Weekly Energy Update (October 14, 2022)

Posted on October 14, 2022December 13, 2022 by Amanda Ahne

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

Crude oil prices remain in a downtrend.

(Source: Barchart.com)

Crude oil inventories rose 9.9 mb compared to a 1.0 mb build forecast. The SPR declined 7.7 mb, meaning the net build was 2.2 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 11.9 mbpd. Exports fell 1.7 mbpd, while imports rose 0.1 mbpd. Refining activity fell 1.4% to 89.9% of capacity. We are clearly in the period of autumn refinery maintenance, so falling refining activity should be expected for the next few weeks.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. As the chart shows, we are past the seasonal trough in inventories. The build seen in October into November is usually due to refinery maintenance. With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

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.

Total stockpiles peaked in 2017 and are now at levels last seen in 2003. Using total stocks since 2015, fair value is $105.85.

The SPR: As we discussed earlier, the SPR has become something of a buffer stock; thus, it makes sense when analyzing prices to consider U.S. inventories as the SPR and commercial stocks combined, as we do above. Another element of the reserve is its composition. Oil is broadly described as heavy or light (the measure of viscosity) and sweet or sour (the level of sulfur). U.S. refineries have made investments over the years to favor sour crudes; the idea was that as fields aged, more oil would be of that variety.[1] And so, when officials filled the SPR, sour crudes were favored, and until recently, the mix was 60/40 in favor of sour. However, in the recent withdrawals, sour crudes were drawn much faster than sweet crudes. Over the past year, 190 mb of crude oil has been pulled from the SPR: 156 mb have been sour, and 44 mb have been sweet. At present, there are only 213 mb of sour crude remaining in the SPR, meaning its effectiveness to provide supply security has been compromised.

Unsavory Tradeoffs: The OPEC+ decision to cut allocations by 2.0 mbpd has broad ramifications. The cartel has argued that falling demand is behind the output decision. This is what we see so far:

The Biden administration is clearly upset. The president traveled to Riyadh earlier this year to attempt to improve relations. Clearly, that didn’t work. Biden did not have kind things to say about Crown Prince Salman during the U.S. elections, and so relations between the U.S. and the KSA had cooled. In the aftermath of the OPEC+ decision, the administration has accused the KSA of aligning with Russia and has warned of other measures to counteract the loss of production from the cartel. The alignment with Russia isn’t just rhetoric. We note the president of the UAE is visiting St. Petersburg to speak with President Putin. There are also reports that the U.S. has asked the KSA to delay the announcement for a month (ostensibly to avoid prices increasing heading into the midterms); Riyadh pressed ahead The White House is indicating that the U.S. will “re-evaluate” relations with the kingdom.
- The KSA has denied the allegations that it is in league with Russia.
- Some members of Congress have called for the removal of U.S. military contractors and troops from the region. There have also been discussions of halting arms sales.
- Additional SPR sales have been announced.
- NOPEC legislation has been resurrected. This legislation would give the U.S. Attorney General the right to enforce U.S. antitrust laws on foreign national oil companies. Although it is not clear how that would work exactly, it’s conceivable that it would make it impossible for the affected OPEC+ nations to sell directly to the U.S. We doubt this legislation will pass as it often returns when the U.S. isn’t happy with the cartel’s behavior. However, we may be reaching a point where divisions between the U.S. and various cartel members have become strained enough that momentum may build for the bill’s passage.
- Another measure would build a case to take OPEC+ to the WTO on restraint-of-trade charges.
- What has not been mentioned yet is some sort of action against Saudi investments in the U.S.
- Clearly relations are cooling.
We should note that all of these actions have a clear potential for adverse consequences. Withdrawing troops from the KSA and UAE may create conditions where Iran could undermine these governments, leading to potentially catastrophic outcomes for the West. Complicating matters is the U.S. political environment. Currently, a significant element of the electorate believes that if the other party is in power, civilization as we know it is at risk. Such attitudes lead those in power to take extreme measures to stay in power. The aggressive SPR sale has elements of maintaining political power at the risk of not having the reserve if a broader crisis emerges. Some of the discussion of attacking OPEC+ is shaded by seeing the KSA as supporting the GOP. At the same time, Riyadh should note that attitudes toward the KSA are hardening in a bilateral fashion.
Finally, it should be remembered that the EU embargo on Russia crude goes into effect on December 5. It may not make sense to punish OPEC+ when the world will need to offset the potential loss of Russian oil.
At the same time, the administration has been ignoring the effects of some of its actions on the concerns of the Gulf producers. The aggressive draining of the SPR was seen as a clear threat. The talk of price caps isn’t welcome either.
One item to keep in mind is that the actual level of cuts will not approach 2.0 mbpd, because the cuts are coming from allocations, not actual production. The actual cuts will likely be closer to 0.8 mbpd, as the Gulf states, who are meeting their production quotas, cut back output.

The IEA is warning that the OPEC+ cuts could plunge the global economy into recession.
In addition to expressing anger about the KSA, the U.S. continues to negotiate indirectly with Iran for the latter’s return to the JCPOA. In theory, this could add one to two million barrels per day of oil to world markets, although we have our doubts that there is this much oil available. The sanctions regime has weakened and thus the available supplies would likely be modest. However, the “unsavory tradeoffs” include Iran’s human rights problems, and, perhaps more worrisome, it is in the midst of a crackdown on expanding unrest. The optics of cozying up to Tehran at this particular moment are troublesome as it is estimated that at least 185 people have died, including 19 children. This is especially the case since the protests appear to be widening with anecdotal evidence that security forces may be joining the rioters. Energy sector workers are also going on strike in sympathy. The longer these protests persist, the greater the threat to the regime. The government seems to have little fear of using force against young protestors but appears to be reluctant to attack oil workers. We also note that we are seeing some level of dissent from the clerical class.
- Although we don’t expect the government to fall, we do note that authoritarian regimes tend to collapse without warning. At least initially, an overthrow would be bullish for oil because it isn’t obvious if the lack of government would affect the oil infrastructure. If a Western-friendly government were to take power, however, we would expect the West to rapidly take steps to support that government, which would almost certainly include lifting sanctions.
There have been reports that the administration may ease sanctions on Venezuela in a bid to increase oil supplies, although we note they have been denied. The Maduro regime has also been repressive against opponents, and, again, the optics are not good.
Perhaps the most important point that has been lost in all the controversy is that the world has dramatically underinvested in oil production. As we have noted for months, ESG concerns continue to weigh on non-OPEC supply, but even OPEC+ is underinvested. The fact that OPEC+ now talks about “production targets” instead of “quotas” shows how much conditions have changed. As long as investment remains depressed, oil prices will remain elevated and could conceivably move much higher.

The bottom line is that the commodity business can require compromises. At times, governments can decide that they will bear the cost of higher commodity prices because a producer is so far beyond the pale that cooperation is impossible. For example, the U.S. has avoided buying Iranian oil since 1979, but in other cases, governments will turn a “blind eye” to such behavior to secure resources. The Ukraine War has exacerbated these difficult decisions. The EU delayed applying embargos on Russian oil and gas until early 2023, for example. We expect more difficult issues to develop in the future.

