The price of Oil has been soaring in 2022. It began the year at $75. It eclipsed $100 off the Russian invasion of Ukraine, reaching a decade high of $130. It backed off that level but has since been moving back in that direction. Do you remember when it fell below zero in 2020? That was new. Oil prices are notoriously volatile. Few things drive inflation or deflation more than fuel. The price of Oil matters.
There are 42 gallons in a barrel of Oil. Half of it goes to gasoline. A quarter of it goes to Diesel and Heating Oil. 18% of the barrel is used to make a plethora of Consumer products; More on that below. 10% goes to Jet Fuel and 3% makes asphalt. That’s the heavy, viscous stuff at the bottom of the barrel. It’s dirty business. But our roads rely on it.
So, what type of products are made with that 18% of the barrel you might wonder? How about nearly everything. In addition to gas and plastics, petroleum is used for so many products that we use every single day. Oil is in toothpaste. It’s in shoes. It’s in your pants, your soap, your shaving cream, and shampoo. Oil makes boats, heart valves and hearing aids. It makes life jackets and aspirin. Oil is used to make fertilizer and credit cards. Those golf balls; Oil is in there. It’s also in paint and nail polish; Pillows and purses.
Maybelline and Vaseline; they’re derived from petroleum. Did you know that Maybelline was named after a pharmacist’s sister? She dabbed Vaseline and coal dust on her eyelashes for effect. She liked it. Others liked it. Her name was Mabel. It was over a century ago. That’s how it started. The rest is history. Oil is used to make so many things. And it’s needed to transport them to the stores and to your homes. It’s no wonder prices have been soaring in our shopping carts.
95 Million barrels of Oil are produced daily around the globe. The United States produces just under 12 Million barrels per day. It peaked in 2020, just before Covid struck, at nearly 13 Million barrels. Production fell in response to the lockdown and subsequent reduced demand. American Oil accounts for roughly 15% of the World’s total. Both Russia and Saudi Arabia produce 10.8 Million. Canada and China produce 5 Million barrels per day. Iraq produces 4 and Iran 3.5 Million. That is roughly what the United States produced a decade and a half ago, before the Energy renaissance in shale took off. Importantly, the State of Texas produces 5 Million barrels per day alone. You know, Black Gold; Texas Tea.
A big problem presently is the fact that the World consumes 100 Million barrels per day. That’s 5 Million more than produced. The United States is the largest consumer of Oil at 20 Million barrels per day. China is second at 13 Million. Basic supply/demand imbalances drive prices. Increased demand with reduced supply results in higher prices: Econ 101. We are living it every day. And supplies keep shrinking. Russian Oil has been sanctioned. In America, “Drill Baby Drill” was replaced by the ESG (Environmental Social and Governance) movement. Lenders were fed up losing money chasing speculation. Investors and consumers wanted more green solutions. Profitability and environmental issues drove Oil production down. Renewables were the future. The system nearly broke. Renewables are the future. They’re a big part of the present too. However, Renewable Energy is not the complete solution. This has been a stark reminder that the World still runs on Crude.
Planet Earth is certainly complicated. Large Oil supplies reside in unstable regions. Russia is atop that list. The European Union just agreed to a Russian Oil ban. This is a big deal. Americans haven’t done much business with Russia. Europe certainly has.
EU leaders reached an agreement this week to ban 90% of Russian crude by the end of this year. This is a bold and risky move. It’s not clear how effective this ban will be. Europe is a large customer of Russia, mostly Oil & Gas. That’s coming to a halt. In response, Russia is sending more Oil than ever to India and China. It is being sold for around $90 a barrel. That is a significant discount to the price of Brent and West Texas Intermediate.
It is believed it costs Russia somewhere around $40 to produce a barrel of Oil. Despite the sanctions, Russia still appears to be making huge profits on its sales. The key for Russia is to maintain those buyers. The European deal will ban seaborne Russian crude, which covers about two-thirds of Europe’s imports from Russia. Germany and Poland also agreed to stop imports from the large Druzhba pipeline. There are reported shell games going on across the high seas. Russian Oil is apparently being transferred to other ships on the Mediterranean and off the coast of Africa to hide its origin and change its label. This should come as no surprise. Oil & Gas revenue account for nearly half of Russia’s annual budget. It matters. It matters a lot.
Markets were already on edge after the Iranian Navy seized 2 Greek tankers. This was in retaliation to the confiscation of Iranian crude by the US from a tanker held off the coast of Greece. This runs the risk of further disruptions to Oil flows through the Strait of Hormuz, which carries a third of global trade. War Games are nothing new in the Strait of Hormuz.
This was a headline this week which caught our attention: Some OPEC (Organization of Petroleum Exporting Countries) members are considering suspending Russia’s participation in its oil-production deal. This seems quite unlikely since Russia has been such a large participant, if not ally, to OPEC. Saudi Arabia is the most powerful member in OPEC. It could be that the Saudis may be sensing an opportunity to repair their splintered relations with the United States. President Biden is planning to meet Saudi Crown Prince Mohammed bin Salman later this month. The White House is seeking Saudi Arabia’s help to lower Oil prices. Record prices at the pump are angering the American people. It is also hurting the Economy as Dollars get sucked away from other discretionary spending that fuels the system. You know that the price at the pump is going to be a main focal point in the midterm elections in November. 70% of the US Economy is driven by consumer spending. American consumers are also voters.
