Daily Comment (March 30, 2023)

Posted on March 30, 2023March 30, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! It’s Opening Day for major league baseball. In the financial markets, it’s a “risk on” day: equities and commodities are moving higher, while the dollar is weaker but interest rates have reversed higher.

In today’s Comment, we open with China news where Taiwan’s president has arrived in the U.S., and both China and the U.S. are hardening their blocs. Markets are up next, with a look at banking. International news follows, and we close with an update on the war in Ukraine.

China News: Taiwan’s president is arriving in the U.S. today. Steadily, China and the U.S. are pressing other nations to choose with whom they will align despite resistance from nations wanting to avoid such a choice.

Taiwan President Tsai Ing-wen will visit the U.S. and Central America this and next week. Semi-official visits of Taiwanese leaders tend to aggravate Beijing and this trip is no exception. The focus of the tension is an expected meeting between House Speaker McCarthy and Tsai. Much like former Speaker Pelosi’s visit to Taiwan, China is threatening to respond negatively to the meeting. The administration is taking great pains to portray the tour as “private,” meaning it isn’t officially a state visit. We also note that McCarthy is meeting Tsai in California, not Washington, next week.
- We will be closely watching to see how Beijing reacts to the trip. In the wake of Pelosi’s visit, China seemed to be practicing a blockade. Our expectation is that China is less likely to invade Taiwan, but more likely to blockade it instead. Amphibious invasions are very hard, and China has no real experience with such operations. Given that the official position is that Taiwan is a province of China, exercising such a control, like a blockade, would fall into an unclear legal situation. If China does something similar this time, it would likely increase the odds that if/when China moves to take control of Taiwan, a blockade may be the preferred tactic.
- We also note that National Security Advisor Sullivan had a call with Wang Yi, China’s top diplomat. The White House has been trying to place guardrails around the U.S./China relationship for some time, but events continue to keep tensions elevated. We note that there was no readout from the call, but we would not be surprised to hear that the Tsai visit was part of the discussion.
One of our geopolitical themes has been the idea that the world is evolving into a China-led bloc and a U.S.-led bloc. As this process continues, both group leaders are trying to woo nations into “their” alignment. This process is taking on multiple forms.
- We note VP Harris has recently made a trip to Africa. This continent is likely to become increasingly important in the coming decades. Not only is it a source of key minerals for the energy transition, but it also has young people, something that the developed nations are increasingly beginning to lack. The U.S. is promising increased investment in Africa.
- It isn’t just countries that are being pressed to choose. Companies are too. After three decades of globalization when production was moved to China, the U.S. and China are slowly unwinding their economic interdependence.
- As part of its Belt and Road Initiative, China has lent large sums to frontier economies. As often occurs, some of these loans have failed, forcing China into the unfamiliar role of providing emergency support. Although this is a short-term problem for Beijing, if it is handled well, it could increase China’s influence.
In a recent Bi-Weekly Geopolitical Report, we discussed China’s moves to undermine the dollar system. We note that Brazil and China have agreed to use their own currencies in bilateral trade. China has also settled an LNG trade in CNY. In a related development, Saudi Arabia is taking preliminary steps to join the Shanghai Cooperation Organization, a China-led Eurasian bloc.
The southern U.S. border is perhaps the prime gateway for immigrants. Although most of those attempting to cross the border are from the Americas, there has been a surge of Chinese nationals reportedly showing up on the Mexican/U.S. frontier seeking asylum.
As it turns out, the crypto exchange Binance (BNB, $319.21) has deep ties to China, something it tried to hide from U.S. financial regulators.
China is seeing a new surge in African swine fever, and if not contained, this event could lead to reduced pork supplies.

Markets, Economics and Policy: We update the latest on the banking issue. There is also a growing realization that margins matter to inflation.

Fractional reserve banking is fraught with risk. Banks take deposits and, through leverage, expand the money supply through lending. Depositors don’t think of their money in the bank as a loan; there is almost a belief that the bank has taken your money and is holding it in an envelope with your name on it. Of course, that isn’t the case. It instead lends that money into the economy, and, as long as depositors don’t demand their funds all at the same time, the system provides ample, low-cost credit to the economy. However, if a large number of depositors decide to get their money back, chaos can develop. Essentially, societies that use fractional reserve banking make a tradeoff—cheap credit but with the potential for occasional crises.
- Over time, governments have tried to address this problem. Deposit insurance has been one response. By ensuring that the money will be there, the impetus to “go get it” and thus triggering a bank run is dampened. But by guaranteeing deposits, bankers can take excessive risks, leading to the moral hazard problem. In the U.S., the response has been to limit deposit coverage, although in practice, all deposits are usually covered.
- Another way governments have addressed this issue is to allow banks to avoid pricing their assets at market. This means that there is a bit of uncertainty as to the value of bank assets at any given time. Since bank loans are often unique, it may be difficult to actually price these assets.[1] Although when banks have securities on their books, these can be priced. To avoid asset price volatility, banks are allowed to claim that a security will be held to maturity. Since bonds usually expire at par, there is no price risk as long as the bond doesn’t need to be sold in order to meet depositor demands.
- It has become increasingly apparent that large banks become so important to the economy that governments can’t allow bank runs or failure. To deal with this situation, large banks are heavily regulated. In most nations, large banks are the only choice, but in the U.S., due to our fear of economic concentration[2] (especially in banking), we have a strange mix of a few very large banks and a whole bunch of small ones. Unfortunately for the small banks, there is some degree of uncertainty about how depositors will be treated. Thus, we are seeing something of a “slow motion” run on small banks. Although most financial crises occur quickly, some take a long time. For example, the savings and loan debacle took over a decade to resolve. This problem of large vs. small banks might be similar.
- Because small bank failures are rarely systemic, they tend to get a lighter regulatory treatment. But after recent bank failures, regulators are looking to expand regulation, which may lead to fewer banks.
In economic theory, inflation is usually addressed in simple terms; e.g., it’s all about the money supply or supply constraints. In reality, it can be devilishly complicated. One factor gaining attention is that market power can lead to inflation if margins are maintained.
The debt ceiling issue has sort of fallen from the news, but it remains a threat to stability. The House GOP seems no closer to a plan on how to address it.
Young graduates are finding a tentative job market. As we note below, initial claims remain remarkably low and stable, which likely reflects labor hoarding. Firms loath to lose current employees, fearing the cost of replacement. However, it may be leading to a lower number of new graduates being hired.

International News: Russia detains a Wall Street Journal reporter, Britain gets a trade deal, and Cargill stops carrying Russian grain.

WSJ reporter Evan Gershkovich has been detained by Russian security services on charges of spying. He was reportedly investigating the Wagner group. This is a high-profile event and will likely weaken already fraught relations.
Britain has joined the Indo-Pacific trade bloc, the CPTPP, which is the successor of the failed TPP. The U.K. is the first nation to join the group since its founding in 2018.
Cargill, a top 10 exporter, announced it will stop handling Russian grain.
The German ruling coalition is showing signs of stress. The Greens are increasingly out of step with the Social Democrats and the Free Democrats.

