Monday 2 May 2022
The latest US GDP report contained familiar late-cycle qualities, a cause for real concern beyond its negative headline number. Economists spent the end of last week explaining how a GDP reading of -1.4% was actually not a bad thing. These arguments are valid, and I would highly recommend the commentary provided by former White House CEA chair Jason Furman who not only wrote a terrific wrap-up after the release, but who also provided some comparisons to his thoughts written before the report. Furman’s point (also embraced by most economists): US consumer spending and investment remains super strong.
But perhaps a bit too strong. Net exports got hit hard as US consumption of foreign goods soared, blotting out a decent contribution from US exports. This component alone dragged GDP down meaningfully. The New York Times’ Ben Casselman went into some detail on this factor. And here, the concern is as follows: late in economic cycles—especially ones driven by US consumption—the import/export mix tends to become very asymmetric as the last hurrah of consumer spending bursts forth. This tends to happen as foreign economies are already weakening, reflected in decelerating US exports either on an absolute, or relative basis. One could temper these uncertainties right now by noting that exports are still growing, and have even reached new highs post the pandemic.
Unfortunately however Europe’s economy is either headed for recession, or is already in one. And China’s economy, damaged by the unwise market policies of Xi and now a second round of COVID, is also weak. So weak that Chinese authorities are now scrambling to repair and support their damaged stock market, as economic forecasters continue to downgrade China’s oil consumption growth. One particular problem for Europe meanwhile is that its prospects for a turnaround continue to dim as the continent remains exposed fully to its dependency on imported fossil fuels. Tougher still is that the ECB not is exactly backing down from its stated intent to tighten.
Perhaps one could say these are not late cycle effects, but rather late stage effects of the entire two year pandemic period. The final chapter of all bad things, if you will, before our story finally brightens. After all, we have offsetting indications that air travel is robust, and that a fuller, broader reopening will occur this summer. A tidal wave of holiday tourism would do wonders for Europe—southern Europe especially. Tourism still represents about 10% of Europe’s GDP. And the Euro is especially weak right now, compared to the US Dollar. That’s the kind of foreign exchange dynamic that Europe has used many times in the past to rake in consumption from foreigners, thus replenishing economies.
This time however that may not work. It’s not merely that the US Dollar is strong. Rather, it’s way too strong. Any three-month benefit to US tourists traveling abroad cannot possibly counter the tightening and ratcheting effect the soaring US Dollar has on global monetary conditions. Against the Japanese Yen (JPY), the US Dollar reached a twenty year high last week. Now, in a different part of the economic cycle, a weakening JPY and a firming US Dollar would more typically be a risk-on, global growth signal. But the JPY hitting twenty year lows against the US Dollar is not a good signal at all. The US Dollar has done far more than just firm up. The US Dollar Index (DXY) is also hitting twenty year highs against a basket of foreign currencies. Financial market observers like to call the dollar, when it gets this strong, a kind of wrecking-ball.
The negative print on Q1 US GDP therefore will act as a kind of political football, reaching the front page, and taking center stage in economic discussions. When the FOMC meets this week, Jay Powell will undoubtedly get questions about GDP. And we can expect a continuation of the assertion that the US economy remains strong. That’s true. It does remain strong; and if a recession were to unfold, a short period of significant damage would have to ensue, first. But the GDP report equally looks like a warning shot. High petrol prices, high levels of consumption, and rapid interest rate increases are the kinds of conditions that we tend to see preceding sharp slowdowns.
The reason we’re already seeing slowdowns in housing, and now autos for example, is that while the Fed may have only just started to raise the federal funds rate, the yield on the two year treasury has already done most of the tightening for the Fed already. The two year treasury, as you can see in the above linked chart, has rocketed from a microscopic 0.25% to over 2.5% since last summer. What this means is that the US economy is currently weathering a very, very rapid tightening cycle in which energy prices, interest rates, mortgage rates, and the soaring US Dollar are all putting the squeeze on activity. And that’s why the US GDP report is a warning: the US consumer may be shooting their last shot, as they always do, before the cycle comes to a close.
The unusually rapid economic recovery of 2020 amplified the normal, post-recession challenges to the restoration of oil production. As a result, the public at large and markets especially convinced themselves that a new, physical constraint has been the primary cause of today’s supply-side problems. We saw the same phenomenon a decade ago after the great recession, but in much smaller form, in both coal and oil. The difference being, however, that the demand pullback in the great recession was actually far shallower, and thus the recovery period was more forgiving. To make this plain: it is not within the scope or ability of the global oil industry to restore a 100 mbpd oil market that has lost 9% of its demand in the first year, back to those high levels in the subsequent year.
The great recession required the oil industry to restore 2.77 mbpd in 2010, after a two year cumulative decline of just 1.42 mbpd. That restoration alone caused the oil price to advance from $62.00 in 2009 to $80.00 in 2010, and then to $95.00 in 2011. So a far shallower decline in demand still produced a fairly rapid price recovery to the $100 area. Moreover, the demand change from 2010 to 2011 was quite mild. And yet, price bolted higher. Readers may recall during this time that the narrative around oil was still very much in the peak oil vein, and the ongoing view of a geologically constrained oil industry was very much confirmed in people’s minds by the rebound to the $100 range.