Market News:

The EU held talks about setting a natural gas price for the group. The idea is that they agree on a price and if the market price is above that level, the cost would be subsidized. At the time of this writing, the meeting did not succeed in setting a policy.
A leak in the Durzhba pipeline was discovered in Poland. Although there are fears of sabotage, first accounts seem to indicate that it was an accident. The event has reduced oil flows to Germany.
As the EU ramps up LNG purchases, emerging market (EM) nations are struggling to acquire supplies and the buying will also likely push U.S. prices up as LNG production ramps up.
The U.K. has announced a new round of drilling licenses for the North Sea. The U.K. government stopped issuing licenses in 2019, promising a comprehensive environmental review. High prices have prompted the decision to start issuing licenses again.
In an ominous sign, so-called “ducs,” or drilled but uncompleted wells, inventory is shrinking. This development suggests that wells are being completed faster than new wells are being drilled. Without rapid investment soon, U.S. production will likely begin to contract.
In the late 1970s, President Carter gave his famous “malaise” speech, commenting on energy while wearing a cardigan. The message was that sacrifice would be required in the face of high energy prices.[2] French President Macron is offering a similar message today. Partly in response, Paris, the “City of Lights” is darker.
Another element of the 1970s was price caps on energy products. These caps were blamed for the infamous gas lines at filling stations. Price fixing is one response to scarcity, but if rationing isn’t included, it usually leads to shortages. Why? There is a political incentive to set the price below the market-clearing price. If the market price were acceptable, no one would have an interest in fixing the price. During WWII, price fixing coupled with rationing worked reasonably well. However, the incidence of this policy fell on higher income households who had the money to buy more food but were restricted by rationing. As the war ended, so did rationing, and prices were allowed to fluctuate. Note that as rations were lifted, food prices jumped after the war.
China’s LNG demand will remain elevated in the coming years. As we noted above, without increasing investment, the globalization of natural gas will tend to move U.S. domestic prices to overseas prices, meaning Americans will pay more for heating, fertilizers, and electricity.
Despite these experiences, price caps are being reconsidered as a way to make it through the winter. Several different ideas are being considered, but without proper care, the end result is likely shortages.

Refinery workers in France have gone on strike and there are numerous reports of spot shortages and tensions at filling stations. The Macron government is trying to force workers back to the refineries but is struggling to enforce its will. There is talk of wider protests against inflation.
The Permian Basin has been responsible for nearly all the production growth this year. However, to continue to expand, associated natural gas that comes from drilling must be processed. Flaring, which could be one way to address this issue, has become untenable. While there is still some natural gas processing capacity available, without additional investment, production growth could stall.
Although OPEC+ has called on production cuts, we note that the KSA has signaled a reduction in supplies to Asia. It appears supplies will be met by drawing down inventories.
Munich Re (MURGY, $24.40), the world’s largest reinsurer, announced restrictions on issuing policies on oil and gas projects. Financing constraints have been a factor in restricting oil and gas production.
Venture Global (1557028.MC, €10.16) announced a deal to send U.S. LNG to Germany.

Geopolitical News:

Germany’s unilateral energy price support package continues to raise hackles across the EU. In response, Germany is proposing to support unified EU debt to broaden subsidy support. Increasingly, the EU and Eurozone have been creating bonds as opposed to member nation debt instruments.
Sweden’s investigation of the recent Nord Stream pipeline attacks strongly suggests sabotage.
Last week, we noted that Lebanon and Israel were nearing a deal on production sharing for offshore natural gas development. A deal has been tentatively agreed upon but will need ratification by both governments. We expect it to pass as Israel wants energy security without the distraction of tensions with Lebanon, and Lebanon desperately needs the revenue from natural gas sales. The U.S. cheered the arrangement, which may ease tensions between Israel and Hezbollah, which dominates the Lebanese government.
Iran has been an observer of the Shanghai Cooperation Organization (SCO) since 2005. It has wanted to join the group, but the leadership was uncomfortable admitting a member under sanctions, fearing that the SCO would face scrutiny from the West. However, now that Russia, a long-time member of the SCO, is under sanctions, there is a higher likelihood that Iran will be admitted. If so, the SCO will probably become an anti-U.S. organization.
- In Iran, state television was hacked during a news bulletin.
- The IAEA reports that Iran is aggressively moving to expand uranium enrichment at its underground facility at Natanz. This news will raise questions about the wisdom of returning to the JCPOA.
The U.S. energy industry is warning against implementing product export constraints.

Alternative Energy/Policy News:

Florida’s electrical grid has reportedly recovered rather quickly in light of the hurricane devastation. The grid was strengthened by using concrete and steel power poles and burying power lines underground. Areas that built solar capacity have mostly emerged unscathed.
One problem with EVs is their high cost. Ford (F, $12.16) has announced a second price increase of the F-150 Lightning since summer. The base model now costs over $50k.
The recently passed Inflation Reduction Act has provisions that provide large subsidies for EVs if the vehicle is mostly made in the U.S. with American components. The EU is crying foul, suggesting this is protectionism.
Copper is critical to EVs, and the West is short on copper supplies.
Austria is challenging the EU ruling that nuclear power and natural gas are “green” fuels. This suit joins others from environmental groups. If the challenges are successful, ESG guidelines will restrict investment in these two sources of energy.
General Motors (GM, $32.65) has decided to expand its battery production to include electricity storage for home and commercial use. For homeowners, this possibility will be tied to an EV.
Researchers have developed a prototype lithium battery with 40% more capacity.
A new cobalt mine, the only one of its kind in the U.S., recently opened.
The EU wind industry is contracting due to rising input costs.
New Zealand is applying taxes on livestock to curtail methane emissions.
The uranium miner Cameco (CCJ, $21.95) announced an investment in the nuclear power division of Westinghouse, which is owned by Brookfield Partners (BBU, $19.48). Cameco’s investment looks like a bid to vertically integrate.

[1] This decision turned out to be a mistake. Crude oil from fracking turned out to be sweet, meaning that it wasn’t ideal for U.S. refiners. Thus, sweet crude is usually exported, forcing the U.S. to import sour crudes. In broad terms, this means the U.S. is oil independent, but in practical terms, it’s not, due to the sweet/sour imbalance.

[2] It wasn’t a popular speech.

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Daily Comment (October 13, 2022)

Posted on October 13, 2022October 13, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning and happy CPI day! U.S. equity futures were moving higher in front of the report, and we will cover the CPI numbers in detail below, but in short, they were bad, leading to a sharp reversal in equity futures. Our coverage begins with economics and financial news, with a deep dive into the Fed Minutes. Up next is China news as the U.S. is cracking down on technology transfers. War coverage follows and we close with the international news roundup.

Economics and Finance: The Fed Minutes offer some insight into the bank’s thinking.

The September FOMC minutes revealed that the Federal Reserve favors hefty rate hikes, but we are starting to see some concern emerging about overdoing it. Although the report showed that supply chains are improving, officials are worried that the pace of increases in goods prices is still elevated. The persistent pick up in goods inflation has led some members of the committee to take a look at firms’ profits. Wholesale and retail margins, referred to as trade services below, is the largest contributor to producer services inflation.