War in Ukraine: There are renewed concerns over the safety of the Zaporizhzhia nuclear plant. Russia has been shelling the region around the plant and both sides are increasing troop strength around it. The IAEA is trying to work out an arrangement to prevent the plant from being directly attacked. This is the largest nuclear plant in Europe and although the cores are in hardened containment units, a direct attack could lead to a potential catastrophe.

[1] Private equity does something similar.

[2] This is why we have 12 Federal Reserve districts, for example.

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Weekly Energy Update (March 30, 2023)

Posted on March 30, 2023March 29, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil decisively broke its recent $72-$82 per barrel trading range. Recent weakness was exacerbated by funds that sold out of long crude oil positions. Prices have recovered to the lower end of the previous trading range. We will see if this acts as resistance.

(Source: Barchart.com)

Crude oil inventories plunged 7.5 mb compared to the forecast of a 1.5 mb build. The SPR was unchanged.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.2 mbpd. Exports fell 0.3 mbpd, while imports dropped 0.8 mbpd. Refining activity jumped 1.7% to 90.3% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and then declined this week due to the rise in refinery activity. Levels are nearing seasonal norms, which should relieve the bearish pressure on the market.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $54.26. Although we think there is enough geopolitical risk in the world to prevent a decline to this level, it does suggest that the oil market is dealing with rather weak fundamentals.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories. With another round of SPR sales set to happen, the combined storage data will again be important.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001. Using total stocks since 2015, fair value is $93.58.

Market News:

We have held a generally bullish position on oil and gas because of persistent underinvestment. The ESG movement has raised concerns that long-term demand will fall, and since many projects have long lead times, investment has been discouraged. When investors buy into a “sunset” industry, they don’t expect growth but instead demand high current returns in the form of high dividends and stock buybacks. Investment, which reduces current returns, tends to be frowned upon. The outcome is that oil and gas prices will likely remain elevated until energy alternatives grow enough to render oil and gas irrelevant. That might take a long time.
- Drillers have gone into this year with reduced hedges and are therefore vulnerable to price declines. This fact might make oil equities more sensitive to falling prices.
The Ukraine war has led to a major restructuring of global oil and gas flows. As Russian oil is increasingly sold to China and India, the U.S. has become a key exporter to the EU. Similar patterns are emerging for LNG. As we noted last week, Russia has replaced the Saudis as the lead supplier to China. China and India are taking advantage of this restructuring by purchasing Russian oil at lower prices.
China’s recovery from its Zero-COVID policy is expected to lift oil demand. Forecasters expect that this recovery will account for 40% of this year’s growth in demand.
The Chamber of Commerce is pressing to speed up permitting for energy projects. Interestingly enough, it’s not just oil and gas companies that are supporting the effort.
Western sanctions have changed global oil flows. One result of this rerouting is a glut of diesel fuel in Asia.
Despite promises, the Biden administration continues to delay the rebuilding of the SPR. Our position is that these delays will become permanent.

Geopolitical News:

Last week, there was an attack on a U.S. military post in eastern Syria. Iranian-backed militants were involved, and the U.S. has retaliated with air strikes. Although the U.S.’s commitment to the region is being questioned, it is important to remember that the American military footprint in the Middle East is still substantial. The attacks have increased tensions between the U.S. and Iran. It is arguable that Iran is using such attacks to encourage the continued withdrawal of the U.S. from the region. Meanwhile, the administration is trying to avoid escalation while also maintaining a presence in Syria.
- Internal tensions within Iran remain elevated. The leadership is trying to decide if its harsh response should be adjusted.
Oil exports from the Kurdish region of Iraq have been halted as Iraq has won an arbitration ruling concerning the control of oil flows from the area. The news was offered as the reason for this week’s bounce in crude oil prices, although we suspect that technical selling had been exhausted.
Russia has become a major investor in Iran. We are seeing a China/Russia/Iran bloc emerge fostered by Western sanctions.
- The U.S. has added sanctions on firms involved in the Iranian drone supply chain.
- Russia is supplying Iran with cyberweapons.
- Russia is working to restore relations between the Assad regime in Syria and the Kingdom of Saudi Arabia (KSA).
- Although Russia was unable to get the UN to investigate the Nord Stream pipeline explosions, Moscow says it will continue to call for international investigations.
Russia has cobbled together an aging fleet of oil tankers to evade Western sanctions. There are growing concerns that the state of these vessels could trigger an environmental incident.
Although Russia was initially able to evade sanctions and benefit from high oil prices, as the war grinds on, there is growing evidence that the Russian economy is starting to topple. There are increasing reports of labor shortages, caused by military recruitment and draft avoidance, and the lack of Western investment is beginning to take a toll. If this continues, it could lead to less oil being available on world markets.
We have been monitoring the rapidly evolving diplomatic situation in the Middle East. One element of that change was China’s involvement in fostering a détente between Iran and the KSA. This change has somewhat isolated Israel, and we note that the Israelis, who view Iran’s nuclear program as an existential threat, are warning that uranium enrichment above 60% may trigger a military response.
- The KSA announced it will invest and participate in the construction of a new refinery in China. The Saudis have agreed to store oil in China as well.
- The KSA has formally joined the Shanghai Cooperation Organization, a China-led group of like-minded nations. This action is further confirmation of the KSA’s drift toward Beijing.
- The biggest prize in the region, in terms of oil production, might be Iraq. The country produces about 4.5 mbpd, but some analysts believe it could lift production to rival the KSA. With 20-year retrospectives being made on the U.S. invasion of Iraq, one unfortunate consequence is that Iraq has never developed a working government. For the most part, governments have been riven by religious and ethnic strife, and corruption is endemic. As we noted in a recent Bi-Weekly Geopolitical Report, China viewed the Iraq invasion as evidence that the U.S. was trying to secure oil supplies. Although events tend to discount that take, as we note in the report, Beijing’s opinion on the matter hasn’t changed. As a result, China has been encroaching on the region to secure oil flows. We could see Beijing try to bring order and investment to Iraq; however, as the U.S.’s experience has shown, it can be hard to manage the divisions in the region.
Mexican President AMLO has generally pined for a return to the 1930s when the Institutional Revolutionary Party (PRI) created its political monopoly. One of its tools was the nationalization of the Mexican oil industry. In recent years, Mexico has gradually opened its oil industry to foreign investors in a bid to lift production. AMLO has aimed to reverse that opening but has generally found it impossible to do so without declines in production. Thus, we are seeing a reopening of Mexico’s oil industry to foreign companies.
Venezuela has arrested 21 people connected to a corruption scandal tied to PDVSA, the state oil company. Oil exports have been curtailed due to various investigations.

