The Governor
Monday 16 May 2022
At the precise moment in the global tightening cycle when oil prices would normally fall, they are not falling. Economic booms that necessitate interest rate increases follow a typical pathway. First, rates rise. That puts pressure on equities which then fall. When stocks finally fall far enough, entering volatile and nasty bear markets, interest rates then stop rising, and reverse lower to begin pricing in slower growth. Commodities like metals, and energy especially, also reverse at this time after having been “hedges” against inflation. More broadly, the inflation narrative itself begins to peak (as it is doing right now) and all these evolutionary developments coalesce into a familiar moment: markets stabilize, and begin to discount a return—if even a slow return—to economic growth.
The past twenty years have taught us much about these cycles, and they have taught policy makers as well. One primary lesson learned is that equity markets themselves are a source of spendable wealth, that drive consumption when high—and kill consumption when low. Most market observers today now discern that the US Federal Reserve is very likely targeting equity markets, wanting to see them dented, as part of an overall strategy to lower consumer demand that’s been driving higher prices of goods, services, houses, cars, and travel. All good.
The challenge is that much of the Federal Reserve’s mission has now been accomplished. Casual observers may find this notion odd. After all, they see that the Fed is still on course to hike the federal funds rate further. What they don’t see: the tightening has already occurred, through the action in the two-year treasury bond, mainly, but also by the ascent of yields in the entire rate complex. US mortgage rates have skyrocketed, for example, punishing the stocks of listed homebuilding companies and putting a chill into the real estate market. Global equities have fallen by at least 20% with many important indices like Nasdaq having fallen over 30%. The demand which has been driving inflation is pivoting.
But oil is not pivoting. And we know why. Because 10% of global supply is under geopolitical pressure, weaker demand is not leading to lower oil prices. Sure, $100 oil is lower than the $130 price level seen two months ago, during the spike. But the salient point now is as follows: $100 oil may be even more damaging to the economy we have today, than the economy we had just several months ago. This is the moment when lower demand globally needs to be reflected in easier prices, thus giving consumers some relief from the asset declines they’ve already experienced, and the slower economy that is about to unfold.
For many decades a popular view in some quarters has held that oil holds the key to the global economy. That belief however has become far less true, given oil’s long declining market share in the global energy mix. But the view has some merit, right now. The global economy is frankly on a knife edge, with a looming recession in Europe, a plodding China, and not very robust emerging market economies. Accordingly, oil should be thought of in this moment as the governor of the world’s economic engine. If prices fall, then inflationary pressure—already easing from many directions—will ease more rapidly, thus conforming to the expected transition which typically unfolds at this part of the cycle. It should also be pointed out, because oil is priced in dollars and the US Dollar itself is quite high, oil prices for non-dollar based consumers are even higher. Accordingly, it’s not just oil prices that need to fall, but the dollar along with them.
But if oil prices do not fall then any attempt by equity markets to rise, and bond yields to fall, will be met with opposition. Oil is now in control for the simplest of reasons: the moment is precarious.
A small shift in posture has emerged from the Federal Reserve amidst its tightening campaign. At the 4 May press conference given by Fed Chair Jerome Powell immediately following the most recent FOMC meeting, we learned that the committee has not been contemplating rate hikes larger than 0.50%, and further, that the Fed believes much of the tightening has already occurred through the rapid increase in the two year treasury bond (sounds familiar, yes?) Markets initially loved this shift, despite its slight nature, and took off to the upside. But then bond markets—which were perhaps not expecting any shift at all, even one so mild—sold off again, thus pushing yields higher on the 10 year treasury. Rising yields have plagued stocks all year. And when equity markets saw yields back on the march, they sold off hard, extending the current global rout.
Both bond and equity markets are currently waiting for the same deliverance: an easing of inflationary pressure. When that pivot arrives, pressure on stock multiples can ease, and treasury bonds—which are seeing some of their highest yields in years—will likely be scooped up by institutions and pension funds. Is there any promise that such an inflection point is imminent? Possibly so, yes. Just two days after the 4 May FOMC meeting, the Labor Department’s report on US employment showed that the pace of wage growth continued to slow. Put another way: if you were fearing a wage-price spiral, well, that is not a thing that’s actually happening. And then the following week, the CPI showed continued inflationary pressure in the internals, but at least the headline number fell from the prior month. It wasn’t much (and there are legitimate concerns that inflation could now migrate from goods to services, and not in a way that would ease conditions at all) but it did give pause to those certain inflation will just keep marching higher.
Powell was followed by other Fed members in the following days—Bostic, Kashkari, Daly—who also reiterated the view that a .75% rate hike was simply not on the table. This wouldn’t normally be seen as anything particularly notable. But the conversation has meaning because for the past six months global banks, financial institutions, and market observers have been engaged in a competition to see who can make the most hawkish, aggressive forecast of Fed tightening. A rate-o-rama game, in which wild calls for full percentage point hikes were embraced as everyone herded into the same pen. Perhaps the biggest surprise came when James Bullard, who is known for intemperately hawkish outbursts, also joined the Fed chorus saying he too saw the next rate rises at the .50 level, over summer. It’s legitimate to ask: does the Fed also have a view, now, that inflation has peaked?
Follow up: Paul Krugman, who was wrong about inflation and has very publicly admitted to being wrong, now has a view on inflation’s current position, which is worth consideration.