Today, therefore, price once again functions as a fuzzy cloud, bending people’s thinking and advancing the overall impression that oil supply is tight. But here we stumble into the complexities of supply and demand that sit on top of a simpler, either/or proposition in supply vs demand. Yes, supply is currently tight because the oil industry is still in recovery in the face of far more rapid demand restoration. And now a massive geopolitical event putting 10% of world supply at risk is only furthering this perception. To this mix we now add a highly polarized culture, that insists on viewing all phenomena through the lens of political partisanship, and soon something as literal and concrete as natural resource extraction is the fault of policies and their respective advocates.
There is a concept however that may be helpful, here. One that may emerge as a governing factor as we move into the current decade: the oil industry is not a charity, they see the poor outlook for demand growth globally, and collectively they are forever now going to be averse to overstepping investment, and output.
On this dynamic, readers may want to review the work of Harold Hotelling. Simply put, Hotelling’s view held that owners of natural resources, like oil, have a choice: either leave the asset in the ground to appreciate in value, or, extract the asset and convert it into a different asset, with greater appreciation potential. It’s possible that owners of oil are currently trapped between the two prospects, with an unclear answer. The Gregor Letter takes the view that oil in the future will be worth less. But if owners of oil assets agree with that view, they may collectively hold back production to create ongoing pressure on price where it counts most: at the margin.
Nota bene: US oil production is now swiftly recovering towards its all time highs, despite an extraordinary tidal wave of political blather asserting that government policy is trying to stop this from happening. Sigh. This recovery rate is pretty normal! According to the EIA, production will reach 12 mbpd this year thus nearly matching the all time average of 12.3 mpbd, and will surpass the all time high next year.
Preventing retirements of existing nuclear power—or even turning back on recently retired nuclear capacity—is a good idea. Yes, much of the world’s nuclear fleet is old, especially in the US. And old nuclear plants bear higher costs. But the clean power deficit that’s created through nuclear closures also has a high cost: a bigger call on natural gas or coal fired power, and in some domains like Europe that means an increased dependence on imported natural gas. Hello Russia.
Germany has come in for strong criticism over the sequenced closures of its nuclear fleet. As always, the details of this retirement program don’t fit as easily into the strong opinions that have gathered on all sides of this debate. In its most basic form, Germany struck a bargain many years ago in its political economy to close nuclear and aggressively build wind and solar. At the time, this did not seem to be an act of self harm. Now it does. Because this strategy led in part to a greater dependence on Russian natural gas, and a longer than expected tail of dependency on coal. On the other side of the ledger, it’s also the case that natural gas in Germany is weighted pretty heavily towards industrial applications, rather than electrical power. So, Germany’s dependence on natural gas was going to extend for a while yet. And as we know, the only solution we have at the moment to transition away from natural gas in industrial applications is hydrogen, whose economics are difficult, but whose learning curve is already being pursued in Europe, and yes in Germany.
So, Germany made mistakes. Fine. Let’s fix them. Over in California, for example, Governor Gavin Newsom appears ready to change his mind about the closure of Diablo Canyon, pictured above. Yes, Diablo Canyon needs to close—eventually. But not now. All old coal, natural gas, and nuclear plants eventually need to close. We also need to admit to a suite of ancillary problems with existing nuclear, mainly the waste problem here in the US, as our politics have failed for decades to come up with a solution. This means that shuttered plants like the fifty year old Pilgrim Plant in Plymouth, Massachusetts have become de facto nuclear waste storage facilities. That is just unacceptable.
The Gregor Letter has been consistent in making the following point: wind and solar and storage are clearly the leaders of new global power generation. Nuclear cannot compete with them either on a cost basis, or a timeline to construction basis. The latter point is increasingly poignant. Most agree that bringing clean energy into operation is urgent, and that time is critical. New wind, solar, and storage capacity can often be brought online in two years, and sometimes less. That is a serious challenge to the competitiveness of nuclear. But existing nuclear is available now. And even if you advocate for the buildout of some new nuclear (also the position of The Gregor Letter) it must be acknowledged that new nuclear currently takes at least seven years, and often longer to deploy in the OECD.
Germany has already shot down the idea of re-opening the nuclear power plants it recently closed last year. OK, that is just flat out illogical. Germany is already suffering economically from high cost natural gas, is engaging in the provision of arms to Ukraine, is making plans to wean itself off natural gas and oil imports on a staged basis, and will join the rest of the continent in paying a premium for LNG supply, now growing from the US. Given all those enormous compromises, it appears this supposedly very good idea is not playing as one, in Germany. Do the Germans know something the rest of the world does not? Unlikely.
