Energy prices are top of mind for most people now. From a couple of years ago when fuel prices were low, the rapid rise has helped put a crimp on the economy and raised driving costs for retail consumers. The signs of this rise are everywhere as service station operators adjust prices higher on an almost daily basis. The national average for 87 octane gasoline has reached $4.50 a gallon for the first time ever. Diesel is nearing $6.00 per gallon and raising shipping costs for everyone.
In an OilPrice article a couple of weeks ago, I discussed why we were seeing these steep rises in retail prices for refined products. At the core of the problem lies inflation caused by massive increases in liquidity by the Federal Reserve, to pay for the trillions of dollars spent by the government, during and post Covid-19.
This article will discuss some likely next steps for the economy with potential knock-on effects on crude prices globally.
Inflation and excess liquidity will create a deep recession
Since 2008 interest rates have remained near zero, as the Federal Reserve injected liquidity into the economy by keeping the institutional rate low, and pumping its balance sheet, buying corporate bonds. This never-ending reserve of liquidity had the knock-on effect of inflating the value of real property and stocks in particular. There is a fair amount of evidence tying these two actions together. We all know what has happened with house prices, gaining each year since, and rallying by double-digits the last couple. The stock market-DOW 30, has nearly sextupled in that time rising from around 6,000 in early 2009 to just over 36,000 this year. Obviously, there have been fits and starts along the way but the chart shows an inexorable path higher in this time frame.
Inflation that should have been attendant to this liquidity was kept at bay largely through increases in productivity and a global supply chain that hummed like the well-oiled machine that it was, until the global Covid shut-in, in March of 2020.
Since that time the world has injected trillions in liquidity into the marketplace at a time when supply is still restricted from its default manufacturing center-China. Accordingly, the "dogs" of inflation have been let loose upon the world and in response, Central Banks are beginning to tighten the reins to relieve the demand pressure. This is a textbook case for recession. Or perhaps the first step toward a depression.
Most of the conversation around the effects of tightening monetary policy has shifted away from “if” and toward will the landing be Hard, or Soft. Economist-speak for a deep, prolonged recession in the hard case, or a shallower, shorter downtrend, with a sharp spike higher in a few months, in the soft case. A “V” shaped recovery that has enabled the world economy to rebound with few lasting effects in the past couple of times.
The notion that we can avoid a "hard fall" as the current Fed Chm, Jerome Powell seems to think possible is the subject of much debate. And, he has recently moderated this tone as noted in the linked article. I would call your attention to the tightening cycle of 2004-2007, which precipitated the recession of 2008-2010, and the tightening cycle of 2015-16, which was interrupted by the Covid crash of 2020.
My takeaway from this chart is that we had a false crash in 2020 led by a dramatic reduction in demand due to the world shutting down for three months. You can see the slope of the rebound since then is very similar to the years of 2009-2011 when the Fed was rapidly adding liquidity, as happened in 2020 to early 2022. That suggests to me that as a function of Fed tightening, we may have seen the cycle peak, and the oil price could be in a plateau for the next several years, as in 2011-2014, or until an inflection in the market similar to what Saudi did in 2014 occurs.
That is certainly one outcome that we could see, but there are other forces at play in this equation.
What's different this time?
As I noted in a recent OilPrice article on problems in the Shale-Patch, supply, and the expectation of the market that oil will be readily available, is out of sync with the demand picture. A look at the EIA-STEO for that time period shows you the beginning of the U.S. inventory build that culminated in mid-2017.
From a peak in mid-17 of ~550 mm bbl, thanks to growing U.S. production, and bountiful Saudi exports in that era, the oil market was over-supplied and prices suffered. Drilling in the U.S. had been on the decline starting in 2019, dropping about 300 rigs over the course of that year, when the Saudis and the Russians formed OPEC+ and began to withdraw crude from the market to raise prices. Thanks to a surge of production from newly completed wells, we reached another near peak capacity level in 2019, as this SP Global article notes.
Flash forward to today, and as of the most recent EIA-WPSR, we are bumping around 420 mm bbl currently. Hence the case can be made that as a combination of fiscal restraint in the post-2019 era, and OPEC+'s voluntary withdrawals, the strategy to raise prices, by reducing supply has been pretty successful.
This decline in supply meets rapidly rising estimates for demand, as noted in this OilPrice article. The article also notes that OPEC+ is unlikely to raise production beyond its stated goal of 432K per month. As they are currently ~2-mm BOPD under quota, it is questionable whether they have the capacity do if they were inclined. Supporting that notion is their commentary in this OilPrice article. The article notes that the cartel is in significant arrears of its agreed production targets.
“While OPEC+ is sticking to its policy of modest monthly increases, many of its members are not pumping to their quotas and the group overall is estimated to be around 2.5 million bpd below its quota.”
I think there is a fair probability that we may have sharp a recession as the Fed tightens. Some of the earnings reports that I've seen are lackluster. Take Walmart, (NYSE:WMT) earnings miss and resultant sell-off as an example It suggests to some that inflation is beginning to take its toll on the consumer. It's fair to say results are mixed in this regard though, as some consumer-facing companies have turned in strong reports for Q-1. (NYSE: Costco) and (NYSE: Dell) being a couple examples of companies finding a way to succeed in these challenging times.
In this scenario restrictions on credit will impact mortgage originations-already happening, and home building-already happening. Consumer plans for travel this summer, appear strong, but I have to wonder if those big, multi-state destination type national park trips will give way to a state park trip or even a staycation. At the $6.00 a gallon that's being tossed around for mid-summer, filling up a Chevy Tahoe is about $150 bucks every 350 miles.
If we don't see a prolonged recession, in the "soft-landing" scenario, I think there will be a sharp spike higher in crude. The demand picture globally will tug at supplies everywhere. With the adverse political scenario facing drilling presently-I think that may ameliorate somewhat as we go forward, the mindset of shale companies toward not scaling production significantly higher this year, and the inability of OPEC+ to even meet its own production goals means, we could see WTI $50-$75 a barrel higher than it is today. There are estimates of $300 WTI floating around, but I think demand destruction will set in long before we get there.
In the “hard-landing” scenario, my expectation is that we will get a demand-led sell-off in crude, and an inventory build that should work to put a lid on prices. I think this will be in the current range of $90-$110 per barrel due to persistent underperformance in raising output significantly by shale producers or OPEC.
In short, the world is going to experience an era of higher oil and gas prices, and there just isn’t much anyone can do about it.
By David Messler for Oilprice.com
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