Alternative Energy/Policy News:

This week, the Biden administration is expected to issue rules on what exactly will qualify for the green subsidies associated with EVs. Trade negotiators are actively trying to shape the outcome.
Change creates winners and losers. Although there is the rare circumstance of a win/win scenario, we find that such an outcome is exceedingly rare in real life. Geothermal energy may be about as close as we can get to clean, low-cost power with seemingly few “losers.” Japan has great geothermal potential as it rests on the ring of fire, a region of the world where volcanic activity is near the surface, meaning that tapping the planet’s inner heat is easy. Yet, Japan has been slow to exploit this power source, which is a bit shocking given that the island nation is notoriously energy deficient. Why? Japan is famous for its hot springs and the owners of these springs fear that tapping this resource will harm the springs and end their livelihood.
- As cities implement regulations to curb greenhouse gases from buildings, direct geothermal power is one alternative that might help buildings meet the new rules.
Europe continues to expand its solar power but is increasingly beholden to China for raw materials and technology. This is a vulnerability the EU feels it must address (see below).
The U.S. and Japan have entered a narrow trade agreement on critical minerals. The U.S. is moving away from large, multilateral trade arrangements, but narrowly focused ones are getting done. We note that it looks increasingly likely that the EU will join the U.S. and Japan in this effort.
As we noted last week, carbon capture technology will likely be critical in curbing the effects of greenhouse gases, and the field is rapidly evolving. This database from the IEA shows all the global projects underway.
Researchers have successfully created “green” hydrogen from seawater. If this process is scalable and economical, it could provide an alternative to electrification for transportation.

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Daily Comment (March 29, 2023)

Posted on March 29, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the U.S. banking crisis, where the Senate Banking Committee took testimony yesterday from Federal Reserve Vice Chair for Supervision Barr and other top bank regulators. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including this week’s big break-up of a major Chinese internet-commerce company and increasing weakness in the Russian economy.

U.S. Banking Crisis: In his testimony to the Senate Banking Committee yesterday, Fed Vice Chair for Supervision Barr revealed that the central bank regulators had issued numerous warnings to Silicon Valley Bank (SIVB, $106.04) about its asset and liability risks over more than a year, virtually up until the time that the bank failed earlier this month. Nevertheless, the Senators on the committee castigated the Fed for not following through on those warnings and not forcing the bank to take action. Barr and other top bank regulators will testify today before the House.

When asked how quickly a bank should respond to supervisory directives from the Fed, Supervisory Chair Barr, incredibly, said he didn’t know the time frame for such action.
The hearing showed that legislators are not only considering making more banks subject to the stricter regulatory regime imposed on the biggest banks, but they may also consider new supervisory rules and procedures for the Fed itself.

U.S. Labor Market: With multiple state and local governments now requiring that job listings include pay ranges, new research suggests the added information can incentivize employees to work harder, so long as they believe the pay system is fair. The research helps ease some employers’ concerns that the new pay transparency could spark tension in their workforce and cause lower productivity.

U.S. Artificial Intelligence Industry: Elon Musk and more than 1,000 other technology executives and researchers have signed a public letter calling for a six-month pause in the development of advanced artificial intelligence systems, such as OpenAI’s ChatGPT, in order to halt what they call a “dangerous” arms race. According to the letter, the advanced AI systems which are now being developed so quickly are beyond what humans can understand, predict, or reliably control.

The signatories hope that a break would allow for the development of safety protocols and other controls for the technology.
If the pause can’t be put into place voluntarily and verifiably, the signatories urge a government-mandated moratorium.
While we doubt such a pause will be implemented, we think the letter does reflect the extraordinarily rapid development of the technology, which is already transforming everything from key industries to military strategy.

China-Taiwan-United States: As Taiwanese President Tsai Ing-wen prepares to embark on her 10-day visit to the U.S. and Central America, the Chinese government warned that her planned meeting with House Speaker McCarthy would be “another provocation” and that China would “resolutely hit back”. When then House Speaker Pelosi visited Taiwan last year, the Chinese responded with an aggressive series of military exercises around the island. The coming “transits” through the U.S. and the meeting with McCarthy could well spark a repeat of those exercises or other potentially dangerous responses.

China: Internet commerce giant Alibaba (BABA, $98.40) announced yesterday that it will reorganize into a holding company with six independently-run units for cloud computing, Chinese e-commerce, global e-commerce, digital mapping and food delivery, logistics, and media and entertainment. Each of the units could seek their own initial public offerings of stock.

In all probability, the breakup was ordered by the Chinese government as part of President Xi’s continuing effort to rein in the country’s technology giants and bring them to heel. While that effort has diminished the companies’ power, it could also be a positive for investors. Alibaba’s shares have surged in response to the reorganization.
Government officials and investors here at home have also called for some big U.S. technology giants to be broken up on antitrust and freedom of speech concerns, which could likewise unlock a lot of value. However, authoritarian governments like the one in China have much more power to do so. In a democracy like the U.S., bringing such break-ups into effect can be much more difficult due to the diffuse power structure and multiple political actors that would need to agree.

United States-Russia: Attempting to retaliate in a calibrated manner against Russia’s recent decision to suspend its participation in the New START nuclear arms control treaty, the U.S. yesterday said it will stop sharing certain detailed data on its strategic nuclear forces with Russia.

The move will likely lead to a further weakening of the last remaining Cold War-era arms control agreement between the U.S. and Russia.
Full abrogation of the treaty would allow the U.S. to boost its nuclear arsenal to account for China’s rapid nuclear build-up, but that would also likely set off a risky nuclear arms race between the U.S., China, Russia, and potentially other countries.

Russia: Although the Russian economy initially appeared to be weathering the Western sanctions imposed after the Kremlin launched its invasion of Ukraine, it now appears that it is starting to suffer more substantially. Since global oil and gas prices have retreated from their post-invasion highs, the resulting revenue declines and big military expenditures have left the government with huge budget deficits. The ruble has also started to decline sharply, while emigration and mass conscription have produced labor shortages.

The intensifying difficulties are likely a harbinger of continued economic weakness in the long term.
As we have long argued, Russia’s economic problems will also force it ever more deeply into China’s embrace, making it a key-but-junior partner in China’s evolving geopolitical and economic bloc.

Source: Russian Finance Ministry via CEIC Data

United Kingdom: Yesterday, the pro-independence Scottish National Party narrowly elected Humza Yousaf to replace Nicola Sturgeon as its leader. The election also puts Yousaf in line to be elected as Scotland’s first minister in the coming days. Because of the narrowness of Yousaf’s win and the attacks he endured over his past roles as Scotland’s transport, justice, and health minister, he may not be a strong advocate for independence in the coming years. If he does prove to be a weak leader for the SNP, the resulting political stability could be a positive for British stocks.

