The Big Conversation
Episode 97: What is driving the global energy crisis?
This week we break down the data pointing to a global energy crisis. The prices of energy commodities like oil, natural gas, and coal are skyrocketing, but it isn’t because the global economy and demand have returned to pre-pandemic levels, in fact, it is supply shortages and lack of production that are driving these price increases. In “The Chatter” section Jim Mitchel, head of Refinitiv’s Americas oil analysts, discusses why this global energy crisis is arguably an “ideology crisis” and why this means we could see all-time record prices for oil in 2022.
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Max Wiethe [00:00:00] Global energy prices have skyrocketed since the depths of the pandemic. With this being driven mostly by a lack of supply in the market rather than increased demand. Questions remain as to whether this is the beginning of an energy crisis or if the old adage is true. Are high prices the cure for high prices? Crude oil is the king of the energy complex, and after falling to negative levels in April of 2020, oil's rapid return to higher levels was viewed as a sign of a robust economic recovery. The issue with this theory though, is that global demand for oil is still below 2019 levels, with OPEC plus forecasting that demand will not fully recover until 2022. Today, oil prices sit at over $83 per barrel for WTI crude and over $85 per barrel for Brent crude, with both at levels not seen since 2014. These extreme levels appear to be driven by lack of supply. Earlier this year, in an effort to avoid high prices at the gas pump in the U.S., President Biden pleaded for OPEC Plus to pump more oil after they had agreed to only moderate production increases through the end of 2021. President Biden's request was quickly rebuffed by the cartel, and alternative sources of supply were considered even tapping into the US's Strategic Petroleum Reserve, but quickly dismissed as likely to only have marginal effects on easing supply shortages. OPEC plus production may still be lagging, but this is hardly the only region where this is the case. Since the start of the pandemic, U.S. oil production is sitting at nearly two million barrels per day below its pre-pandemic levels. Going back to 2014, the last time that crude oil prices were this high, WTI crude plummeted to less than $30 per barrel in the U.S. by the beginning of 2016. High prices being the cure for high prices. Those high prices of oil seen in the years leading up to 2014 were exactly what was needed for shale oil and fracking to become economical. The market, however, got quickly oversupplied, and the shale companies, which were once the darlings of Wall Street, declined sharply, with bankruptcies plaguing the sector for years to come. This period is hugely important for what is going on today, as many believe the return of shale and other sources of production as a response to high prices could be would finally puts an end to the energy rally. The issue is that investors and more importantly, executives at these companies are once bitten and twice shy. Couple that with divestment movements and regulations specifically designed to disincentivize future exploration and production, and appears as though more sustained higher prices and changing tunes from regulators may be necessary for companies to finally start to drill again. Part of the issue is the curved shape for oil prices. Currently, the forward curve for oil prices is backward dated. That means that prices in the future are below current spot prices. For many of these producers to justify going back online they need to be able to hedge out future production to raise money for these capital intensive projects. $80 per barrel at spot may be economical, but as near as May 2020 for contract, WTI futures are currently trading below $65 a barrel. Some drilling has returned in North America, but for the most part, this is still well below pre-pandemic levels. Of the 15 to 20 percent increase spend on production in the Permian Basin, most of that is being driven by small private producers who have not been beholden to the whims of public market investors and the ESG mandates that many of them have implemented. Politicians as well are beginning to understand this paradox of balance in the energy transition. As Norway's prime minister recently defended the country's oil and gas industry and their oil investment fund, stating that it was necessary part of the green energy transition. Now the energy complex is more than just oil and across the entire market, similar dynamics have been playing out, with these price rises feeding on each other. Natural gas is hovering around $6 per million BTUs, up over 200 percent from a little over a year ago. This is partially being driven by dry seasons in China, which relies heavily on hydropower having to switch to natural gas for this lost energy. Just this week, natural gas prices gapped up 10 percent in Monday's trading session. With winter right around the corner and demand and natural gas set to rise, many are turning to Russia as the potential supplier of last resort, especially in Europe. Some, including the Biden administration, have floated the