Date: 01/10/2023
Author: Mr. X
Energy stocks crushed in 2022, so much so that President Joe Biden is pushing a “windfall tax” on oil and gas companies. The new Republican House majority might have something to say about that – especially now that its activist wing is walking away with key concessions following their effort to stop Rep. Kevin McCarthy (R-CA) from becoming Speaker. They didn’t keep McCarthy from getting the gavel, but they have more power than they did a month ago.
Still, it’s hard for something that went gangbusters one year to do it again the next. (Just ask Cathie Wood and ARKK investing.) However, when it comes to geopolitics, reason has very little to do with what happens. And unfortunately for all of us, energy is downstream from the Long War that will rage between states until the heat death of the universe.
Still, what is the point of being a trader if you can’t turn something tragic to your advantage? Keep in mind that energy prices can shift remarkably quickly – but there are some good reasons to think oil is about to spike in price again.
The first reason is that oil prices may increase because the United States and other nations no longer have the reserves to force a decline in prices.
Oil prices may be artificially low now because consumers have released oil from their strategic reserve. The 31 countries that make up the International Energy Agency did this ostensibly to hit back at Russia – but given that no politician benefits from high gas prices, it’s simply naïve to think that elections didn’t play a part. At least in America, it worked.
One of the reasons the Republicans did so poorly in the midterms is because President Joe Biden, a political survivor if there ever was one, successfully defused anger about high gas prices and has been bragging about the drop in price ever since. That’s politics. Don’t hate the player, hate the game. Releasing reserves has a disproportionate impact on prices and the Biden Administration kept doing this even after oil prices continued to fall.
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A study cited by the Treasury Department said:
Under the assumption that strategic releases can be modeled as surprise inventory additions, impulse response functions suggest that a strategic release of 10 million barrels would temporarily reduce spot prices by about 2% to 3% and mitigate backwardation by approximately 0.8 percentage points. Historical simulations suggest that past releases reduced spot prices by 15% to 20% and avoided about 5 percentage points of backwardation in futures curves, relative to a no-release counterfactual. This research can help policymakers determine when to release SPR reserves based on economic principles informed by market prices. It also provides an econometric model that can help inform the amount of SPR releases necessary to achieve given policy goals, such as reductions in prices or spreads.
Here’s the problem. By late December, the SPR hit its lowest level since 1983. The election may be over, but the United States still needs oil. President Biden had said at the time that the United States would buy back oil once the price had declined, thus actually making this a profit. This was a plausible response to Republicans who said he was just doing this for the elections. However, the Energy Department recently rejected offers to buy back oil, meaning that the SPR is going to stay low in the short-term. The Energy Department says it is looking for a “fair deal for taxpayers,” but what if prices don’t decline? Releasing your emergency reserves is a trick you can only play once.
The second reason that oil prices may increase is because China is reopening on a large scale for the first time since the COVID-19 pandemic began.
It’s important to keep in mind that China was essentially closed for three years, with travelers facing huge obstacles to get in and out of the country. Now, arguably out of economic desperation, China is letting COVID-19 rip through the population simply because “Zero COVID” has become untenable. Oil prices are already up this week as traders anticipate a spike in demand.
This is something of a gamble – factories in China are suffering from partial shutdowns due to workers getting sick. This is arguably the first time the country has faced the virus on a large scale. However, we can anticipate that this will pass with time. The country’s political leadership can no longer economically or politically afford the “on again, off again” shutdowns.
More importantly, we already have direct evidence that demand for oil is increasing in China. Import quotas for oil are already 23 million tons greater than they were at this time last year – and the year just started. As the economy picks up steam, we can expect domestic demand to increase and put even greater strain on the global oil market.
Of course, about that global oil market… the third reason oil prices may increase is that there really isn’t a global oil market anymore.
Russia has been hit hard by a global oil price cap imposed by the Group of Seven. This made Moscow reliant on India and China, which are using the opportunity to buy discounted Russian oil. In fact, Russian oil is currently selling well below the price cap.