Central bankers across the world are plowing ahead with tight monetary policy regardless of the economic impact. Minnesota Fed President Neel Kashkari warned against bets in favor of a Fed pivot, stating that the bar is very high given the level of inflation. In the U.K., officials from the Bank of England signaled that rates are likely to rise sharply and announced plans to end its bond-buying program on Friday. Lastly, the European Central Bank President Christine Lagarde dismissed speculation that the EU is in recession in a sign that the bank plans to forge through with additional rate hikes. Tightening financial conditions will hurt risk assets and slow the global economy.
One of the complicating factors for the Fed is that labor markets remain tight. A factor driving this situation could be a condition called “labor hoarding.” For the past four decades, firms treated workers as expendable; the entire gig working industry is essentially built on an idea that a firm can call on labor only when needed. As the labor force growth slows, firms are finding that it has become difficult to fill positions, leading companies to hold on to workers even as economic activity slows. If the Fed doesn’t take this situation into account, it may lead the FOMC to overestimate the economy’s strength and overtighten.
- One way to resolve the lack of labor force growth is through immigration. We note that the U.S. is planning to issue the maximum legal level of H-2B visas.
Hawkish central banks have added to the debt burden of emerging market countries. Most emerging markets rely on foreign debt due to their favorable interest rates. However, as the central banks have raised their benchmark interest rates, investors are pushing up borrowing costs to compensate for the additional risk. The problem will likely get worse as the global economy begins to slow. To prevent an emerging market debt crisis, the International Monetary Fund is trying to rework the debt for developing countries, but it would like China to participate in the restructuring. The risk of an emerging market debt crisis is elevated especially as Beijing continues to drag its feet on negotiations.

Tomorrow, the BOE says it will halt its bond buying, which has led pension funds to increase selling to build liquidity. As we noted earlier in the week, central banks are facing the Tinbergen problem of not having enough policy tools for the problems they face. Specifically, if central bankers prioritize financial stability, then inflation will rise while if they instead fight inflation, then financial risks increase. We note that there are rumors that the Truss government is considering backing away from some of its fiscal expansion policy, which may be enough to give the BOE some room.
The IMF warns that there is a 10% risk of negative global GDP growth next year.
Although we will cover the information in more detail in tomorrow’s Weekly Energy Update, OPEC+ has cut its global demand forecast for oil, which is probably why it made its controversial output cuts. In its monthly report, the IEA warned that OPEC+’s actions could trigger a global recession.
Japan’s bond market traded today for the first time in five days. Yield-curve control has made actual trading just about non-existent.
Florida’s orange crop is set to be the smallest since WWII. Hurricane Ian contributed to the small crop.

The Ukraine War: Sensing weakness, NATO ramps up its support for Ukraine against Russia, while Moscow gets a needed break on oil.

Western countries pledged more military equipment to Ukraine and new penalties to curtail Russia’s revenue generation. The new ammunition will allow Ukraine to defend itself from retaliatory attacks from Russia. New reports suggested that Russia has targeted 40 Ukrainian cities with missiles. Meanwhile, the new penalties will likely be an alternative way to punish Russia after OPEC+ cuts have put price caps at risk.
- The latest developments in Ukraine suggest that the war is not close to being over; however, there does seem to be hope for de-escalation. Russian President Vladimir Putin offered to resume gas supplies through Nord-Stream 2. The plan was quickly denied by Berlin, who fears that the move would come at the expense of Ukraine.

The IMF warned that Ukraine would need $3 billion a month in 2023 to fund its debt obligation. The war-torn country has not been able to run its government without additional aid from the West.
Putin is pressing Belarus to join the war. We doubt President Lukashenko wants to join this war and it isn’t obvious if Belarusian troops would be effective, but, it may draw some Ukrainian forces to guard its northern border.
Winter offensives are difficult. Cold weather complicates armor operations and soldiers must fight both the weather and the enemy. Thus, there have been expectations that the pace of operations will slow as winter sets in. However, Lloyd Austin, the U.S. Secretary of Defense, indicated that the offensive would continue through the winter.
Russia has formally blamed Ukraine for the Crimea bridge attack.

China News: The U.S. increases pressure on China’s semiconductor industry.

In the wake of new U.S. restrictions on semiconductor equipment sales to China, the chip toolmakers announced the suspension of equipment sales. There have been some exemptions granted, but only for a year. We also note that the FCC is likely to ban all new sales of Huawei (002502, CNY, 3.10) and ZTE (ZTCOF, $1.79) equipment in the U.S. Although complete isolation isn’t likely possible, supply chain disruption is clearly underway.
After a long delay, the Biden administration did issue its National Security Strategy. The document makes it clear that China and Russia are its main focus.

International Roundup: There is flooding in Nigeria, and Orbán gets shunned.

Massive flooding in southern Nigeria has killed at least 500 and displaced 1.4 million people. Disruptions to agriculture and energy production are likely.
Germany made it clear it isn’t pleased with Hungary’s actions.

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Daily Comment (October 12, 2022)

Posted on October 12, 2022October 12, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. Markets are higher this morning, with U.S. equity futures moving higher before the PPI data. The PPI data came in “hotter” than expected, taking equity futures off their earlier highs. The dollar is mixed, with the GBP modestly higher while the JPY is lower (and in the area that has triggered intervention recently). We expect a mixed trade today in front of tomorrow’s CPI data.

In today’s Comment, we begin with economic and finance news by trying to answer the question: what on earth is Andrew Bailey trying to do? The Ukraine War update follows, China news comes next, and we close with the international roundup.

Markets, Economics and Policy: BOE Governor Andrew Bailey has rocked the financial markets with inconsistent statements, so we will attempt to parse out what is going on with the U.K. central bank. The IMF is meeting, and its forecast is dour.

