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Good morning. I have tried to avoid writing about oil for as long as possible. There are a lot of people at the FT who understand it better than I do. But this is a markets newsletter; one can only not write about oil for so long. If I’m missing something important, email me: Robert.Armstrong@ft.com.
Why Opec matters
Here’s a price chart that looks like all price charts seem to look recently: a lopsided V, higher on the right. The swings this one shows are more extreme than most, though, because it’s oil:
Oil has had a good run since April of last year. Back then, the Opec oil cartel committed to cutting 9.7m barrels a day in production, about a tenth of world supply, to stabilise prices. Looks like it worked! Opec has only gradually eased the production restrictions since.
There is an Opec meeting on Thursday. The consensus expectation is that another half-million barrels will be released. This is not much. The politics of increasing production are tricky; the Saudis are generally against it, and Russia is generally for it.
Opec’s control of the oil price is stronger now than it once was, because private oil producers are drilling and producing less. They are under a lot of pressure from ESG types who want them to achieve carbon neutrality. This helps explain this chart, from Morgan Stanley, showing private oil company capital investment and the oil price:
Oil prices have risen, but oil companies aren’t chasing the prices with higher production. That leaves it up to Opec to do so. As Morgan Stanley’s Martijn Rats sums it up: “If Opec keeps the oil market tight now, it no longer needs to worry that it will lose market share to non-Opec producers.”
All of this is happening as we head into what is expected to be a significant economic expansion, with correspondingly higher oil demand, in the second half of this year. That means, as Bill Farren-Price of Enverus put it to me, that “the biggest moving part is Opec. Whatever high oil prices incentivise in terms of new supply growth, it’s not going to happen significantly in the next six months. So how quickly does Opec restore the barrels it took out in April?”
This makes Goldman Sachs, for example, feel “constructive” on the oil price: “Much more Opec supply will be needed to balance the oil market by 2022. We forecast demand to rise by an additional 2.2m b/d by year-end, leaving a 5m b/d supply shortfall” the bank’s oil team wrote this week.
Why does this matter to investors generally? Higher oil prices contribute to inflation, which as you remember is The Thing We Are All Worried About Now. And persistently high oil prices can become a drag on economic growth, because they are an input cost, directly or indirectly, for just about every industry.
Inconveniently, the relationships between oil prices and inflation, and oil prices and growth, while indubitably real, logical and important, are dynamic and hard to track. Here is a chart from the Federal Reserve of the oil price and changes in CPI, less food and energy.
There are suggestive correspondences in several periods, but the relationship breaks down at others. Ian Harnett of Absolute Strategy Research has done a better job matching oil price increases and US growth slowdowns, comparing changes in each over 18-month periods, and lagging the oil price by a year. That is to say, on his model, oil takes a while to make a difference, and makes a difference for a while. The resulting chart shows an interesting and somewhat reliable relationship. Note the oil price scale is inverted:
“I have always found that oil prices need to be elevated/rising for some time to then drive activity rates down further out . . . This suggests that any negative oil price effect is more likely to kick-in towards the end of 2022 on this simple model . . . however, as you can see the leads and lags look to vary over time [and] this did not work at all in 2016, for example, or 1996.”
One reason that the relationship between oil prices and US gross domestic product has changed over the past 10 years is that the US now produces a lot more of the stuff, so higher oil costs are offset by higher oil revenues.
In any case, the historical relationships do not render pithy predictions. Given that confounding fact, we can either pretend there are no relationships at all; pretend the relationships are simpler than they are; or muddle along as best we can. Unhedged takes the third option.
Two swing factors could affect the oil price. One is Iranian supply coming on, if there is a breakthrough in the talks over that country’s nuclear programme. Speculating on the likelihood of that happening is way above my pay grade. But it seems unlikely that Iranian supply will come on very soon. Here is how Farren-Price sees it:
“My view is that Iran will re-enter the market . . . it is clear that Iran wants to get this deal done, that they want sanctions relief, and the Biden administration wants a deal as well. But it is increasingly likely the incremental barrels are a late-year affair, as it will take 9 months to ramp up production to pre-sanctions levels.”
The second swing factor is how many incremental barrels US shale producers pump in the months to come. Having been absolutely crushed when oil prices crashed in 2020, the biggest shale producers are making very conservative noises about investment this year and next. Here is a chart of the shale “rig count” — the number of active shale wells — from my friends at the FT Energy Source newsletter:
Scott Sheffield, chief executive of Pioneer Natural Resources, biggest of the shale producers, said earlier this year: “I don’t really see much increase in the Permian Basin or the US shale over the next several years.” Rick Muncrief, chief executive of Devon Energy, another big producer, has said he would hold output flat this year and increase it by no more than 5 per cent in 2022.
If the Saudis, myopically, keep prices near $80 a barrel, the shale players’ discipline may weaken, of course. Both sides have fallen into that trap before.
This is a complicated picture. Summing up:
Low investment by private oil producers has left Opec with greater than usual control over the oil price, and if they can overcome their internal politics, they may keep prices high in the second half of this year.
If they do, this may well push core inflation and inflation expectations up this year, and have a negative effect on growth next year.
Iran nuclear negotiations and, especially, US shale producers could play a wild card in this.
The oil price matters, though the economic relationships involved are annoyingly tricky.
First versus second derivative, bull versus bear
When I was speaking with Evan Brown of UBS Asset Management — I wrote about his work on Wednesday — I asked him what everyone was talking about when they were not talking about inflation. He mentioned the first-versus-second derivative debate.
Almost everyone agrees we are at or near peak growth in almost everything, and that growth is now decelerating. The second derivative is falling, which is usually when asset prices turn. At the same time, though, absolute levels of growth are — by consensus — set to stay unusually high for another year or so; growth seems too good for asset prices to fall.
Just to visualise, here are the Goldman Sachs economic team’s estimates for some key economic indicators:
This looks a lot like most people’s projections. Other than government spending, which is going to turn into a drag very soon, growth should be pretty robust through at least the first half of next year. But the deceleration is going to be rapid. Which is more important? Your answer to that question sorts you neatly into the bull or bear camp.
One good read
Robinhood’s consent letter to the Financial Industry Regulatory Authority is absolutely eye-watering reading. Here’s the FT story. My colleague Philip Stafford calls out the highlights in a few tweets.
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