Brazil: Former President Bolsonaro plans to return to Brazil tomorrow for the first time since he fled to Florida after losing his bid for re-election in last year’s elections. Bolsonaro will face a number of probes into corruption and his role in the post-election takeover of the capitol by rioters, but he will also reportedly attempt to re-energize Brazil’s right-wing movement and undermine his successor and political nemesis, leftwing leader Luiz Inácio Lula da Silva. Any resulting political instability would likely be negative for Brazilian stocks.

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Daily Comment (March 28, 2023)

Posted on March 28, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the U.S. banking crisis. Federal Reserve Vice Chair for Supervision Barr will be testifying on the crisis before the Senate today. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including at least a temporary truce in Israel’s unrest over judicial reforms and news of an important new U.S.-Japanese trade deal on critical minerals.

U.S. Banking Crisis: Fed Vice Chair for Supervision Michael Barr will testify before the Senate today on the failure of Silicon Valley Bank (SIVB, $106.04) and the broader U.S. banking crisis. In his written testimony, Barr is expected to paint Silicon Valley as a “textbook case of mismanagement.” However, the Senators are also likely to grill Barr intensively over the regulators’ failures to discipline the bank before it failed. Meanwhile, calmer financial markets continue to suggest that the overall banking crisis in the U.S. has dissipated, at least for now.

European Union-Germany: Over the weekend, Germany and the European Commission reached an agreement under which Germany will lift its opposition to a new EU law banning the sale of automobiles with internal combustion engines starting in 2035. In return, the EU Commission has committed itself to finding a legal way to allow the sale of such engines if they burn synthetic “e-fuels.” The deal diffuses an EU governance crisis and may also help preserve tens of thousands of jobs in Germany’s auto-centric economy.

France: Prosecutors have raided several large French banks today as part of Europe’s broad “cum-ex” tax evasion scandal. The targeted institutions include BNP Paribas (BNPQY, $28.05) and Société Générale (SCGLY, $4.32).

Russia-Ukraine War: Russian President Putin still hasn’t announced another “partial” mobilization of troops like he did last fall, probably because of the political risks in doing so. Reports indicate, though, that the government is still making a concerted push to generate new volunteers for the military to replace the enormous casualties in the war to date. Potential volunteers are being offered a wide range of incentives, including lucrative combat pay, educational assistance, tax breaks, and debt assistance.

Separately, the Hungarian government approved Finland’s accession to the North Atlantic Treaty Organization yesterday, furthering the strengthening and expansion of NATO that was touched off by Russia’s invasion.
However, Turkey and Hungary continue to stall their approval of Sweden’s bid to join NATO, based on Turkey’s concern that Stockholm hasn’t been tough enough on what it calls Kurdish terrorists that have sought refuge in Sweden.

Saudi Arabia-China-Russia: Saudi state oil company Aramco (2222, SAR, 32.15) said it has signed deals to supply a total of 690,000 barrels per day of Saudi crude oil to Chinese refiners. Aramco will also take a 10% stake in a major Chinese oil refiner. The deals illustrate how the Saudis are fighting to retain their market share in China even as Russia boosts its cut-rate sales to the country in response to the sanctions imposed on it because of its invasion of Ukraine. That sets up an intensifying Saudi-Russian competition to supply China, which will likely help cement China’s influence over the two countries.

Israel: Faced with mass protests and the risk of military opposition, which we described in our Comment yesterday, Israeli Prime Minister Netanyahu has agreed to postpone the initial voting on his controversial judicial reforms. However, he also vowed to have the Knesset take up the legislation again at the end of April, following its spring break. That suggests the crisis isn’t necessarily over and may heat up again later in the spring, which would likely be detrimental to Israeli equities.

United States-Japan: The U.S. and Japan today plan to sign a trade agreement covering critical minerals used in electric-vehicle batteries. Under the deal, the two countries will refrain from imposing export duties against each other for lithium, cobalt, manganese, nickel, and graphite. They will also share information on potential labor violations in the supply chain for those critical minerals and “identify opportunities to build their respective capacities.”

The deal provides further evidence of how the U.S. and Japan are strengthening their ties in the face of growing geopolitical and economic threats from China.
With the critical-minerals trade deal in place, Japanese electric vehicles made with metals processed in Japan could become eligible for the tax incentives included in last year’s Inflation Reduction Act. That would further improve U.S.-Japanese ties.

U.S. Commercial Real Estate Industry: New data show that employees working from home and rising interest rates are now even putting financial stress on “Class A” office buildings, which until now had been holding up well. The data shows that these buildings, which are often well-located and rich with modern amenities, are now facing reduced occupancy, falling rents, and even several mortgage defaults.

U.S. Defense Industry: Yesterday, President Biden invoked the Defense Production Act (DPA) to spend $50 million on expanded U.S. and Canadian production facilities for printed circuit boards, which are used in missiles and radars, as well as civilian energy and healthcare electronics. With supply chain hurdles continuing to hinder the production of key military goods, we suspect we will see further, bigger DPA orders in the future.

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Daily Comment (March 27, 2023)

Posted on March 27, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the U.S. and European banking crises. Fortunately, it is looking more and more like the crises are dissipating for now, although we remain cautious about any other stresses in the financial system because of the central banks’ continuing interest-rate hikes. We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including signs that U.K.-style mass strikes for higher pay are spreading to Germany and an outbreak of major political protests in Israel.

U.S. Banking Crisis: Earlier today, the Federal Deposit Insurance Corporation announced that First Citizens Bancshares (FCNCB, $550.00) had agreed to acquire the deposits, loans, and branches of failed Silicon Valley Bank (SIVB, $106.04). To facilitate the deal, the FDIC said it would share any of First Citizens’ losses or potential gains on Silicon Valley’s commercial loans.

Overall, the FDIC estimated that the failure of Silicon Valley will cost the federal insurance fund about $20 billion.
In response to the deal, shares of regional banks are surging so far this morning, offering additional evidence that the crisis is abating, at least for now. Nevertheless, since the Federal Reserve continues to hike interest rates, we are keeping our eyes open for additional stresses that could arise in the financial system. For example, commercial real estate lending could be a concern, as could a drop in the demand for corporate bonds (see chart below).
- Illustrating the turmoil in the financial system, data provider EPFR said flows into U.S. money market funds have totaled some $286 billion so far in March.
- The jump in inflows likely stems in large part from individual and corporate bank depositors shifting investments to money market funds in search of higher yields and greater security.

Source: Axios Visuals.

European Banking Crisis: Ammar al-Khudairy, the chairman of Saudi National Bank, said he will resign his position “for personal reasons” two weeks after his comments about Credit Suisse helped spark a panic about the Swiss banking giant and led to its government-led takeover by UBS (UBS, $18.99). The resignation is just one aspect of the fallout from the Credit Suisse collapse and takeover. All the same, consistent with the rebound in U.S. regional bank shares so far this morning, major European bank shares are also on the upswing today.