Yesterday, in an interview, BOE Governor Bailey surprised the markets by indicating that the emergency funding for the Gilt market would end on Friday, full stop. He warned the markets that they had “three days left.” This declaration contradicted earlier statements suggesting that support would be extended. Financial markets reacted immediately as the GBP plunged, equities sold off, and long-duration yields, not just on Gilts but Treasuries too, rose.
And yet today, Bailey apparently signaled that the BOE will probably continue to support the Gilt market.
So, how do we make sense of this?
- First, a quick recap of how we got here. The U.K. was facing higher inflation. Then PM Truss issued her fiscal plans, which included what was essentially a large fiscal spending program. Gilt yields jumped.
- Whenever interest rates rise sharply, financial stability is at risk. And, in our experience, where the “cracks” appear is often a surprise. In the U.K.’s case, the initial stress emerged in the pension market. Pension funds have long-term liabilities since members will age in a few decades and so the funds try to match that liability with a similar long-dated asset. When interest rates fell to zero, meeting these long-term liabilities became a challenge. And so, to offset this risk, the funds engaged in derivatives which would pay them if interest rates fell further. For this to work, of course, leverage was employed.
- When interest rates rose, it was actually good news for the pension funds, because it became easier to fund their long-dated liabilities. However, these derivatives, which, to remind, protected from falling rates, were triggering margin calls as rates rose. This situation is what we call the “hedger’s dilemma.” The long term cash position in an adverse market action actually improves, but in the short run, the derivative demands for immediate cash must be maintained to continue to hold the hedge position. So, to provide cash to meet margin calls, pension funds started dumping Gilts, sending their yields higher and essentially creating a “doom loop.”
- Here is where the BOE enters the picture. To stabilize the Gilt market, Governor Bailey offers a short-term buying plan to provide a market to break the doom loop.
However, the pension crisis has created a policy dilemma for Bailey. He is facing the “Tinbergen problem.” Jan Tinbergen[1] postulated that policy makers need an equal number of policy tools for an equal number of policy problems. Otherwise, the policymaker is forced to choose which problem to resolve and let the other go untouched. Bailey needs to simultaneously address an inflation problem which demands higher rates and also a financial stability problem, which requires easier policy. So, this is how he is trying to manage this dilemma:
- The BOE has offered to buy Gilts, but the offer doesn’t have a set price. If a pension fund wants to sell Gilts to the BOE, it makes an offer, but the bank can refuse to buy at that price. What Bailey is trying to avoid by this policy is a resumption of QE. This is why so few bonds have actually been sold. The deal being offered isn’t that attractive to pension managers mostly because they have no transparency on whether or not they can actually get liquidity. Thus, most of the transactions are occurring in the market.
- Essentially, what the BOE is trying to do is protect the functioning of the Gilt markets without signaling to the Truss government that the bank is monetizing her spending. It’s a bold strategy…
The BOE’s problem is a cautionary tale for all central bankers. In an inflationary environment coupled with excessive leverage, a byproduct of years of ZIRP, central bankers will almost certainly be facing similar problems in the future. The whole talk of the “Fed pivot” is mostly based on this dilemma. The pivot argument rests on the notion that when faced with combatting inflation or financial instability, the Fed will choose the latter, flooding the markets with liquidity and leading to rallies in risk assets. We see two issues with the pivot argument. The first is that the Fed (or other central banks) may not choose stability; in that case, the downside in risk assets could be much more severe.[2] The second is that the flooding of liquidity may not lead to the rally in risk assets, but a currency crisis (as we are seeing with the strength in the dollar). Thus, the BOE situation is a cautionary tale that is almost certain to be repeated elsewhere.
The IMF offered a downbeat forecast for the global economy that actually reflects what is occurring in the U.K.’s Policy tightening, China’s Zero-COVID policy, and the Ukraine War are creating a toxic mix that will depress economic growth, trigger higher prices, and raise financial stress.
The Biden administration has proposed rule changes to “gig workers” that, if accepted, could undermine the business models of companies that provide platforms for such workers. Essentially, the rules would turn more of these workers into employees, forcing firms to provide benefits that they currently don’t offer. Shares in such companies slid on the news.
Railroad workers rejected a tentative agreement, brokered by the Biden administration, increasing the chances of a national rail strike. The railroad industry has become increasingly concentrated in the past decades, leading to stronger profit margins but also making the system more vulnerable to labor action. A nationwide strike will put the administration in a difficult spot. If they support the unions, it could paralyze the economy and lead to higher inflation from panic buying, but if it steps in and forces the workers back on the job, they could lose political support from the unions.
High frequency data suggests imports plunged in September. This may reflect production problems in China but may also be tied to falling American consumption. One of the signals of recession is falling imports.
Inflation expectations survey data from the NY FRB suggests that inflation is expected to moderate over the next year, but the three-year expectation did tick modestly higher.
The federal deficit fell by $1.4 trillion in fiscal year 2022 (which runs from November to October) as pandemic spending eased and tax revenue increased. This drop is actually fiscal tightening, one of the overlooked bearish factors for the economy.
As the dollar rises, the JPY is once again at similar levels to where the BOJ had decided to intervene last month. The strong dollar is also creating a boon for Americans traveling abroad.
One of the problems with regulation is a process called “regulatory capture.” The longer a regulatory body exists, the greater the odds that the group being regulated comes to dominate the regulator. This occurs for a couple of reasons. First, all the data to regulate the industry comes from the companies in that industry, and so to obtain the necessary information, the regulatory body must have good relations with the firms. Second, if a regulator wants a job in the private sector at some point, they will almost certainly go to work with a firm they have regulated. This problem is known as the “revolving door.” Recent investigations, however, suggest the problem runs even deeper since regulators are often investing in the firms they regulate, further leading them to side with the companies they are supposed to be monitoring.
Apartment demand is falling rapidly as rents rise.
BNY Mellon (BK, $38.48) is now offering custody services for crypto.

Ukraine War: Russia continues its attacks on civilian infrastructure in Ukraine.

For the second day, Russia is hitting infrastructure targets in Ukraine. As these attacks continue, NATO is mulling over whether it should provide more sophisticated air defense systems to Ukraine. If these are provided, it will be part of a steady broadening of the war effort.
- Sanctions on technology appear to be undermining Russia’s ability to build smart weapons. The lack of precision weaponry is leading Russia to rely on less sophisticated weapons, which is leading to indiscriminate damage.
As the war continues to go badly for Russia, Putin has appointed another general to lead the effort. Sergei Surovikin is considered a hardline professional soldier who conducted the Syrian campaign. It remains to be seen if he can fix the Russian military’s problems in Ukraine.
Putin and Turkish President Erdoğan met in Kazakhstan today. Turkey has supported both sides in the Ukraine war, and so Erdoğan has suggested he could act as a broker between the two sides.

China News: The news is quiet in front of next week’s Party Congress.

As the Party Congress prepares to meet next week, the party is increasing security to ensure a smooth “coronation” for General Secretary Xi.
Chinese universities are rising in world rankings, while U.S. universities retreat.
Utah is becoming a virtual marriage destination for Chinese LGBTQ couples.

International Roundup: Japan reviews its defense posture.

Japan’s PM Kishida is preparing for an extensive review of Japan’s security. Since the end of WWII, Japan has relied on the U.S. for security, but facing a more uncertain future, it appears that Tokyo is moving to expand its power projection.
We are covering the tensions between Saudi Arabia and the U.S. in our Weekly Energy Update, which will be published Friday.

[1] A Dutch economist who was the first to win a Nobel prize.

[2] When the Fed faced this issue in 1929, it opted to address the inflation/asset bubble instead.

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Daily Comment (October 11, 2022)

Posted on October 11, 2022October 11, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

In today’s Comment, we begin with economic and finance news as the BOE had to rush support to the Gilt market after rates jumped on fears that the bank would withdraw support from the market. War news comes next, with a look at Putin’s retaliation. China news follows and we close with the international news roundup.

Markets, Economics and Policy: The U.K. is facing increased financial system stress and U.S. retailers are pushing Christmas forward.

The BOE offered plans to scale back its support of the Gilt market by the end of the week. When market volatility threatened to upend the pension system at the end of September, the BOE rushed to announce bond purchases for a two-week period. As that emergency period ended, the bank suggested yesterday it would provide backstops but that direct purchases would end. Oh well…best laid plans sometimes fail. Overnight, the BOE announced it would expand its buying to include inflation-indexed bonds as well. As the market prepared for less support, yields spiked yesterday, again raising fears of systemic risk.
So, at present, we have three major central banks—the BOE, BOJ, and the ECB engaged in some form of yield-curve control. The BOE is trying to prevent rapid increases in long duration debt to prevent systemic risk. The BOJ is simply fixing the long rate to near zero, and the ECB is actively preventing the sovereign spreads between northern and southern Europe from widening. So, out of the G-7 nations, only the U.S. and Canada are not setting rates in long-duration sovereign bonds.
- What is happening here? It looks to us that due to high levels of debt, central banks can’t let long-duration bond yields rise to their normal level without triggering financial stress. For context, the long-term ex-post real U.S. 10-year yield is 2%; in English, this means that with U.S. CPI at 8.3%, the 10-year yield “should” be 10.3%. It’s rather difficult to fathom how the financial system would deal with that level of rates. So far, market participants believe the Fed will bring down inflation[1] and so are “looking through” the current inflation to project lower price growth. This position isn’t unreasonable, but the longer it takes for inflation to fall, the more likely rate raises will follow. This is why, we think, the FOMC has been so hawkish: the members fear a loss of confidence that could lead to a buyers’ strike in bonds.
- We have to wonder if we aren’t seeing something akin to nations leaving or maintaining the gold standard in the 1930s. As the U.S. refrains from fixing the long end (and in fact is doing QT), the dollar is rallying because it is becoming increasingly alone in this position. At some point, it may become impossible for central banks not to engage in yield-curve control for the sake of financial stability. If that situation arrives, real assets may be the best refuge.
- So, when does the Fed “blink?” Yesterday, Fed Vice-Chair Brainard and Chicago FRB President Evans suggested some degree of caution on the drive to lift the policy rate. Perhaps the best gauge of when the Fed might at least pause is any one of the financial conditions indices. We prefer the Chicago FRB’s variation.