Supermajor investment in new oil and gas has been declining since 2014. While the investment principles of ESG and the ongoing global signal from the energy transition have undoubtedly had an effect on energy sector investment, it’s important to see the duration of this trend laid out so plainly, as this recent Bloomberg article shows. Eventually, the highly politicized arguments around the oil sector’s decision-making will fade, and with the luxury of hindsight most will agree that the industry acted rationally in the face of poor, future prospects for demand growth.
The IEA only slightly cut its 2022 demand forecast this month, shifting instead to warning about the erosion of Russian supply. Both IEA and EIA take cues from the IMF and World Bank to build global economic forecasts into their main task: gauging demand. But global growth hasn’t been downgraded quite enough, perhaps, to trigger a more aggressive takedown of this year’s oil outlook. Starting from a high of 3 mbpd of annual growth, IEA is now down to just 1.9 mbpd of growth. The Gregor Letter continues to forecast that growth will be closer to zero, by the time the year ends.
While demand is now adjusting downward, however, there is still more pressure on supply to come. Yes, US production is recovering quickly towards the previous highs. But Russian supply, although steady in March, could decline by a fresh 4-5% according to Russian oil ministry sources as reported by the IEA and may have already turned down by 700 thousand barrels per day. To state the obvious, demand is going to have to continue drifting lower to balance this loss of supply. But that brings us back to the main proposition of today’s letter: the price of oil must come down soon, and if it does not, then a global recession will force the matter to resolution.
Update: as the newsletter goes to press, China has just released economic data showing a far more severe slowdown than already expected. Retail sales were particularly hard hit, and unemployment rose. Much of the data was nearly as weak as it was when the pandemic first began.
US gasoline demand is not recovering, as a combination of work-from-home and high prices have suppressed normally strong seasonal demand. We were assured in the month after the Russian invasion of Ukraine that high prices were having no effect at all on American petrol demand. You’ll never guess what happened next. The month of April saw all four weeks of gasoline demand at levels lower than April of 2021. Ponder that. An economy reopening, with increased air travel, and people heading back to the office. And yet, April 2022 petrol demand was lower than the previous year? While the US specifically is not near a recession (or so it seems) these are the kinds of developments one sees when a shaky slowdown begins.
In the table above, you can easily see how each week of April this year saw lower gasoline demand than the corresponding week last year. (Data Note: these are the 4 week average data). The central point however is that US gasoline demand is turning away from its seasonally strong period, which you can also see in chart form:
The energy transition is not on hold, but the complications of a post-pandemic economy threaten the forward motion we need to move quickly. BP announced last week it would take a stake in the spectacular Asian Renewable Energy Hub; EV adoption is finally taking off in the US; wind and solar deployment is going faster than ever; and western governments in the EU and North America are newly energized to help accelerate all of these trends.
The problem, however, is that the fossil fuel constraint has bent the attention of policymakers, which has forced them to spend political capital to try and ease the price pain among the electorate. Egregious examples can be found in domains like California, where Governor Newsom, a democrat ostensibly committed to climate change, has proposed a nearly $20 billion payment to registered car owners as a rebate for the past year of high food, and petrol prices. This is absolutely stunning on a number of levels. One example comes to mind: $20 billion was a figure that at one time would have funded a good chunk of the long-proposed California high speed rail project—a project that has gone nowhere, of course. That the state would essentially incinerate built up capital from two years of stimulus, thus offering no investment return to a long simmering problem (the problem of running a system on cars) is sobering,
Turning to Europe, it’s now actually possible to consider that the attempt by western governments to embargo Russian oil and gas has backfired. Consider that the original plan was to sanction Russia in every possible way, except for oil and gas. Why do you think that was the original intuition? Given the lurid outcome, one can easily discern it: policymakers were likely correct that an energy embargo would do more damage to Europe, and the global economy, than Putin. Now let’s consider the actual results: the sanctions destroyed the Russian Rouble, making for a tidal wave of inward flowing USD based oil revenues that flowed through the weak currency. Second, the move to embargo oil and gas put price risk into global prices and kept them there at elevated levels, thus increasing even more the windfall to Russia. Now where are we? Europe has spent enormous time trying to sort out a half-baked set of energy sanctions, as oil sits firmly above $100 and global LNG prices soar also. Thus, the worst outcome of all: a Europe on the brink of recession.
The world needs to be developing lithium resources, battery production capacity, high transmission power lines, and a modern, computer-aided powergrid. Instead, we’ve been sidetracked by high fossil fuel prices. Yes, these are the exact prices that will eventually produce a faster transition, as the memory of their pain points drives society forward. But it’s a warning: some level of dependency on fossil fuels—even a declining dependency—will hound energy transition from the rear as the years go by. And it will be for a rather complicated, ironic reason: fossil fuel producers will be laboring under the knowledge that demand growth is in permanent decline. That knowledge, which is now coming through to the industry, will mean that investment in new supply will be minimal, thus keeping prices elevated. This leads to a second irony. It was long theorized this was the optimal outcome, with renewable prices falling and fossil fuel prices sticky high. But the theory failed to mention the nasty twist, that unless energy transition goes alot faster, it will likely fall prey from time to time to the restrictive clutches of fossil fuel dependency.
—Gregor Macdonald
The Gregor Letter is a companion to TerraJoule Publishing, whose current release is Oil Fall. If you've not had a chance to read the Oil Fall series, just hit the picture below.