Germany: Strikes by two major transportation unions have disrupted economic activity throughout the country today, potentially indicating that public sector strikes for higher pay like those in the U.K. may be spreading to the rest of Europe. Organizers of the 24-hour warning strike in Germany say they are protesting huge increases in the costs of food and energy and are demanding higher pay to compensate for them.

Russia-Ukraine War: Ukraine’s top military commander, Gen. Valeriy Zaluzhnyi, stated that his forces are close to halting any further Russian advances around the eastern Ukrainian city of Bakhmut. Meanwhile, an analysis by the British Ministry of Defense also suggests the Russian advances around the city have run out of steam in the face of massive losses of troops and equipment.

If the Ukrainians can indeed stabilize the front around Bakhmut and avoid having to abandon the city, the victory could help maintain Western support and continued arms deliveries.
At the same time, the huge losses incurred in trying to take Bakhmut have left Russian forces extremely weakened. That could potentially set the Ukrainians up for a romp against the Russians when they finally launch the spring counteroffensive they have long telegraphed.

Israel: Prime Minister Netanyahu fired his defense minister, Yoav Gallant, yesterday after he publicly urged postponement of Netanyahu’s controversial proposal to weaken the country’s judiciary. Not only has the proposal sparked massive protests among Israeli citizens, but Gallant said it had also caused turmoil in the country’s military and was therefore undermining security.

The firing highlights the political polarization and instability touched off by Netanyahu’s proposal, which could impede Israel’s hard-won attractiveness as a place to invest.
The firing and imminent final passage of the legislation has sparked especially large and intense protests so far today. The Israeli president has called on Netanyahu to postpone the reform, the country’s biggest union is threatening to strike, and flights out of the major airport, Ben Gurion, have been suspended after its workers said they would join the protests. As of this writing, members of the governing coalition are reportedly deeply divided on whether or not to proceed.

Japan-China: Illustrating how strained relations between Japan and China have become, new reports say Japanese Prime Minister Kishida declined to meet with former Chinese Ambassador to Japan Kong Xuanyou before his departure in late February. Kishida’s decision not to bid farewell to the ambassador was also aimed at registering his complaint about a Chinese spy balloon that recently passed over Japan. The reports claimed that Kishida took the unusual step to protest the Chinese navy’s recent forays into the waters around the Japanese-controlled Senkaku Islands in the East China Sea, which China also claims.

The incident suggests Japan will remain fully onboard with the aggressive U.S. efforts to suppress both China’s military and its territorial aggression in the region.
That means investors could suffer collateral damage not only from actions taken by the U.S. and China directly, but also from Japan and other allies of either power.

China-Honduras-Taiwan: As suggested by President Xiomara Castro earlier this month, the Honduran government formally recognized the People’s Republic of China yesterday, severing its longstanding diplomatic relations with Taiwan and leaving Taiwan recognized by just 13 countries. The announcement appeared to be a warning to the U.S. to stop intensifying its relationship with Taipei, as Taiwanese President Tsai Ing-wen embarks on a trip to the U.S. this Wednesday.

As we have noted before, China is leaning heavily on its enormous economic heft to manage the countries in its own evolving geopolitical bloc and try to peel countries away from the evolving U.S. bloc (our analysis assigns Honduras to the U.S.-led bloc). Many countries are also trying to play China and the U.S. off each other to maximize their own economic and political benefits.
Prior to switching its diplomatic relations to Beijing on Sunday, Honduras reportedly asked Taipei to double its economic aid to the country and restructure its debt, but the request was refused. As part of China’s economic carrots and sticks, it is highly likely that Beijing offered Honduras an attractive package of economic aid, infrastructure investment, and debt relief.

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Asset Allocation Bi-Weekly – Have Policymakers Solved the Tinbergen Problem? (March 27, 2023)

Posted on March 27, 2023March 23, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

Central banking was initially created to address commercial bank runs. Commercial banks engage in a liquidity transformation, where they accept deposits, which are mostly available on demand, and turn that liquidity into less-liquid assets, usually loans or securities. Bank revenue comes from capturing this liquidity premium as less-liquid assets tend to pay a higher return than liquid ones—the advantage for giving up immediate access to the funds. A bank run occurs when depositors demand their cash back en masse but the bank cannot liquidate its loan and security assets quickly enough or at a high enough price to meet the demands of depositors. Central banks were created to accept the loans and securities from the banks in return for cash, which would allow them to address the liquidity demands of depositors.

Over time, central banks have been given additional roles. For example, during WWII, the Federal Reserve facilitated Treasury borrowing for the war effort by fixing interest rates along the entire yield curve. In the U.S., the Fed has been given the additional mandate of conducting monetary policy to achieve full employment and stable prices. As part of its financial stability mandate (described above), the Fed is also a bank regulator. At the present time, the Federal Reserve has three main mandates: financial stability, stable prices, and full employment.

Jan Tinbergen was a Dutch economist who was awarded the first Nobel Prize in economics. He formulated a rule stating that policymakers need an equal number of policy tools for an equal number of problems. If the Fed has three mandates, the Tinbergen Rule would suggest that it needs at least three policy tools. If it has less than three tools, then it may be forced to choose which mandate is the most important.

The Fed’s most important policy instrument is the fed funds rate, which (directly or indirectly) sets short-term borrowing costs for the economy. Although it has regulatory tools as well, for most of its history the interest rate tool has been its primary method for meeting its mandates. Clearly, this situation violates the Tinbergen Rule, and as such, this means the FOMC will occasionally find itself facing the Tinbergen Problem, which requires that it must choose one mandate over the others.

The key question we will try to address is, what does the FOMC do when faced with the Tinbergen Problem? More specifically, what does the Fed do if it faces a conflict between its financial stability mandate and its inflation mandate? To measure the financial stability mandate, we use the Chicago FRB’s National Financial Conditions Index (NFCI). This index of 105 financial market variables is the longest-running index of its type.

The chart on the left shows the fed funds rate along with the aforementioned NFCI. From the index’s inception in 1973 until July 1987 (when Paul Volcker’s term as Fed Chair ended), the correlation between the two series was 72%. After August 1987, it fell to 9.8%. When the FOMC changed rates during the earlier period, there was a nearly immediate response seen in financial conditions. In the later period, the correlation declined. What changed? In the earlier period, the FOMC was dealing with a persistent inflation problem. The chart on the right shows our Fed indicator, which is the yearly change in the CPI less the U-3 unemployment rate. After Volcker, monetary policy appeared to have been aimed at keeping the Fed indicator below zero. The Fed would raise the policy rate when the indicator approached zero, essentially treating a negative Fed indicator as having met the inflation/full employment mandates. Note that when the NFCI rose during this period, the policy rate was usually reduced. This is how the Fed resolved the Tinbergen Problem. By preemptively keeping prices stable (and arguing that price stability led to full employment in the long run), the Fed could directly address threats to financial stability.