When this index moves above zero, stress levels are a concern. We are slowly rising toward that level, which may coincide with Brainard and Evans’ warnings. However, we also caution that the Fed really didn’t have to worry about inflation for the past 30 years, and so we don’t know how it will react if there is a financial accident under conditions of elevated price levels. It is notable that the VIX futures curve has moved above 30, suggesting that elevated volatility is expected to continue for the foreseeable future.

On the inflation front, we note that general retailer inventories remain stubbornly elevated.

Stores are beginning Christmas promotions before Halloween this year, likely in an attempt to work off excess stocks. Although inflation remains elevated, news such as this does offer the possibility of slower price increases.

Germany has faced criticism for its plans to subsidize energy consumption. Other nations in the EU fear that German buying, bolstered by these subsidies, will create shortages for their own citizens. In response, the German government is backing joint EU debt, a further extension of EU-wide borrowing that began during the pandemic. If this debt becomes securitized and backed by the entire EU or the Eurozone, it will be further progress on creating a unified debt structure.
The Quebec pension fund is writing off $150 million of bad investments in crypto.
The U.S./Mexican border has always been a gateway for immigration to the U.S. For years, it was mostly Mexicans looking to enter the U.S., sometimes legally, sometimes not. But in recent years, the immigrant flows have become increasingly diverse. But we were surprised to see Indians looking to cross this border.

Ukraine War: Putin retaliates for the bridge attack. This link shows the current war map.

Yesterday, Russia launched missile strikes against civilian targets in Ukraine in response to the attack on the Kerch Strait Bridge. Putin indicated that if attacks on Russian infrastructure continued, he would respond as he did yesterday.
- Ukraine has been asking for more sophisticated air defense systems, and yesterday’s attack may help in this effort. Bolstering Ukraine’s military hardware is becoming increasingly difficult for Europe’s defense industry. One of our expectations is that defense spending will soar globally in the coming years.
- The G-7 is meeting in response to the missile attacks.
- We note that Russian-based hackers disrupted several U.S. airport websites. Killnet took responsibility for the attacks.
There is a growing backlog of wheat freighters as inspectors struggle with the shipping activity. As part of the deal, Russia demanded extensive inspections at the Istanbul monitoring center to prevent the vessels from shipping arms to Ukraine. The delays will tend to boost grain prices.
In response to Russia’s annexation of areas of eastern Ukraine, Ukrainian President Zelensky has signed a decree ruling out negotiations with Russia.

China News: A rash of COVID infections is leading to wider lockdowns.

As China’s early October holiday season winds down, reports of COVID-19 infections are rising. Shanxi province and Inner Mongolian cities are restricting traffic and increasing testing, and there are also reports that Shanghai may soon implement measures. These lockdown measures continue to throttle China’s economic growth.
Why does China persist in its Zero-COVID policy despite the economic damage it causes? There are a several reasons:
- Zero-COVID is a key policy of President Xi and so backing down is tantamount to admitting failure. Although he may relent after winning a third term, we wouldn’t count on it.
- China’s domestically developed vaccines don’t offer much protection but to avoid admitting failure, Beijing won’t import the more effective mRNA vaccines that were developed in the West.
- The problem of lockdowns is that it prevents infections; although that’s a goal, the lack of infections also prevents the development of immunity. China celebrated its discipline compared to Western nations, who faced higher rates of infection. But now, China has a large population of unexposed, under, or unvaccinated citizens that would trigger a potential crisis if the virus were to spread without restrictions. And given China’s older population, this outcome could be catastrophic. Thus, without importing vaccines, China appears stuck with the Zero-COVID policy.
- If so, that means that China’s economy will continue to struggle.
German Chancellor Scholz will travel to China in early November.
In a speech, the head of the U.K. GCHQ warned about China’s expanding security state and the risk is poses to the West.

International Roundup: Poland is about to get EU funds and Iran faces further stress.

Poland has been unable to garner emergency aid from the EU due to disputes over Poland’s domestic political situation. But it appears that an agreement is now close.
For nearly four weeks, Iran has seen significant unrest that followed the death of a young Kurdish woman at the hands of morality police. Now demonstrations have spread to the oil industry as workers are striking in sympathy.

[1] If one observes the “real” rate from the TIPS spread relative to the ex-post rate (nominal yield less the yearly change in CPI) it is clear that investors think inflation won’t last.

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Bi-Weekly Geopolitical Report – Europe’s New, Right-Wing Leaders (October 10, 2022)

Posted on October 10, 2022October 10, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA | PDF

Late summer can often be a quiet time for global affairs, economics, and the financial markets. Especially in Europe, people are off on their long summer holidays, making it difficult to find a “quorum” for political events and business meetings while sapping liquidity in the investment markets. This year, however, August and September were marked by groundbreaking political changes that could have big consequences for investors going forward. This report takes a look at the new, right-wing leaders in the United Kingdom and Italy. As always, we will wrap up with a review of the implications for investors.

View the full report

Don’t miss the accompanying Geopolitical Podcast, available on our website and most podcast platforms: Apple | Spotify | Google

Daily Comment (October 7, 2022)

Posted on October 7, 2022October 7, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with a discussion about central banks around the world becoming more hawkish. Next, we give an overview of rising geopolitical tensions in Central Asia and Europe. We conclude the report with thoughts on how U.S. moves are impacting global financial markets.

Central Bank Worries: Monetary policymakers continue to dig in their heels as price stability remains their top priority even as output falls.

European Central Bank officials are worried that an economic slowdown will not be enough to meaningfully bring down inflation. According to the ECB’s September meeting minutes, central bankers expressed concerns that a weaker euro and fiscal stimulus have made inflation resilient. The comments suggest the bank will opt for a jumbo rate hike in its next meeting on October 27. The market has priced in a 66% chance of a 75 bps rate hike and a 34% chance of a 100 bps rate hike.
Fed officials keep throwing water on the possibility of a slowdown in rate hikes. Five officials on Thursday reiterated the central bank’s desire to bring down inflation at all costs. In her first remarks since taking over as Fed governor, Lisa Cook argued that the Fed needs to push rates higher until the data shows that inflation is moving toward the bank’s 2% target. In a separate statement, Fed Governor Christopher Waller shot down the possibility that financial instability could force the bank to pivot. If Waller is correct and the Fed maintains rate hikes during a financial crisis, a recession could be more profound than most investors expect.
- In the event of financial market turmoil, we suspect the Fed will use the emergency tools developed during the pandemic. Accordingly, we may see some cash injections from the Fed to relieve some of the stress in the banking system.
Global liquidity is drying up as central banks tighten monetary policy and the world economy slows. The U.S. banking system appears to be ground zero for financial distress. Treasury market liquidity, as tracked by the Bloomberg U.S. Government Securities Liquidity Index, rose to its highest level since the 2020 pandemic. The lack of demand for government bonds is driven by high inflation and large deficits. As a result, if left unchecked, the Treasury build-up could lead to the financial system getting clogged again and the Fed might be forced to end quantitative tightening prematurely.