It can’t be forgotten that before coming into office, President Biden was highly critical of the Saudi monarchy. He, like many, blame Saudi Crown Prince Mohammed Bin Salman for the 2018 murder of US-based journalist Jamal Khashoggi. Relations between the 2 nations have been coarse, following a much stronger alliance under Trump. Things seem to have changed in recent weeks though. With gas prices at record highs, several high-level delegations were sent to Saudi Arabia from Washington to arrange a Biden visit in June. So, there’s that.
Back at home, the beginning of so-called quantitative tightening (QT) commenced this week. The Federal Reserve let bonds mature off its $9 Trillion balance sheet without replacement for the first time since the Covid outbreak. This is a huge step for a central bank that performed unprecedented bond purchases from March 2020 to March 2022 to stem the financial chaos. It had previously redeployed proceeds back into additional purchases. Money is now being pulled out. This has never happened before in this size or scale. The Federal Reserve has never injected money into the system like it did in early 2020 to combat the Covid crisis. Consequently, it has never taken this much money out. The Fed has shifted from being a large buyer to a net seller. The impact is unknown. The first Treasury securities are set to run off on June 15th when $15 Billion mature. The Street anticipates the Fed balance sheet will be reduced by roughly $2.5 Trillion in this campaign. That would get it back down to $6.5 Trillion. In case you were wondering, it was $4 Trillion pre-Covid.
This QT campaign comes at a time when the Treasury Market has been grappling with bouts of volatility and reduced liquidity. The unknowns about the effects of QT clearly contribute to it. Yields should technically move higher in response to QT, while the yield curve should steepen. That would be natural in a tightening of financial conditions and the money supply. A $2.5 Trillion reduction would represent roughly 15% of US GDP. This is designed to cool the persistent red-hot inflation, which triggered a rare meeting between President Biden and Fed Chair Powell on Tuesday. Blame keeps being thrown around for this inflation. For sure it started with Covid. It was an issue well before Ukraine. The White House, Congress and the Fed all contributed to the inflation crisis by keeping money flowing into the system, which inflated asset prices to record highs. The result was bubble-like conditions in both the Stock Market and Real Estate. Corrections have begun. The Market always forces the Fed’s hand. Housing is next.
The Dow and S&P headed into the weekend erasing the week’s gains in the wake of a strong job report for May. 390K jobs were created. Stocks sold-off as this better-than-expected economic report gives the Fed more cover to hike rates in order to cool inflation. Jobs are not the problem. Inflation is. The prices people pay have spiked, particularly in food and fuel. Interest rates jumped again, putting the squeeze on stocks and bonds. Of course, the price of Oil continues to squeeze the consumer.
Elon Musk made a bold statement yesterday. He said he had a “super bad feeling about the Economy.” The quote is unquantifiable, but you get the point. Musk is planning to cut jobs at Tesla. This followed JP Morgan CEO Jamie Dimon’s caution that an economic hurricane is approaching. These are some high-profile CEOs with some serious attention-getting headlines. High prices and a slowing Economy generally leads to recession and stagflation. Not good. The Fed absolutely has its hands full.
The Stock Market had put in an impressive rally since the substantial washout in May. Things got really, really oversold. The Bull case consists of a reopening of China after strict lockdowns with peak inflation and peak Fed fears, resulting in a soft landing that avoids recession. The theory is economic normalization is ahead driven by a strong consumer, stable earnings growth, and corporate buybacks. That seems like a pretty tall order right now, but the sell-off certainly priced in a lot of bad.
So where’s this leave us? Volatility will almost certainly remain. There are lots of moving pieces in place, which contribute to the bumpiness. Fed officials pushed back against the possibility of a September “pause.” It’s still early on that theme. We think they will need to. The Market will force the Fed’s hand. There are many on the Street that say the bottom is in. There are just as many that say new lows are ahead. Bottom formation is a process. It takes time and patience. Our thinking is last week’s bounce was a normal Bear Market rally off very oversold conditions. It followed a 7-week losing streak for S&P and 8 on the Dow. Sentiment got so extremely negative, it seemed primed for a reversal.
There could be some more in this rally. But we are confident that this defined range for 2022 will remain in place until there’s more clarity on inflation and the Fed. A slowing economy is normal. In many ways, for this inflationary environment, it’s not a problem. It’s a solution. The best solution for high prices is high prices. The Economy is cooling from overheated levels in 2021. An economic slowdown is naturally deflationary. Prices will fall when demand slides. The challenge for the Fed is to keep the Economy from sliding into recession. High Oil prices are the biggest issue. We’re firmly in the Digital Age and the 21st century, where smartphones and autonomous electric cars are in expansion. But Oil still matters. It matters a lot.
Have a nice weekend. We’ll be back, dark and early on Monday.