Desperation And Austerity Hit Global Energy Markets

We are starting to see the makings of energy curtailments in Europe - an exceedingly unpopular step that governments would be unlikely to take if there were any other choice, highlighting the acute desperation that exists over oil and gas supplies. 

Another signal of this desperation is Biden's plan to release a massive 180 million barrels of crude oil into the market from the SPR at a rate of more than a million barrels per day. This is a huge figure that will shrink the SPR to lows not seen since the '80s (~388 million barrels) when U.S. oil consumption was substantially lower than it is today. This decades-low emergency inventory would come at a time when U.S. production has stagnated with oil companies resisting calls to invest/pump more, and at a time when demand continues to rise.

The UK said on Friday that it would also release more oil from its reserves.

The drastic actions will be interpreted in the medium term as a cause for concern. OPEC+, on the other hand, appears content to stay the course, agreeing on Thursday to stick the agreed-upon production hikes for May. At the same time, Canada continues to raise the price of carbon, thereby raising the price of gas. 

Germany's economy minister has triggered its early warning system for low levels of gas, and has appealed to companies and private consumers to conserve energy. France's gas distributor is also expected to issue a decree in the next couple of days detailing a plan for possible gas rationing. The Netherlands' economic ministry said it, too, would soon ask its citizens to use less gas. 

Europe and the United States have expended much time and effort trying to scrape together additional fuel supplies and trying to subsidize energy and gasoline for their people. Unfortunately, gas tax holidays, national caps on energy prices, and one-off payments to economically strained residents have only given way to steady demand. Now, Europe has come to the realization that there are no white knight oil and gas producers that have just been waiting in the wings to supply their needs.

The age of austerity is here, and while it might start with oil and gas curtailments, it certainly won't end there. And the age will hang around with us for quite some time.

The high cost of diesel is already starting to be passed on down the line to end-users of products that are transported. In the United States, the CPI for food, for example, has climbed 7.9% from February 2021 to February 2022 according to the USDA. The UK has seen grocery prices rise at the fastest rate in 8 years, at 4.3% last month. Germany, which has seen a 39.5% rise in energy prices from a year ago, has seen consumer prices increase by 7.6%. There are whispers of a looming recession. European Central Bank president Christine Lagarde has warned that Europe is now entering a difficult phase. Considering the chart below, it is hard to disagree.

It was originally assumed that there would soon be some increase in production from some of the world's largest oil producers. It was also assumed that, with the exception of the United States, Russia's oil really wouldn't be removed from the market in the absence of actual sanctions. 

U.S. shale and OPEC, however, have failed to deliver on those production hopes. U.S. production is stagnant and OPEC+ is holding the line with its 400,000 bpd per month quota increases. 

Meanwhile, Cushing inventories are low, U.S. crude inventories have shed 80 million barrels since the start of last year, and distillate inventories are down to just 25.9 days of supply, a level not seen since 2008. 

It is fair to recognize that inventories have been low in the past and didn't cause as much panic in the market as we are seeing right now.

Cushing inventories were close to this low at the beginning of 2019. For distillate inventories, while it has been a while since they've been this low, it certainly has kissed the 26-28 days of supply levels a few times in recent years, as recently as 2019, in fact. But the reality is that the world is just now realizing that there doesn't appear to be any more spare capacity. Low inventories combined with a lack of additional capacity is a recipe for disaster. Whether this "capacity" doesn't actually exist in the physical sense or whether it exists but is deliberately withheld is irrelevant.

The reality is this: oil prices are at the level the market has dictated, and only higher supply or lower demand will cure it.  On the supply side, there are only a handful of major producers that have potential spare capacity. We expect to see Russia's oil, thanks to self-sanctions, look for another outlet (Asia). But it would require some serious shipping gymnastics to get all that oil to market and will add months of lead time to the oil that used to find a home within a couple of weeks.

Neither Saudi Arabia nor the UAE is willing to increase production at a rate beyond what OPEC+ has agreed to - and with Russia in the group, the group isn't going to be agreeing to additional supplies. For the remainder of the agreement, it is nearly certain that we will see 400,000 bpd monthly increases in OPEC+ quotas. If history is any indication, actual production will be less than that quota. The United States will continue to invest and add rigs at a moderate pace in line with what companies have predetermined, no matter what today's price is. They have said as much. We may see small, private drillers in the U.S. increase production at a greater rate, but this will not be the millions of barrels per day that the market is hoping for. Even if investments were to ramp up substantially today, it would be at least six months before that oil makes its way to market. The only other hopefuls are Iran and Venezuela. Although there, too, it would take some time for either to increase production, and it certainly wouldn't be millions more barrels per day. This is the supply reality. 

Then there are the demand realities. Subsidies, tax holidays, and stimuli are temporary measures that do not change the fundamentals for the better. Instead, it will only encourage increased demand. Increased demand without additional supplies will, of course, sink inventories further. People who have been locked away during the Covid era are itching to resume life and travel, and they will. Until prices or lack of inventory sap demand.

The oil industry has had its fair share of missteps over the last decade, but no misstep would be greater than underestimating the consequences of demand curtailments, whether through austerity measures such as rationing, because of higher prices, or even by running out. The flip side, of course, is that if the oil industry could ride to the rescue and act now to increase production, it is a near certainty that they will once again find themselves the dirty pariah that they were just two months ago as soon as the crisis is averted, potentially rendering their investments obsolete in short order. 

For the oil industry, it is a no-win scenario.