Rising Global Frictions: As everyone focuses on Russia, there are signs that frozen conflicts are starting to thaw in other parts of the world.

Turkish President Recep Tayyip Erdogan threatened to invade the Greek islands on Thursday. Erdogan accused Greece of militarizing the Aegean Islands in violation of the 1923 and 1947 treaties. The U.S. did not welcome the comments as it believes the countries should focus their attention on Russia. Greece has been helpful in the transfer of weapons to Ukraine, while Turkish drones were pivotal in fending off Russian troops at the start of the invasion. A conflict between the Mediterranean rivals threatens to divide NATO and calls into question the military alliance’s unity.
- Erdogan’s comments are another example of his split allegiance between the West and Russia in the war in Ukraine.
A deal to formally end a dispute between Israel and Lebanon is in jeopardy. The sides were close to an agreement that would allow Israel to start drawing gas from the Karish gasfield, but Lebanon has demanded last-minute changes to the deal. The hiccup in talks will prolong negotiations as Israel prepares for elections next month. Assuming the deal is not resolved, the outcome will prevent an additional supply of natural gas from entering the market. Renewed threats from Lebanon against Israel also raise the likelihood of a war between the countries.
Lastly, squabbles among Central Asian countries are becoming more common as Russia focuses its attention on Ukraine. Kyrgyzstan’s President Sadyr Japarov skipped the Commonwealth of Independent States (CIS) summit in St. Petersburg on Friday due to anger at home over Moscow’s inability to prevent Tajik forces from invading Kyrgyz territory in September. His lack of attendance is viewed as a slight to Putin, who is celebrating his 70th birthday at the event. We suspect that Russian losses in Ukraine have led countries within Central Asia to question Moscow’s security commitment. Thus, there is the possibility for violent outbreaks in an area that holds 10.6% of the world’s oil reserves.

The U.S. Leads the Dance: American foreign and monetary policy decisions continue to rattle markets as the world waits to see how the U.S. will respond to Russia and rising inflation.

President Biden warned that Russia’s threat of a strategic nuke was not a bluff. In a speech at a New York fundraiser, Biden acknowledged that his administration is seeking an off-ramp for Putin following a series of Russian losses in Ukraine. The comment from Biden suggests that his administration is looking for ways to get Putin to the negotiating table. The possibility of nuclear conflict could lead to a broader war in Europe and would be detrimental to risk assets.
- We do not believe it is probable that Putin will use a nuke at this time, but we think the risk is to the upside.
A strengthening dollar has contributed to a substantial decline in foreign exchange reserves in Japan and China. The rise in the greenback has forced countries to enter exchange rate markets to prevent their currencies from devaluing. Japan’s reserve drop resulted from the Bank of Japan’s decision to sell off U.S. Treasuries. In China, the decline in reserves was driven by a reduction in gold holdings. These moves show the level of pressure governments are under to preserve their respective currency’s value.
The world waits as the U.S. pressures OPEC to back off its decision to cut its output target by 2 million barrels per day. On Thursday, the Biden administration expressed that all measures are being considered to prevent rising oil prices from putting upward pressure on gas prices and inflation. In addition, the U.S. is considering offloading some of its strategic reserves as well as a potential export ban. Depending on what it decides, it could have slightly beneficial or disastrous effects on global energy prices.

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Daily Comment (October 6, 2022)

Posted on October 6, 2022October 6, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about the Federal Reserve’s insistence on raising its benchmark interest rate despite the global outcry. Next, we discuss the impact that Ukraine’s successes in the south have had on Russian sentiment. We end the report with an overview of how foreign governments are looking to calm discontent within their countries.

The Fed Marches On: Despite calls for the central bank to rethink its policy stance, the Federal Reserve is poised to keep raising rates until it sees trouble.

The Fed may not be finished tightening, but officials are looking toward the horizon for a potential end date. On Wednesday, San Francisco Fed President Mary Daly pushed back against the suggestion that the Fed will wait until something breaks before it acts. During an interview on BloombergTV, Daly hinted that central bank officials are monitoring economic signals that would suggest it had gone too far. Her remarks indicated that some Fed officials are uncomfortable raising rates in a recession.
A possible end to the interest rate hikes explains the rise in gold and equity prices throughout the week. The ISM Supplier Delivery Index, a proxy tool to gauge supply chain efficiency, fell to a post-pandemic low. The improvement in manufacturing deliveries suggests that supply-driven inflation may be on the decline, paving the way for a possible Fed pivot. Investors responded to the report by piling into gold which is now hovering around $1700 an ounce. Additionally, equities mounted a two-day rally that ended after a positive jobs report from ADP signaled that the labor market remains tight.

At this time, the Fed is on track to continue raising rates until inflation slows to the central bank’s 2% target. The latest CME FedWatch Tool forecast shows a 67.3% chance that the Fed will raise its benchmark interest-rate range of 3.75% to 4.00% and a 32.7% chance of an interest-hike range of 3.50% to 3.75%. The recent movement in the market indicates that many investors believe that the Fed will not be able to keep raising rates for much longer without triggering a recession. As a result, many market participants likely have yet to offload some of their poor-performing financial assets. This scenario suggests that the market may still have a ways to go before it hits bottom if the Fed proceeds with its tightening cycle.

Ukraine update: As Russian losses continue to pile up, Moscow learns to accept some hard truths.

This war is becoming increasingly unpopular. After Putin’s call for “partial mobilization,” Russian protests have become louder and more widespread. Although most of the pushback initially came from major cities such as St. Petersburg and Moscow, there are now signs of resistance in poorer areas such as Dagestan. The sustainability of this war hinges on the Kremlin’s ability to maintain popular support. Unfortunately for Putin, time may not be on his side as he would like to secure a decisive victory in Ukraine before he begins his presidential campaign late next year. Putin is unlikely to lose any election, but the lack of turnout could dent his political clout. Although we are not forecasting his ousting, we would like to remind our readers that his exit would likely be sudden.
- The removal of Putin would lead to much uncertainty as it is unclear who would be his replacement. Additionally, his transition from power may not be peaceful as Putin has many supporters in the military. As a result, Putin’s removal could lead to a rush toward safe-haven assets in the short run as events played out.
Low morale among Russian troops is a core reason why Ukraine has been so effective in their campaigns. The Ukrainian offensive in the southern part of the country has led to a series of Russian retreats, and although the mobilization effort will likely provide the army with more manpower, it also has the potential to lead to more disobedience. The lack of support among Russian soldiers may have contributed to Putin’s decision to promote the controversial Chechen leader Ramzan Kadyrov to Colonel Leader on Wednesday. Additionally, Russia could look to push for Belarus to become involved in the war. As Ukraine’s forces continue to stack up successes in the south, Russia is likely to take more extreme actions.
The longer the war rages on, the more isolated Russia will become from Europe. In 2021, the EU accounted for 36.5% of its imports and 37.9% of its exports. Its deep trade ties with Russia have made the two sides somewhat dependent on each other for critical resources and revenue. However, this dynamic is on the verge of changing following Russia’s invasion of Ukraine. On Thursday, U.S. exporter of LNG Venture Global signed a contract to provide Germany with liquified natural gas. This is the only deal thus far between Germany and the U.S., but it is unlikely to be the last.
- The disentanglement between Europe and Russia will likely favor Western energy companies as countries look to prioritize the security of resources over convenience.