Financial markets began to expect that when financial stress rose, monetary policy would be eased. Investors would suffer through the declines in risk assets during stress events but would also assume that easier policy was on the way, which would support an eventual price recovery. In other words, when faced with the Tinbergen Problem, policymakers would opt to reduce financial stress. Since this policy has been in place for over 35 years, it makes sense that investors would expect easier policy when “something breaks” in the financial markets.

The recent bout of financial system problems has raised expectations that the FOMC will stop raising rates. Financial markets have been signaling for some time that the Fed should end this tightening cycle.

This chart above shows the fed funds target rate compared to the implied three-month LIBOR rate from the two-year deferred Eurodollar futures market. Because LIBOR lending isn’t government guaranteed, the rate usually exceeds the fed funds rate. However, there are occasions when the spread inverts; we show this on the chart with vertical lines. Usually, the inversion leads to at least an end in the tightening cycle. That hasn’t been the case thus far, and we suspect the Fed has continued tightening due to elevated inflation.

The key question is, now that we have seen a financial stress event, will the FOMC follow the pattern of the past 3.5 decades and end its tightening cycle? We suspect the Fed is close to the end, but, as the chart below shows, cycles don’t usually end until the policy rate is at least within the model’s lower standard error band.

This model projects the fed funds rate using the Fed indicator as the independent variable. Since 2000, the FOMC has tended to hold the policy rate around the lower deviation line. The current deviation is about 40 bps below the lower standard deviation line, suggesting that the Fed is 15 bps short of “neutral.” We note that the rate was raised to fair value during the tightening cycle in 2004-2006, but we would not expect that to occur in this cycle.

Since the Fed has created a backstop for bank deposits called the Bank Term Funding Program, policymakers may be less inclined to lower rates due to the recent financial concerns. If so, the Fed may keep raising rates until inflation falls to an acceptable level. Given that market participants mostly expect tightening to end when the financial system comes under stress, further rate increases may be an unwelcome surprise. But, in any case, we suspect we are near the end of this tightening cycle.

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Daily Comment (March 24, 2023)

Posted on March 24, 2023March 24, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an overview of our thoughts on the Congressional hearings for both TikTok and Treasury Security Janet Yellen. Next, we discuss why central banks have decided to raise interest rates in the face of an ongoing banking crisis. Lastly, we explore the reasoning behind China and Russia’s new interest in the Middle East.

Congressional Attention: Lawmakers are looking to bolster their reputation of being tough on big banks and China during hearings on the Hill.

TikTok CEO Shou Chew testified before a hostile Congress on Thursday, as officials weigh a potential ban of the social media app. During the hearing, politicians did not shy away from confrontation. Chew, who tried to walk a tight line between being vague and honest, was challenged on his company’s ability to remain independent of Beijing. In one exchange a politician implied that Chew was committing perjury when he refused to say that the social media site does not disseminate material that would upset Beijing. The row over TikTok is likely the first of many fights over whether Chinese firms pose threats to U.S. national security.
- Chinese authorities have raided the Beijing office of Mintz Group, a U.S. due diligence firm. The raid may signal that Beijing is willing to crack down on U.S. firms and comes just a week before the country hosts Tim Cook of Apple (AAPL, $158.93) and Noel Quinn of HSBC (HSBC, $33.48) for its annual investor conference.
Meanwhile, Treasury Secretary Janet Yellen’s flip-flop regarding efforts to insure U.S. bank deposits without the approval of Congress has added to concerns that the government may need to rescue the banking system. While speaking to Congress, Yellen walked back remarks that suggested that the Treasury Department was not prepared to expand deposit insurance. Any rescue plan without congressional consent will likely meet pushback as politicians would view unilateral executive action as evidence that banking officials are not being forthright about the severity of the banking crisis. Investors have been paying close attention to Yellen’s remarks for signs of a possible bailout for regional banks.
The two separate hearings on banks and Chinese companies reflect a trend away from the Bork rule that defined the period between 1970-2010. Named after former Federal Judge Robert Bork, the rule stipulates that regulations should not be used to interfere with economic efficiency or consumer welfare. This sentiment has been the bedrock of elitist thinking regarding the government’s approach to business but is showing signs of eroding. As the congressional hearings demonstrate, lawmakers would like to prioritize policies that favor state objectives such as national security and bank stability over economic efficiency. If we are correct, this will likely lead to a higher inflationary environment as firms look to push the cost of burdensome regulations onto the consumer.

Interest Rate Fallout: Major central banks still decided to raise rates despite the ongoing banking crisis.

The decision to raise rates indicates that monetary policymakers are hesitant to stop tightening without solid evidence that the banking system’s health has no other fix. Recent liquidity injections by the Federal Reserve and Swiss National Bank have given officials confidence that the worst of the crisis has peaked. In individual statements, the Bank of England, Federal Reserve, and European Central Bank all offered reassurances that the banking system remains resilient amidst the turmoil. Additionally, each bank maintained that they remain committed to bringing down inflation and preserving financial stability.
Although central bankers signaled that they are not considering rate cuts, the market seems to believe otherwise. The CME FedWatch tool shows an 80% chance that the Fed will cut rates by its July meeting. Meanwhile, the overnight index swap rates for the GBP and EUR suggest that the BOE and ECB will look to stop hiking around June or September of this year. Movements within the bond market also suggest that investors believe that policy will begin to normalize. As of Thursday, the inversion spread between the 10- and two-year Treasury narrowed by 42 bps since the start of the month.
Monetary policymakers want to raise rates but do not want to destabilize the financial system. The usage of the backstops has offered banks some relief from deposit outflows. The latest figures from the Fed show that U.S. banks borrowed $53.7 billion from the Fed’s new Bank Term Funding Facility. However, there is still no guarantee that the turmoil in banking will end anytime soon. The sudden spike in Deutsche Bank’s (DB, $9.65) default insurance costs will likely add worries that the financial system remains fragile. As a result, it is still reasonable to assume that central banks could consider easing monetary policy this year if the banking issues persist.

Middle East Problems: The China-Russia pivot toward the Middle East complicates the efforts of the U.S. to exit the region.