According to an estimate reported by myself last year In Petroleum Economist, approximately 10%-30% of the remaining US nuclear fleet could be greatly helped by financial rescue programs that would offer a very good cost benefit over a moderate life extension of these plants. That’s according to Alex Gilbert, formerly of the Nuclear Innovation Alliance.
A persistent problem with our current moment is that flexibility and compromise are scarce as dearly held views and opinions are not just ascendant, but dominant. The brutal invasion of Ukraine, however, in all its nihilism, craziness, propaganda, and horror, is a reminder that archaic human cruelty remains a threat, and sometimes (many times) in life we are not handed easy choices. Now that Russia under Putin has revealed itself to be existentially dangerous, while at the same time sitting atop vast fossil fuel resources, western leaders need to sober up and make far more aggressive plans to stage progressive exits from this dependency. In doing so, existing nuclear can’t be cast aside just because some don’t like it. The west, and its economies, are at serious risk from a Russia gone rogue. The adult way to manage through this period is to engage flexibility on a shorter term basis, while maintaining ideals for longer term goals.
The juiciest harvest for oil displacement by EV adoption remains the United States, and signs are now arriving that EV sales are finally taking off. US EV sales crested over 200,000 units in Q1, which indicates that a million unit EV market is now coming into view. The growth was of course led by California, which sold over 80,000 units in the same quarter. The data comes through Veloz, which is currently partnering with the State of California to better distribute information on EV sales. The figures are for all plug-ins, both pure 100% BEV and also PHEV. Hybrids without a plug are not included (which is the right data approach).
Just to remind, the US automobile fleet runs at low efficiency, compared to its two large counterparts Europe and China. So the harvesting potential is significant. The Gregor Letter is currently using a figure of 0.445 million barrels per day of avoided oil demand for every 10 million new EV that hit the road globally. This year, the world is expected to sell at least 10 million new EV, and we may see 10.5 or even 11 million sold. The US may wind up accounting for 10% of those sales by the time we finish the year. Roughly speaking, we might project that as the US starts to more forcefully enter the mix, annual avoided oil demand will fill out from 0.445 to 0.500 mbpd for every tranche of 10 million EV sold.
One way to think about the road ahead (heh) is how far US EV adoption remains from its potential. The total vehicle market here runs historically at about 18 million units a year. So EV (all plug-ins) sales are still trying to inch above just a 5% share, and probably will do so, this year. Compare that to EV market share at roughly 20% in Europe, and over 13% in China. Moreover, data suggests that China will soon also see EV reach a 20% share, as Europe moves towards a 25% share. The US, to pull into range of its two counterparts, would need to sell not 800,000 or even a million units a year, but something more along the lines of 2.7 million units a year to reach a 15% share, or better still 3.6 million units to reach a 20% share.
The basic idea: that is definitely going to happen! And when it does, it will help global EV move to a 20 million unit market annually, which will avoid a fresh million barrels of oil a day. That is a very, very big deal.
Nota bene: US gasoline consumption peaked in 2006, but hasn’t declined much in the ensuing years, as it’s hung around an oscillating plateau. The EIA declared a couple of years ago that US gasoline consumption would not reach a new high, and they were right.
Oil’s share of global energy consumption is poised for its next leg down. It’s easy to understand why the OPEC crisis of the early 1970’s was so profoundly disruptive when you consider that oil’s market share of total global energy was close to 50%. And it’s equally easy to understand how that crisis had an equally profound impact on the world’s posture towards oil. We are at a similar juncture, here in 2022. Helen Thompson, a professor of Political Economy at Cambridge, comes right out and says it, in her recent New York Times Op-Ed: “What lies ahead promises to be more disorderly — and ultimately transformative — than the events of the 1970s.”
But Thompson gets something wrong. She argues that Asian fossil fuel demand, because it’s much higher now than in the 1970’s, presages a serially structural shortage of fossil fuels globally, failing to note that such demand has either been in decline or flat in the OECD. Coal demand peaked globally in 2014, for example. Natural gas demand continues to grow, but the world has absolutely no shortage at all of recoverable natural gas. Which brings us to oil. Well, it’s not necessary to restate The Gregor Letter view that oil demand has almost surely peaked, in 2019. The definition of this peak is not that demand won’t touch that level again—but rather, that demand won’t be able to make its way higher than that level for any sustained period of time.
The problem for oil is that the pattern seen in the chart below is about to repeat, because electrification is thundering forward, and the world’s transportation sector is now moving in tranches towards the powergrid. No amount of new demand from plastics, material science, chemicals, or other Non-OECD growth is going to change that fact. Professor Thompson’s political analysis is solid. But that she fails to mention the electrification of China’s transportation sector is a huge miss. As laid out in today’s letter, China is following in Europe’s footsteps, and the US is now about to follow. There is not now, nor will there be, a structural shortage of coal, natural gas and oil. This is why The Gregor Letter has highlighted the material constraints of energy transition, instead. If one wants to worry about the geopolitics of natural resources, best to concentrate now on copper, nickel, cobalt, and the new king: lithium.