Global discontent: The slowdown in growth and inflation has led to political backlash worldwide, and governments are starting to respond.

China has ramped up its corruption crackdowns in the run-up to the country’s Communist Party Congress later this month. Although Chinese President Xi Jinping has made fighting corruption a central theme of his leadership, some of these investigations appear to target mainly potential rivals and critics. We suspect that the crackdowns are a way to make it easier for Xi to push through policies that may not be growth friendly. This shift is designed to help China decouple from the West and become more self-sufficient. As a result, investment opportunities in China may not be as plentiful in the future.
The White House is preparing to punish OPEC+ for its decision to cut its oil output by 2 mbpd. The Biden administration is working with Congress on legislation reducing the oil cartel’s control over energy prices. Introduced in May, the aptly named NOPEC bill seeks to expose countries to anti-trust lawsuits from the U.S. government. However, it is unclear how the U.S. could enforce a ruling against a foreign country. These countries’ dependency on the American financial system could be a target. If we are correct, the weaponization of the dollar will likely encourage countries to diversify their currency holdings away from the U.S dollar.
Prime Minister Liz Truss failed to quell criticism of her tax policies from fellow Tories. Truss was heckled at the Conservative Party Conference after members were displeased with her bold fiscal plan that rattled markets and temporarily tanked the British pound. Although she vowed to plow ahead with her agenda, the conference showed that she might be losing support from members of her party. The latest polls show that the Labour Party would win if elections were held today. Although elections are not until January 23, 2025, Labour’s lead is not a good sign for the Tory leadership. Hence, Truss could be pushed out if she cannot regain support for her policies.

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Weekly Energy Update (October 6, 2022)

Posted on October 6, 2022December 13, 2022 by Amanda Ahne

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

Crude oil prices remain in a downtrend.

(Source: Barchart.com)

Crude oil inventories fell 1.4 mb compared to a 2.1 mb build forecast. The SPR declined 6.2 mb, meaning the net draw was 7.6 mb.

In the details, U.S. crude oil production was steady at 12.0 mbpd. Exports fell 0.1 mbpd, while imports fell 0.5 mbpd. Refining activity rose 0.7% to 91.3% of capacity. We are in the usual period for autumn refinery maintenance, so falling refining activity should be expected for the next few weeks.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. As the chart shows, we are at the seasonal trough in inventories. The build seen in October into November is usually due to refinery maintenance. With the SPR withdrawals continuing, the seasonal build could be exaggerated this year.

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.

Total stockpiles peaked in 2017 and are now at levels last seen in 2003. Using total stocks since 2015, fair value is $108.71.

Market News:

This week’s big news is that OPEC+ has agreed to a production cut to bolster prices. A reduction of two million barrels per day has been confirmed. This news offers a number of insights into the thinking of the cartel. First, such action would have to be considered an affront to the Biden administration who has taken great pains to reduce oil prices to improve consumer confidence. A rise in oil prices will eventually lead to higher product prices, thwarting that goal. In fact, Washington is raising diplomatic pressure on the Gulf states to try and prevent such actions. Second, the news suggests that prices under $80 are not making producers happy. Third, worries about global recession are likely leading producers to try to prop up revenues, even though higher oil prices will also tend to hurt global growth. Finally, the KSA may be trying to reduce output to build a capacity buffer. It appears that OPEC+ is close to being out of capacity, and the fact that most nations can’t meet their quotas suggests that the cartel may not be able to lift output during an emergency. By cutting production, the KSA could create some excess supply, but it is unmistakable that the KSA/U.S. alliance that has existed since the end of WWII is fraying badly.
- Although the U.S. could continue SPR withdrawals in response to an OPEC+ cut, there is growing risk that the reserve is being depleted with little chance of rebuilding.
- The administration is considering a ban on product exports to keep gasoline and diesel prices low in the U.S. Such talk smacks of desperation. Europe will likely shift to oil from natural gas if the latter becomes too scarce to maintain electricity production, and it will need U.S. diesel to do so. Cutting off exports would show a profound lack of leadership from Washington and undermine support for the Ukraine war effort among Europeans. The fact this is even being considered shows a cost of political polarization as once both parties believe that the other being in power will lead to catastrophic outcomes, any action appears justified. Cutting off product exports, however, could have profound geopolitical effects and may, in the end, not even lower prices in the U.S. It is not hard to imagine that refining activity would decline if refining margins narrow.
The Dallas Fed’s survey of oil and gas activity in its district paints a picture of deteriorating conditions for energy firms. Most participants expect oil market supplies to tighten into 2024. The industry is bracing for a recession.
The head of Saudi Aramco (2222, SAR, 35.95) is warning that the world lacks adequate productive capacity for oil and natural gas, mostly because of the lack of investment in production. Oil and natural gas are depleting assets and without constant investment, production will decline. Although recession will likely reduce demand, once growth resumes, oil and gas prices could move higher.
The rise in EU natural gas inventories suggests that the region has been trying to prepare for winter. Unfortunately, we still don’t know if the plan demand and supply actions will be sufficient. Germany’s energy regulator warns that consumption is still too high, raising concerns about a crisis this winter. Complicating matters is that Germany, like other nations in Europe, is planning subsidies to shield consumers from higher prices. Although understandable, preventing consumers from feeling higher prices will simply add to demand.
- One way the EU will likely try to address natural gas shortages is through fuel switching. Unfortunately, diesel inventories are also tight.
- Germany is building new LNG terminals to replace lost Russian production. There were no Russian natural gas imports to Germany in September.
- Europeans have opposed fracking, which has denied them potential energy supplies.
- A new gas pipeline to Poland from Norway has recently opened.
- Russia has shut off natural gas flows to Austria.
- China has been rerouting U.S. LNG to Europe since China’s economy has been sluggish, which frees up this resource for resale. The sale has been profitable for Beijing.
The Inflation Reduction Act has measures designed to reduce methane emissions. This report offers a primer on the impact.
The following chart shows how coal has lost market share for U.S. electricity generation.

(Source: EIA)

Geopolitical News:

We continue to monitor the Nord Stream 1 and 2 situation. The EU and NATO have both declared the act to be sabotage. Although Russia is suspected to be behind the attacks, it is still uncertain who actually attacked the pipelines. The gas that was leaking was mostly for line pressure, and Danish officials have noted that it appears that most of the gas that was in the line has dissipated. Both Sweden and Demark claim that the pipeline leaks were caused by “several hundred kilos” of explosives, increasing the likelihood that a state actor was involved. NATO may not have the wherewithal to protect Europe’s energy infrastructure.
The EU is expanding its sanctions against Russia. The current package includes an oil price cap along with other measures. A price cap on natural gas hasn’t been agreed upon quite yet. We are starting to see protests against high energy prices in Europe, and if the winter turns out to be cold, such unrest could spread and undermine support for Ukraine. Meanwhile, the U.S. appears to be calling for a phased implementation, likely to reduce the potential for price spikes.
Germany caused a firestorm in the EU by unveiling a support package for its industrial sector that would likely harm smaller nations in the EU. The “go it alone” approach is coming under strong criticism as other countries fear that Germany’s subsidy program would lift German demand for natural gas and reduce supplies available to other areas of Europe.
- Adding to concerns about the fracturing of the EU are reports that Germany may cut electricity exports to keep the lights on at home.
Iran is continuing to shell Kurdish areas of Iraq which Tehran suspects are supporting the unrest in Iran. The U.S. shot down an Iranian drone that was threatening a U.S. installation. Unrest continues for the third week. Rioting has moved to universities where security officials are responding harshly. Officials are warning against further protests, with both the parliamentary speaker and Ayatollah Khamenei calling for calm. There are reports that shopkeepers are joining the protests, and there is greater risk to the regime if participation widens. History is generally on the side of the regime. Although it has faced unrest before, harsh reprisals have tended to turn back protests. However, authoritarian regimes can unexpectedly fall, and with Ayatollah Khamenei suffering from cancer and being elderly, it is possible that the clerics could lose control of the government to a coup.
- In a related note, Tehran may be reconsidering its position with regard to the nuclear talks in light of the protests. Accepting a deal may be attractive if it would boost the economy. However, given the protests, it might be hard for the Biden administration to offer any concessions.
As we noted last week, Israel and Lebanon were close to an agreement to share offshore natural gas fields. The deal has now been made.