Russia and China are working to mediate tensions between Arab countries to help reduce the region’s dependence on U.S. security. On Wednesday, Moscow had announced it was close to restoring diplomatic ties between Saudi Arabia and Syria. The move comes on the heels of several recent successes of China and Russia to calm violence in the region, highlighting the U.S.’s declining importance. Last week, China assisted in restoring diplomatic ties between Saudi Arabia and Iran. Moscow and Beijing may be looking to build their influence in the Middle East to disrupt efforts by the West to isolate them.
U.S. foreign policy within the Middle East continues to show signs of disarray. Despite efforts to reduce the U.S. forces within the region, the Pentagon carried out airstrikes in Syria against an Iranian rebel group. The U.S. has about 900 troops in Syria to help with Syrian fighters’ efforts against Islamic State militants. Meanwhile, Israeli Prime Minister Benjamin Netanyahu’s efforts to undermine the country’s Supreme Court and other democratic institutions have frustrated Washington. The Biden administration expressed concerns about the changes to Israeli law earlier this week. The ongoing friction will complicate cooperation efforts between the two countries as they look to take on Iran and expand the Abraham Accords.
As the U.S. looks to focus its attention on expanding its influence in the Indo-Pacific, it appears that Russia and China are looking to deepen their ties with Middle Eastern countries. The China-Russia pivot toward the region will aid efforts to reduce their respective reliance on the West. It will also ensure that China can maintain its access to commodities even as its relationship with the U.S. deteriorates, while Russia can use its relationship with Arab countries to undermine the West’s efforts to slow its petro sales through price ceilings.
- The biggest loser in this scenario may be the European Union, as it is stuck between kowtowing to authoritarian governments that challenge its value or being forced to accept U.S. foreign policy that often challenges its strategic interests.

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Daily Comment (March 23, 2023)

Posted on March 23, 2023March 23, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the Federal Reserve’s rate decision. Next, we discuss the Fed’s economic outlook and why it may not be representative of future policy. Lastly, the report examines China’s battle to avoid isolation by the U.S.

Proceed with Caution: The Fed insists it believes that the U.S. banking system is “sound and resilient,” but its guidance suggests otherwise.

The banking crisis has shifted Fed sentiment regarding future policy. On Wednesday, the Federal Open Market Committee decided to raise its benchmark policy rate by 25 bps to a target range of 4.75% – 5.00%, its highest level since 2007. The hike was in line with market expectations but comments in the Fed statement indicated that policymakers may be less committed to hikes going forward. This view is reinforced by the FOMC’s decision to replace the phrase “ongoing increases in its target rate” with “additional policy firming” in its official statement. In another sign the Fed has become less committed to imminent hikes, Fed Chair Jerome Powell implied that the FOMC may view stricter lending standards as a substitute for policy tightening.
- On a related note, the Bank of England also raised rates by 25 bps.
Despite hints that the Fed may be close to ending its hiking cycle, Powell also insisted that the central bank does not plan to cut rates this year. The lack of commitment to either raise or lower interest rates confused the market as the ongoing banking turmoil and elevated inflation suggests that the Fed should be taking some sort of action. This indecisiveness led to concerns that the Fed fears a recession may be near. As a result, the S&P 500 seesawed by rising to a session high of +0.8% at the beginning of the press conference but closing down 1.7% on the day. Additionally, gold was up 1.3% around market close, and the U.S. Dollar index dipped 0.62% in the same period.
Policymakers are still worried about the ongoing banking crisis. After all, deposit flight remains a major issue for regional banks, as demonstrated by the recent disclosure from PacWest Bank (PACW, $10.12). The possible guarantee of bank deposits do little to allay those fears since rising interest rates incentivize depositors to put their savings into higher yielding mutual funds and U.S. Treasuries. If deposit outflows persist, the Fed may be left with no choice but to cut rates in order to protect small banks, which make up nearly 40% of all loans and 70% of commercial real estate loans, and their failure could lead to a broader economic crisis.

Not Adding Up: The Summary of Economic Projections (SEP) highlights the inconsistencies regarding the Federal Reserve’s narrative.

Although the Fed dot plot from 2023 appears to be unchanged from the previous meeting, a direct comparison shows that policymakers were less inclined to reduce interest rates. The latest median forecast policy rate of the dot plots remained relatively unchanged from the December meeting, with the 2024 forecast revised slightly higher from 4.1% to 4.3%. That said, a direct comparison shows that members are more hawkish than the statement implied. As the following chart indicates, several fed officials revised up their policy rate projections. The upward revision signals that policymakers are not comfortable with lowering rates even with the ongoing banking turmoil.

GDP and employment predictions also failed to articulate a consistent story about the Fed’s view regarding the economy. Policymakers’ median forecast showed economic output expanding by 0.4% in 2023 and the unemployment rate increasing from 3.6% to 4.5% in the same year. These projections are confusing as it implies that the Fed expects that over 1.4 million workers could be displaced over a 10-month period and that would translate to merely an economic slowdown and not a recession. There is no historical precedent of this ever happening, with the closest being a period between 2002 and 2003, when household unemployment climbed to 962,000 while the annualized GDP growth ranged from 0.5-3.6% within the same time frame.
The SEP reinforces our view that the Federal Reserve may believe that the window for raising rates may be closing fast. Its modest upward revision in dot plots reflects members’ belief that the economy is too hot to bring inflation back to its 2.0% mandate. Meanwhile, the year-end forecast of the unemployment rate implies that they are not confident that the labor market will be able to remain tight throughout the year. The lack of clarity suggests that interest rate expectations could become very volatile over the next few weeks as the market weighs the release of economic data and Fed speeches. This may lead to sideways movement in the S&P 500 as investors battle over the direction of the economy and monetary policy.

China Related News: Beijing’s fear of being isolated by the U.S. and its allies appears to be edging closer to reality.

Apprehension over China’s growing influence has made it easier for the U.S. to strengthen its ties with its Indo-Pacific allies. Chinese officials expressed fury over the U.S. and U.K.’s attempts to supply Australia with nuclear-powered submarines. Beijing’s ambassador to the International Atomic Energy Agency, Li Song, warned that such a move could lead other countries to follow suit. Meanwhile, a growingly assertive China has forced some former foes to warm their ties. On Wednesday Japan ended trade restrictions on exports to South Korea, paving the way for a normalization of trade relations which had been weakened due to a dispute involving Japan’s treatment of Koreans during World War II.
Intelligence sharing by the U.S. allowed New Delhi to repel an attempted Chinese military incursion along the contested China-India border late last year. The U.S. provided satellite imagery and other real-time intelligence showing the Chinese forces gathering and preparing for the operation, which then allowed India to position sufficient forces to thwart the incursion with only minor casualties. The intelligence assistance was reminiscent of the aid provided to Ukraine last year that helped it fight back against the Russian invasion.
As China and the members of its evolving geopolitical bloc continue to probe for weak spots in the territorial defenses of their rivals, it appears that the U.S. has decided to use increased intelligence sharing to help strengthen and secure the cooperation of countries within the Indo-Pacific region such as India, Japan, Australia, and South Korea. The move to isolate China from the rest of the world risks retaliation from Beijing, who may look to offer its military weapons expertise to countries opposed by the U.S. If this assumption is correct, it would suggest that we may be headed toward a more hostile and less trade-friendly world.
As we have mentioned in previous reports, this situation generally bodes well for commodities as the hoarding of essential raw materials are likely to drive up prices.