idea that Russia is exploiting this crisis and using natural gas as a weapon to force Europeans to give on big political issues. As well, the most unloved energy commodity coal has not been spared from this crisis. Coal prices peaked out over $260 per ton recently and have hovered around these levels. This is after an over 300 percent increase in coal prices since the same time last year, an all time high for the commodity as measured by futures prices. Coal may be the number one target for ESG efforts to decarbonize energy production, but it appears as though policy might have gotten out ahead of demand. China still uses coal as its number one source of energy production, but it has recently fallen into a supply shortage. Over the last few months, national coal inventories fell to levels not seen in decades, prompting response from Chinese authorities. China's National Development and Reform Commission has ordered Chinese coal companies to produce as much coal as possible. Coal output has increased but only modestly, meaning that China might have to turn to imports to meet this demand. Altogether though, this may be too little, too late when combined with natural gas shortages. Leading some analysts to believe this may not be enough to avoid nationwide power rationing this November and December. The energy crisis for fossil fuels seems to be a supply and policy driven issue. But other energy commodities have also been on the rise. Uranium prices have also risen sharply over the past year after modest rises coming out of the depths of COVID as the narrative around uranium as an ESG fuel began to shift, a new four stepped into the market, pouring gasoline on this nuclear fire. Since the announcement of plans and subsequent purchases of spot uranium by Sprott Physical Uranium Trust. The price of uranium jumped over 50 percent in the months of August and September. These price rises in energy commodities have meant strong performance from related equities. Over the last 12 months, the energy sector has nearly doubled up over 93 percent. The only sector even close to this is the financial sector at over 60 percent, with both of these sectors being buoyed by the recent rise in interest rates. For consumers, these energy price rises are being felt acutely. Rising energy prices are one of the strongest indicators of inflation and because of its direct consumption by consumers and its near universal role as an input for industry is being felt everywhere. Inflation, although it has cooled off, is still running well above two percent. This is showing up in consumer sentiment as both the CCB consumer confidence and the University of Michigan survey have shown trends of deteriorating confidence for months now. All of this finally lands at the feet of central bank policymakers, who must now decide whether to follow through with their signaled monetary tightening. High energy prices can be an incredible strain on the consumers who drive the US economy. But will policymakers change their tune in light of these unforeseen stressors? Or will they continue as eluted with tapering and eventually with rate hikes to combat higher inflation? Positioning by the market is starting to price in the probability of rate hikes, though at least one hike priced in being the market expectation by June 15th 2022. Compared with just one month ago, when the market was only pricing in six percent chance or more of one hike at that June meeting. Inflation has already met the standards needed by the Fed for hikes and with increased heating needs and travel around the winter, the hugely important energy component looks unlikely to reverse in the near term. Aside from maybe positioning shocks. That's why this week in the chatter segment, I spoke with Jim Mitchell, head of Refinitiv Americas Oil Analysts, to discuss if we're in an energy crisis and if so, what that means for markets. Jim, welcome back to the Chatter segment here on The Big Conversation. Excited to have you. Anybody who's paying attention to the world knows that energy is where everyone is focused at this moment in time, partially because it doesn't matter whether it's oil, natural gas, coal prices are pretty close to all time highs or at least local highs, and the weird energy crisis is being thrown around a lot. I'd love to get your take. Are we in an energy crisis?
Jim Mitchell [00:08:48] You know, Max, I don't think we're in an energy crisis as much as we are in an ideology crisis. And what I mean by that is we're kind of stuck between what we want to do and kind of what we need to do to get there. And how does this manifest? So there's a trading maximum, at least there was, it may have changed. That says high prices, the cure for high prices are higher prices, which means basically as prices get higher, the incentive for producers to produce more kind of solves the supply problem. The problem, the ideal ideological problem that we're having now is that it takes a lot of money and a lot of time to get these wells and get these projects online. Energy companies need to have a certain assurance that they're going to be able to operate through this length of time. When you take that assurance away, or at least make it uncertain, you get what we have now.
