above is key because it keeps the 'decision' open to revision by leaving the 'session', or outcome, open to revision. Even OPEC is less certain of the variables at play and their outcome (like the new Omicron variant). Prior to this last meeting, OPEC had affirmed that they will continue to adhere to monthly meetings for the entire duration of the Declaration of Cooperation, to assess market conditions and decide on production level adjustments for the following month, endeavoring to end production adjustments by the end of September 2022, subject to market conditions .
Combining the OPEC+ meeting results with the US SPR loan release schedule presented last week and we get a sense of the combined result of the two:
Since OPEC+ only addressed January output in their meeting, we don't assume further increases beyond that, even though in previous meetings OPEC has outlined that the 400k bpd monthly increases will continue through September, 2022. Combined US SPR loans and OPEC output increases look to add a little over 600k bpd of supply to the market in December 2021 and January 2022 (orange column, far right above).
But, OPEC weren't the only ones that left the door open for revision. As oil prices began to slide last week there were some headlines from the US administration implying that not only might they adjust the SPR release schedule if prices get too soft, but also revealed further action they may take should prices continue higher. One of the more controversial actions suggested was a ban on US oil exports. Talk about adding a whole new level of uncertainty to the mix!
At face value it seems that between OPEC, SPR releases and other less conventional options we have put a strangle of sorts around oil prices. Supply will be pulled back off the market should prices get 'too low' and more drastic measures will be taken to add more supply to the market if prices get 'too high'. In the short-term, the market now needs to explore the boundaries of this theoretical strangle - probing both the upper and lower bounds to discover it's limits.
The key difference between the OPEC increases and the US SPR release is that the former represents supply growth, while the latter doesn't. This is why the longer-term bullish narrative lingers. Will US production finally resume it's growth trajectory or will we just be left with an even more grim supply picture?
Renewable Volume Obligations
The Environmental Protection Agency held a public hearing last Friday on its proposal to extend compliance deadlines for renewable volume obligations for 2019 through 2021. Biofuel groups continue to call for the EPA to stop the delays and release the renewable volume obligations as required under the Renewable Fuels Standard (RFS).
The 2019 RVO compliance deadline for small refineries was set for November 30, 2021, and the 2020 RVO compliance deadline for all obligated parties is currently set for January 31, 2022. It missed its November 30th statutory deadline. These continued delays add more uncertainty to refined product output and prices.
Growth Energy Senior Vice President of Regulatory Affairs Chris Bliley testified that instead of delaying the RVOs, EPA should take immediate steps to restore integrity to the RFS, restore lost biofuel demand, “and remove remaining hurdles to E15 and higher biofuel blends. The intent of the RFS is to blend more biofuels into our nation’s transportation fuel supply. Period,” says Bliley. “It is not meant to reward oil companies for suing to prevent higher blends and then demand that the agency further delay compliance.”
Also speaking on Friday, Secretary of Agriculture Tom Vilsack told ag reporters he anticipates actions from the Biden administration on biofuels to create more stability than the past administration. Vilsack says he’s worked very closely with EPA Administrator Michael Regan in reinforcing the importance of the EPA to take actions regarding the RFS to provide much desired stability.
“We look forward to when those announcements are made to also be able to provide more details on the distribution of $700 million of assistance and help that we’ve already identified and earmarked for biofuels,” Vilsack says of the COVID relief funding awaiting final Office of Management and Budget approval that was allocated by Congress at the end of 2020 and part of USDA’s additional pandemic assistance in 2021.
The supply of renewable volumes or renewable credits are far from being robust. The slightest change to the RVO has the potential to create an outsized moved in renewable fuels and renewable credit prices and place a larger burden on producers. The assumption is that the Biden administration is pro-renewables and therefore would want to set the RVO limits as high as possible to encourage growth in this sector. This adds extra cost to the price of refined products consumed in the US. Is the US administration reluctant to take a stance given the current price environment? Remember, President Biden tweeted this after the SPR announcement:
"This week, we launched a major effort to moderate the price of oil — an effort that will span the globe in its reach and ultimately reach your corner gas station. It will take time, but before long you should see the price of gas drop where you fill up your tank."
Restoring RVO's to pre-2020 demand levels has the potential to put upside pressure on renewable blending components and renewable credits. By default, this adds to the retail price of gasoline. That's not good, is it? How this administration threads that needle remains to be seen. Another uncertainty with a potential unknown bias.
The introduction of a new and spreading coronavirus variant (Omicron) spooked markets and recent bias (over what happened in 2020) kicked in sending markets lower. In reality though, it's simply too early too draw conclusions from the limited data points out there. The market seems to find comfort in the narrative that the Omicron variant is more transmissible, but milder. That only seems relevant if you believe government responses to contain the variant are rational. People are losing faith in rational responses.
Oil prices have continues to move lower since the beginning of November as shown by the futures curve shift on the left below. Supply increases and the introduction of the Omicron variant initially have helped flatten the price curve. Comparing futures curve shifts since the beginning of the year (right chart below) reveals how much the curve has flattened, but shifted higher.
The risk premium has essentially been wiped out of the front of the market as a result of supply additions and downside demand risk due to Omicron. Did the market overshoot to the downside or have we actually alleviated the dreaded winter supply shortages everyone was predicting? Doubtful, but time will tell. One thing is for sure, we have now been made aware that there will be government intervention should prices continue to rally. That certainly doesn't imply that said intervention will be successful. If anything, they have laid their cards on the table regarding future measures being considered (ban exports, release more from the SPR, etc.). It's now up to futures markets to challenge the threat level these present. How real are they?
The last two weeks revealed how sensitive the political world is to oil prices, which led to a form of intervention from countries that hold strategic reserves, which led to a market pullback. The Omicron variant then took center stage and propelled markets even lower.
Uncertainty led to risk off as it became more difficult to quantify. As we near the end of the year, risk appetite generally fades and gives way to things like tax loss selling and PNL protection. Known risks have become less known and new uncertainties have been introduced.
Of Note Over the Weekend
Saudi Aramco raised the January OSP for Arab Light for in Asia by 60 cents/bbl m/m to USD 3.30/bbl
CDC Director Walensky: Omicron COVID-19 cases have been discovered in at least 15 states in the United States - interview with ABC News.
WH Press Sec. Psaki: The United States is preparing for a variety of Putin actions in Ukraine, including an invasion.
EIA Inventory Recap
The EIA reported a total petroleum inventory BUILD of 3.40 for the week ending November 26, 2021 (vs a net DRAW of 3.20 last week).
Year-to-date cumulative changes in inventory for 2021 are DOWN by 148.0 million barrels (vs down 151.4 million last week).
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 draw as long as backwardation in the market persists.