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Weekly Energy Update (March 23, 2023)

Posted on March 23, 2023March 22, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil decisively broke its recent $72-$82 per barrel trading range. Problems in the banking sector are raising fears of a global economic slowdown. Classic technical analysis would suggest that the former support at $72 will become resistance; in other words, this level will need to be overcome if prices are going to rise.

(Source: Barchart.com)

Crude oil inventories rose 1.1 mb compared to a forecast of a 1.8 mb draw. The SPR was unchanged.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.3 mbpd. Exports fell 0.1 mbpd, while imports were steady. Refining activity rose 0.4% to 88.6% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace into mid-February, injections have slowed. Levels remain above seasonal norms, but with refinery activity starting to ramp up for summer, we should see some declines in the coming weeks.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $51.90. Although we think there is enough geopolitical risk in the world to prevent a decline to this level, it does suggest that the oil market is dealing with rather weak fundamentals.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001. Using total stocks since 2015, fair value is $92.66.

Market News:

Weaker oil prices appear to be mostly due to fears of a global recession. So far, OPEC+ has decided not to reduce supplies in response. This may be due to the cartel expecting slower production growth worldwide. We note that the Joint Organisations Data Initiative, a group of oil producers and data providers, reported that global oil output fell 0.4 mbpd in January.
Last year, the U.S. exported a record amount of petroleum products.
The EIA is projecting mostly flat U.S. oil production in the coming years, which suggests that there won’t be significant growth in shale production.
One of the behaviors we have been monitoring is hoarding. As supply security comes into question, consumers at all levels attempt to secure extra inventory. At the national level, export restrictions are one common practice. India is currently capping product exports to keep domestic prices down, while China is reportedly continuing to build crude oil inventories.
Although Europe escaped high natural gas prices this winter due to warm temperatures, German regulators warn that next winter could bring a crisis. We do note that U.S. gasification investment is rising rapidly.
U.S. refineries have been structured to produce more gasoline than other products, but as the fuel mix changes due to EVs, the industry is beginning to shift the focus toward diesel.

Geopolitical News:

Last week, we discussed the Iranian/Saudi détente. Already, we are seeing the effects from the agreement. Iran announced that it will stop supplying arms to the Houthis, and Saudi Arabia has opened up talks with Houthi groups with the likely goal of ending hostilities. Although negotiations with the Houthis will be difficult, we do expect a peace deal to eventually emerge.
- As we reported last week, Iran is moving quickly to bolster relations with other Arab states. We note that Iran has secured a new accord with Iraq in the wake of the Saudi talks.
- There are reports that Iranian President Raisi and MBS may have an official visit, providing further evidence of improving relations between the two countries.
- Also, EU diplomats have been meeting with their Iranian counterparts. The EU would like to see Iranian sanctions eased so Europe can import more Iranian crude oil.
Although the oil price cap on Russia has mostly disappeared from Western news, it remains on the minds of oil producers. Russia and the Kingdom of Saudi Arabia (KSA) conducted talks last week and the price cap on Russian oil was a topic of discussion. Although there hasn’t been anything in the Western media about expanding the cap, the Saudis are clearly worried that it might be applied to other oil producers.
- Interestingly enough, although the price cap may or may not be to blame for reducing Russian oil revenue (falling prices for everyone might be doing the trick), oil exports are continuing mostly due to some oil traders who are willing to facilitate the trade. However, we are noting that Russian oil is struggling to find a home, in part because it can only sell directly to nations willing to ignore Western sanctions. Russia is both changing its benchmark for crude oil exports and the tax regime in order to capture more revenue.
- Oil trading firms are suggesting they would handle more Russian crude oil if Western governments had clear rules for the trade. The West really doesn’t want Russian crude oil sales to stop (the world needs Russian oil), but they want to reduce the revenue coming from Russian oil sales.
- Russia is now the largest oil supplier to China. In the past, the KSA took aggressive steps to maintain its market share in the U.S.; for example, when the KSA’s rank fell below second, it tended to boost output which lowered prices. It will be interesting to see how Riyadh reacts if this condition continues.
- Despite reports of oil sales above the price cap, the U.S. is arguing that the all-in costs are below the $60 target.
- We note that rising Chinese oil demand is pushing shipping costs higher.
President Xi was in Russia this week. Although his meetings with President Putin were mostly on Ukraine and expressions of friendship, we note that China has been “slow walking” the expansion of natural gas pipelines that would supply piped gas to China. It is unclear why Xi is uncomfortable with expanding Russian gas sales, but it might be that Beijing doesn’t want to trigger sanctions. It is worth remembering, though, that Russia and China have had hostile relations in the past, and therefore, China may be worried about becoming overly dependent on Russia for energy supplies.
Due to a spat over COVID origins, China had stopped buying coal from Australia. As relations with Australia improve, China has now begun to aggressively buy coal.
There have been a series of military/security helicopter crashes in the Kurdish region of Iraq. Although it is difficult to know what exactly is happening, it has all the hallmarks of an internal squabble between Kurdish groups. One of the reasons a Kurdish state doesn’t exist is that the Kurds themselves are not unified. If these tensions continue to rise, it could adversely impact oil production in the region.
The Venezuelan oil minister has resigned on suspicions of corruption.

Alternative Energy/Policy News:

China’s $7.8 billion battery plant in Hungary, supported by the Orbán government, is facing strong local opposition. Meanwhile, South Korea is implementing a $35 billion battery investment program in an effort to catch up with China.
Europe is taking steps to revive mining to reduce its reliance on Chinese EV materials. Over the past 40 years, raw material production has shifted to developing economies since the developed economies have shunned these activities for either cost or environmental reasons. However, as supply risks rise, there has been a renewed effort to find more reliable sources of these products. The U.S. is engaging in similar efforts.
- We note that Glencore (GLNCY, $10.91) is no longer the largest cobalt miner, losing that rank to China’s CMOC (603993, CNY, 5.70).
We have been monitoring geoengineering for several years. Geoengineering can take many forms, but essentially it involves using various techniques to directly affect temperature or the climate. The practice is controversial as there are concerns that a private actor could deploy a measure that could have adverse effects on some parties who then have little recourse to respond. Unintended consequences could result. MIT has reported that the U.K. performed an experiment with a geoengineering delivery system that had limited oversight.
- General Electric (GE, $91.96) announced it is moving from prototype to demonstration scale for its direct carbon capture technology. Direct carbon capture will likely be needed to contain greenhouse gases.
- It should be noted that once this CO₂ is captured, it must go somewhere. One method of dealing with the gas is to inject it into underground storage. Not surprisingly, the communities involved, either where the gas gets injected or near the pipelines carrying it, are concerned. Another way, although more costly, is to capture the gas in bricks.
There is growing interest in using geothermal power as a battery.
A surge in lithium production has led to lower costs for EV producers. Although lithium demand remains strong, prices have been falling since January.
ESG investing has become controversial. Blackrock (BLK, $638.57) is attempting to manage the competing sides of the debate.

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