Max Wiethe [00:09:48] All right. Well, some of the production that is coming back online, at least in the Permian, is coming from these smaller private producers who maybe one they don't need as much capital or two because they're private, they're not as subject to the whims of the ESG mandates that dominate the public markets. Do you think of that as really a crystallization of what you're talking about?
Jim Mitchell [00:10:10] Exactly. So remember now before COVID, the U.S. was producing a little over 13 million barrels a day, that was a lot. And then we ran into the price war with Saudi Arabia and Russia. And what happened there is it pushed a lot of these smaller producers into bankruptcy. They were heavily leveraged. And then when prices got down, they just had to go bankrupt. So what happened then is the assets went through this process of bankruptcy, so the assets stopped producing for a while and now they're back producing. So that's going to give us this little bit of boost, and we're right around 11.4 Million barrels a day. This little bit of boost can probably get us up to 11.7 or 11.8. We're not going to get back to 13 million or more anytime soon.
Max Wiethe [00:11:04] All right. So if it's only going to be marginal this increase production, does that mean that the status quo is going to stay the same?
Jim Mitchell [00:11:11] Yeah, I believe it is. So the U.S. currently is putting about 15 million barrels into refining. We're producing about 11.4. The net import export is about two or three million. So we're by that math. We're still about 600,000 barrels a day short in the U.S..
Max Wiethe [00:11:35] Demand hasn't recovered fully, but demand still is in the process of recovering. Does that mean that there's potential for this to get worse before it gets better?
Jim Mitchell [00:11:43] Oh, clearly it's going to get worse before it gets better. As we head into the winter, we're going to see a whole bunch of other forces coming into the market. The U.S. exports a lot of gasoline and diesel Mexico, Brazil, other spots in South America. During this shoulder month for them, moving from spring to summer, exports are lower. As we get into our winter and their summer, there's going to be an increased bid for these U.S. barrels.
Max Wiethe [00:12:15] And then what about the other energy commodities beyond oil? It seems like natural gas coal. The higher prices seem to be feeding off of each other as the rotation between these commodities. For things at least, you know, energy production or production of electricity where you do have some ability to rotate seems to be causing them to all move in unison. Is that what we're seeing or are these idiosyncratic rallies that just happen to be happening at the same time?
Jim Mitchell [00:12:41] Yeah, that's a great question. There definitely is some switching worldwide. For the most part, though, it's different equipment, so it's not like you can turn one switch off and one switch on. What we're seeing here is there's a lot of fear going into the winter of where we are now currently in prices and where we can be in January and February. So what's happening is people are paying premiums over current levels just to secure energy for December, January and February. So what that means is that then everything is getting bigger. So it's not really a switching thing as much as a scarcity thing more than anything else.
Max Wiethe [00:13:26] OK, now another thing that we haven't discussed yet is the curved shape and the way that the backwardation of the curve kind of incentivizes production to go out now and not to go into storage, which is causing some of these inventories to draw down. What are the types of indicators that you can look at to see whether this backwardation might start to flatten out and maybe even head towards contango?
Jim Mitchell [00:13:49] Yeah, great question. So when you look at the difference between grades. So if you're looking at, for example, LLS to WTI when that grade differential LLS is usually over WTI, when that grade differential expands i.e. LLS gets higher than WTI, generally the market's going to move higher. When that differential gets compacted, generally the market will move lower, and that's generally because we have a lot in storage. Now we are dangerously low on storage in Cushing, in Houston, in Patoka, pretty much all over the place. So these differentials will continue to expand. And this is not just a U.S. phenomenon, this is happening worldwide.
Max Wiethe [00:14:35] Yes. So inventories are very low and they seem to be drawing down daily, obviously, with those deficits. But what about the places that we can go to offset some of this? There was some floating of the idea of tapping into the strategic petroleum reserve that has since, at least for now, been waved away as only marginally helpful and for that reason, not really something that's being explored. Where can we go from here or is it really just going to be that same axiom that you were talking about of higher prices being the cure for high prices? But in this case, it's higher prices being the cure for ideology, meaning maybe we're going to have to be even higher.