Yet Russia didn’t simply take this lying down. In late December, Russia banned crude oil and oil products to any nations that abide by the G-7’s price cap. Russia will likely have to reduce production – but it won’t be alone. “Saudi [Arabia] is not going to let Brent [Crude] stay around $79 a barrel,” said Scott Sheffield recently. Sheffield is CEO of Pioneer Natural Resources. He thinks that he wouldn’t be surprised if OPEC made another cut in production.
The premise here is that the United States will not be capable of ramping up domestic oil production. This is probably true, as the Biden Administration will face a revolt from progressives within the Democratic Party if it tries to boost production on a rate similar to what the Trump Administration intended.
Russia was clearly not expecting the Western world’s united response to its invasion of Ukraine. Yet Washington has received its own unpleasant surprises, notably with the defiant reaction of Saudi Arabia and India. India is executing a masterclass in statecraft by remaining unattached to all power blocs, simultaneously refusing to be taken for granted by Russia, America, or China. It is calmly doing business with Russia, getting oil at a discount and using the threat of China to prevent the West from retaliation.
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Meanwhile, Saudi Arabia is openly defying the United States. In June 2022, President Joe Biden said that he wouldn’t meet with Saudi Crown Prince Mohammed bin Salman because of “MBS’s” role in the murder of journalist Jamal Khashoggi. Less than a month later, President Biden traveled to Jeddah almost as a supplicant, smiling and sharing a fist bump with the Crown Prince. President Biden didn’t get the truly royal reception that President Xi Jinping received when he went to the Kingdom. Saudi Arabia and China signed a “strategic partnership” and vowed to cooperate on a host of issues.
It’s a far cry from when Saudi Arabia was basically thought of as an American protectorate.
The BRICS countries – Brazil, Russia, India, China, and South Africa, – need to be more independent of the United States if Russia’s dream of a “multipolar world order” is going to be achieved. This will be settled on the battlefield. Russia is currently advancing in Soledar and the situation around the critical city of Bakhmut is turning to Russia’s advantage. It’s something of a race to see whether Russia can capture the city before new Western weapons shipments – including Bradleys and Strykers – could allow Ukraine to go on the offensive. What’s clear is that Russia is not going to sue for peace anytime soon. More importantly, outside the G7 and the West, the world hasn’t abandoned Russia and will still buy its oil.
The result is that we don’t really have a global oil market anymore. We have divided markets. A warm winter has spared Europe from some truly nightmarish choices, but the simple fact of resource shortages, supply chain disruptions, and self-imposed financial hardships in the interests of defending Ukraine (and the postwar world order) are going to tell on Europe the longer this war goes on. Meanwhile, politics, specifically progressive environmental policies, are going to check American efforts to increase oil production.
Speaking of which, politics also has an impact on the final reason oil prices may spike – just about everything needs oil, even so-called “clean” initiatives or ESG (Environmental, Social, Governance) programs. The Consumer Protection Agency is reportedly toying with a ban on natural gas stoves because of the health risks. That will mean more electric stoves – and more reliance on oil to produce electricity. Petrochemicals are also needed in the production of electric vehicles, even if they are not running on oil and gas. Talking about EVs just kicks the can of being “carbon neutral” down the road. The electricity has to come from somewhere first, and barring a massive program of nuclear power or alternative power sources becoming more efficient (all unlikely in the short-term), we’re still going to be reliant on oil.
The pandemic era was a time of great dreams and, unfortunately, great delusions. At the top of the list was the idea that we could do a Great Reset away from oil and traditional energy sources.
The Russian invasion of Ukraine, the rising tensions over Taiwan, and the recession that’s about to hit the UK and Europe is a powerful reminder that there is nothing new under the sun. In the short-term, oil remains the single most important resource on Earth. As countries reopen, demand will increase, but there is no longer one global market that can truly allocate resources in an efficient way. Instead, we’re dealing with a divided world, a continuing (and probably eternal) pandemic that we can no longer stop, and the most dangerous global security situation since the end of the Cold War, with the real threat of conflict between nuclear powers.
All these factors suggest trading, transporting, and acquiring oil is going to become more difficult, even as the world needs it more than ever.
Mr. X is an investment analyst working in the Washington DC area who specializes in the intersection of business and public policy. After fifteen years working in politics, he writes on a classified basis for RogueInvesting.com to bring you news on what those with power are debating, planning, and doing.