Alternative Energy/Policy News:

There is increasing interest in placing nuclear power plants on the sites of existing and closed coal utilities. Since the sites are already brownfields, there is less likely to be opposition and the coal plants are already connected to the grid.
High prices for lithium are spurring interest in other materials for batteries. The search for alternatives is a risk to lithium investment. One battery design that might work for stationary requirements (like utilities) would be a flow battery.
The world’s largest CO₂ removal plant will begin operations soon in Wyoming.
Energy storage other than batteries is another area of interest. Stored hydropower, where water is pumped to an elevated reservoir during periods of lower power demand to flow down through turbines during periods of high power demand, has been around for years. China is working on a project that uses compressed air to accomplish the same outcome.
One of the great ironies of the clean energy industry is that it relies heavily on rare earths, which require large amounts of energy to mine and refine. So, as oil and gas prices have increased, production of these metals is starting to decline.

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Daily Comment (October 5, 2022)

Posted on October 5, 2022 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 Russia-Ukraine war, where there is increasing evidence that the Russian army is collapsing, at least in some specific areas. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a preview of an important OPEC+ meeting and a discussion of yesterday’s JOLTS report in the U.S.

Russia-Ukraine: Ukrainian forces continue to recapture significant swaths of territory in Ukraine’s northeastern Kharkiv and Luhansk provinces and in the southern region around Kherson, in part by utilizing tanks and other equipment recently captured from the retreating Russians. At the same time, the Russians are continuing to stage unsuccessful ground attacks in the northeastern region of Donetsk, while also continuing to conduct artillery and missile strikes against civilian infrastructure throughout Ukraine. Ukraine’s advances and Russia’s poorly executed mobilization of reservists (discussed below) are now generating increased disputes and disagreements among key supporters of President Putin, putting him in a difficult political spot. On top of that, reports indicate that the new call-up of troops is depleting the nation’s police and security forces, making it more difficult to control popular unrest.

At least one Russian source says that the Russian army around Kherson is collapsing catastrophically after Ukrainian forces broke through their lines and ran all the way to the coast, cutting off thousands of Russian troops with no hope of receiving reinforcements or supplies. If true, that event would likely cause even greater criticism of Putin.
Meanwhile, Defense Minister Shoigu announced that Russia has already mobilized 200,000 of the 300,000 new troops it called up in late September. However, even if that figure were accurate, multiple sources say the call-up continues to suffer from a range of problems, including an acute shortage of officers to train and lead the new troops.
On the energy front, EU officials are reportedly preparing to implement the G-7’s proposed cap on Russian oil prices in two stages. The officials are preparing legislation needed to implement the measure, but they will hold off approving it until the rest of the G-7 is ready to move forward. The plan reflects the difficult politics involved in imposing any sort of trade restrictions on Russian energy.

Global Oil Market: The Organization of the Petroleum Exporting Countries and their Russia-led partners are meeting in-person today for the first time in years to discuss a production cut of up to 1.5 million barrels per day. Not all the members are supporting the cut, but now that the UAE has thrown its backing behind Saudi Arabia and Russia in supporting the idea, it appears that a significant reduction in output is likely. That could help boost energy prices again, with negative impacts for consumer price inflation and the electoral prospects of Democrats in next month’s mid-term elections in the U.S.

Meanwhile, the chief of Saudi Arabia’s state oil company, Saudi Aramco (2222.SR, SAR, 35.95) warned that the world is too focused on the near-term demand impact of a possible recession rather than the limitations of supply.
The official said that the global oil market remains extraordinarily tight, in large part because of under-investment in new supply in recent years, and that prices could skyrocket in response to a demand shock like a stronger-than-expected rebound in the Chinese economy.

Germany-Poland: Yesterday, the Polish government signed an official note to Germany requesting the payment of $1.3 trillion in reparations for the damage incurred by occupying Nazi Germans during World War II. The Polish foreign minister also asked that Germany solve the issue of looted Polish artworks, archives, and bank deposits. In our view, the demands are further evidence of the fracturing of political ties in Europe, especially after Germany’s recent actions to give itself a competitive advantage in the evolving European energy crisis.

United Kingdom: Just as Continental Europe’s industrial base has been impacted by the war in Ukraine, thousands of British businesses are now closing or retrenching in response to skyrocketing energy prices, rising interest rates, and falling demand. The reports confirm that U.K. stocks may be among the most vulnerable as Europe’s energy crisis continues to worsen this winter.

Japan-South Korea: Japanese Prime Minister Kishida and South Korean President Yoon plan to talk by telephone on Thursday to discuss North Korea’s recent provocative missile tests, one of which overflew Japan. The call not only illustrates how Japan and South Korea are beginning to coordinate more closely on national security issues, including against China, but it also shows that Kishida and Yoon remain committed to rapprochement after many years of tensions between Japan and South Korea.

Brazil: As results from Sunday’s elections are finalized, it appears that both left-wing and right-wing parties have gained seats in the country’s parliament, but neither has won enough to dominate the body. That’s good news for investors, as it will require alliances to pass legislation, and therefore will reduce the chance of radical new policies, no matter who wins the upcoming presidential run-off election.

Uganda: Over the last two weeks, officials have counted more than three dozen cases of the Sudan strain of Ebola, for which there are no proven vaccines or antiviral treatments and which can’t be detected by rapid tests. Officials fear there are many more unknown cases, including in areas frequented by Western tourists.

U.S. Economy: The monthly JOLTS report yesterday showed employers’ total job openings fell 10% in August to a seasonally adjusted 10.1 million from 11.2 million the month before. The apparent drop in labor demand was taken as an important sign that the Federal Reserve’s interest-rate hikes are having their intended effect, boosting hopes that inflation will soon fall and reduce the need for further rate hikes.

The report was key to sparking yesterday’s big rebound in the stock market, which pushed the S&P 500 price index up 2.6% to 3,774.75.
We would note, however, that the JOLTS report was all positive. The report also showed that quits and layoffs in August were little changed.

U.S. Monetary Policy: Despite the economic slowdown evident in the JOLTS report and some other economic indicators, yesterday Fed board member Philip Jefferson warned that bringing consumer price inflation down to acceptable levels will take time and require a bigger slowdown in economic growth and labor demand. Importantly, he said that the labor market remains very tight, suggesting that he would support continued increases in interest rates despite the market’s hope for a reprieve in the near term.

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