Jim Mitchell [00:15:13] Yeah, yeah, a couple of questions in there. So the SPR question. It certainly will help. But again, as you mentioned, it's going to be limited. It can't go on forever. We should be drawing down the SPR. There's a lot of oil in there and it's not the kind of oil that we want to have available going forward. Right, most of that oil is very heavy. We want a lighter oil going forward, so we should be drawing that out and we are. Now the other part of that question is there any place else we can go? We've already talked about the U.S. it's going to be difficult to expand until we change this ideology or at least, and this is what I'm hoping COP26 will help us with this kind of balance out our way forward. I hope that's what comes out of that. Now, can Russia expand? Maybe a little, but they're not going to get back to 13 million barrels a day, either. Can Saudi Arabia expand? Yeah. You know, they're going to add 400,000 coming up here. But can they get back to 13 million? I don't think so. So what's going to happen is we're going to have this, this scarcity going on for a while and it's going to happen until we get a better balance on what we want and what we need to do to get to what we want.
Max Wiethe [00:16:31] What about some of the at least the posturing, the talk that's coming out of the policymakers who are driving this ideology? You just had the new prime minister of Norway, actually, you know, a left wing politician coming in defending their oil fund and saying, listen, this is part of the transition working together to make sure that we don't have these types of shortages. To me, at least, that was one of the first times at least a politician from Europe on the left leaning side saying something like that. Are there other indicators of people starting to realize the severity of the problem in the way that balance is important in moving forward?
Jim Mitchell [00:17:09] Yeah, yeah. I think every politician, certainly in Europe and in the United States and Canada and South American and everywhere, because energy acts as a tax upon the economy if the economy is not doing well. Politicians don't get reelected. It's not as big a deal in Saudi Arabia because that guy doesn't depend on elections in the U.S. absolutely, it does. In Canada, we saw a very, very close election, which shouldn't have been that close.
Max Wiethe [00:17:38] I guess I'm asking, are you starting to hear changes of tune, at least the Norwegian prime minister? That seemed to be a change of tune from at least what he was saying before you had Biden earlier this year asking OPEC to pump more oil but still not doing anything in the U.S.? Where are we in terms of the politicians who at least at this point, have been on the other side of the ideology starting to move more towards the middle in terms of thinking about how fossil fuels at least fit into the transition to green energy? Maybe not the future, but the transition.
Jim Mitchell [00:18:11] Yeah, and we have and you mentioned President Biden and we've seen President Biden. He's he's getting pulled a couple of different ways. His party has is a group of progressives who are kind of leading this ideology and this group of moderates who are really saying, hold up here. The math doesn't work, we need to set out a better plan to get to where we want to be. And I think that group in the U.S. is starting to get a little more credibility. We've seen the senator from West Virginia gain a lot of credibility over the last couple of months. He's one of the principal drivers of this kind of centralist thing. So how does that manifest? President Biden is, well, his group actually not him, but it is allowing more permits, more permits in the Gulf, more permits on federal land, which is upsetting some side the progressive side of his party. But it's kind of appeasing the moderates. But with that said, it still takes a couple of years. Once that permit gets in and best, it's going to take a couple of years to get that hole punched in the ground and get oil out of there.
Max Wiethe [00:19:19] All right. So I want to leave it on this. We alluded to the idea that it is likely that it will get worse before it gets better. What is worse mean in this case? How high could oil prices go and what is the sort of timeframe you talk about years to really get these things up and running?
Jim Mitchell [00:19:34] Yeah, great question. So a couple of prominent banks have upped their oil perspective going out to 2023. Most of that is kind of where we are. Give or take a couple of banks, one a little bit higher. There are some whispers in the market that this time next year we could or by the time this time next year, we could see record prices.
Max Wiethe [00:20:01] Wow. All right, well, Jim, it sounds like we'll probably have to have you back again soon as this isn't going anywhere any time soon. Thank you so much for coming back on The Big Conversation.
Jim Mitchell [00:20:11] My pleasure.
Max Wiethe [00:20:16] We'd like to remind you that if you have any questions about topics covered in this episode or topics you'd like covered in future episodes, please post them in the comments below. Thanks for watching!
Episode 96: Will repricing rates impact stocks?