Energy Shock: Now and in the Longer Term

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Announcer:
This is the ARC Energy Ideas podcast with Peter Tertzakian and Jackie Forrest. Exploring trends that influence the energy business.

Jackie Forrest:
Welcome to the ARC Energy Ideas Podcast. I’m Jackie Forrest

Peter Tertzakian:
And I’m Peter Tertzakian. Well, markets are still going up and down, whether it’s the broad markets, oil and gas. There’s a lot of volatility out there. Well, actually speaking of up and down, what was your favorite ride at Disney World?

Jackie Forrest:
Oh, that’s a good question, Peter. Well, it has to be this Star Wars ride. It’s called Rise of the Resistance and of course there’s two-hour lineups for it.

Peter Tertzakian:
So actually, I haven’t heard of this. What is it a roller coaster? What is it?

Jackie Forrest:
It’s kind of crazy. After waiting two hours in line, you go into this cargo ship and then you get captured by Darth Vader and his friends, and then you get taken in for interrogation there’s actors and everything, but then you get broken out by the resistance and then the ride starts where you’re going around on these cars, trying to get away from all the bad guys and they’re shooting at you. But it’s pretty incredible. I was really shocked at the quality of this ride. The sophistication.

Peter Tertzakian:
Yeah. I haven’t been to a theme park like that, or I don’t know. It’s probably 20 years. I remember going to Universal Studios in LA. I don’t know. It was well, over 20 years ago it was sort of this lame King Kong that comes up at you sort of in hindsight. It was cool at the time but in hindsight, I think we’ve come a long way in terms of the simulations and things.

Jackie Forrest:
Yeah. That Star Wars area, they had another ride too, which was the Millennium Falcon where you drive it. But actually, the way you drive it is affecting the ride. Like it. It’s really come a long way. Peter

Peter Tertzakian:
It’s come a long way. All these simulations, you don’t know where to draw the line between reality and fiction, but the reality is we’ve got a lot of volatility. So, let’s talk about that.

Jackie Forrest:
Yeah. Today we’re going to talk about the oil market, some of the more short-term things that have happened, but then we’re going to transition to the longer term. And I think when you’re, in times like this, it can be quite helpful to revisit history as a foundation for what could happen next. Today’s energy shock has a lot of similarities to past energy shock. So, we thought we would go through some of that work. This is really taking some main points from an article I wrote in The Globe and Mail a couple weeks that was really founded in the study of past cycles. So we’ll talk about that.

And, but let’s start with the more recent oil news. There has been some bearish things that have happened, although prices still relatively high. One is the concerns that China is having these lockdowns in some cities. China is still a massive oil market, 14 million barrels a day. So 14% of all world oil demand. So, there are big engine of demand growth as well. So, it is always concerning if there’s the potential for weaker demand from China and the markets have somewhat softened because of that.

Peter Tertzakian:
Yeah, that’s a huge issue. And but by the way, we’re going to be talking about oil markets, not in terms of the day-to-day volatility, because there’s no way our podcast could keep up with all the things that go on. But sort of more of a sort of a longer term where all this is trending and headed is really, I think where we should talk about this stuff. And in China’s so important, it’s not only the COVID lockdowns, which presumably will eventually end, but they’re having a lot of trouble with their economy as well in terms of the real estate issues, productivity issues, the labor market issues, which in part translate back to the COVID issues and so on and so forth.

But it’s not going to be the economic engine that it was, for example, between 2000 and 2010, when it was rocketing up and caused a huge pull-on oil. 2010 to 2020, it started to moderate a little bit. And the last few years, of course, there’s the deglobalization trend that made China much more, I guess, internally focused. But there’s some real structural problems there. And to assume that the historical growth for oil is going to come from there, I don’t think is a good assumption.

Jackie Forrest:
Yeah. Okay. That’s a whole other podcast, but I think you’re right. There’s lots changing. And as you say, with the change of the trade patterns, which we’re still kind of not fully understanding, what’s that going to mean for old demand. Now another major piece of news was the US announcing this very large release from their strategic oil reserve, a million barrels a day over six months. Well, this is huge, just to give you a perspective. A lot of people expect that potentially Russia could lose in the range of two million barrels a day or maybe a bit more so that would be half of that amount. There’s expectation there’ll be more releases from other countries as well as a way to help the oil markets out here.

Now, interestingly enough, as of March, we still haven’t actually seen any decrease in the loadings of oil out of Russia yet. So we haven’t actually seen a supply loss yet. And there’s a lot of expectation that’s going to happen in April because the contracts that were for March were set before this conflict ever happened. So the expectation is these loadings are going to slow down, but they may not. It may be that buyers in Asia continue to buy up these barrels and we don’t see as big of a loss. So, I just wanted to add that caveat. The amount of loss is really uncertain.

Peter Tertzakian:
Yeah. I think that’s worth talking about, but before we do that, I want to come back to these million barrels a day, which you said is huge. It is on a 100 million barrel a day market. It’s 1% and that 1% does affect the price of oil. We’ve seen that it’s come down from say the 120 ish level to a 100. And I don’t know where it’s as of recording, it’s around 102, but let’s put this into some numerical context. So a million barrels a day for six months, 365 days in a year. So we’ll call it 180 million barrels total. What is the size of the total strategic petroleum reserve of the US? I think it’s 700 million or so.

Jackie Forrest:
I have the number right now. It is down from its peak because they have been drawing out of it over the last several years. So, it’s currently at 568 million.

Peter Tertzakian:
568. So minus 180 is about 380. I guess or something.

Jackie Forrest:
And actually, if you calculate the IA has asked countries to have 90 days of net oil imports and storage. It gets them right to that threshold with what’s left. It gets them kind of down to the bare minimum of what’s believed to be what you need for security of supply.

Peter Tertzakian:
So, what is the market saying about all this? I mean, as I said, it came down a little bit, but this Ukraine, Russia situation is not a short-term thing, nor is the broader Russia versus the Western world as we heard a few weeks ago with the Candyce Kelshall interview. Candace sort of our security intelligence guru who talked about east versus west basically, or revival of the Cold War. And so, it just strikes me that the market does realize that a million barrels a day for six months, again, looking past that is just, okay. So, what happens after that?

Jackie Forrest:
Well, and also, as I said, it’s still not a very big relative to the potential outage from Russia. Which is still a little unknown, but many people are saying it’s going to be more than two million barrels a day. So it in itself helps, but doesn’t sort of get us away from the fact that we might have a very tight oil market. And there is some concern that potentially one of the reasons the US did this is because maybe they don’t think that there’s going to be an Iran deal. And so maybe we’re getting this million barrels a day for six months, but we’re not getting an additional one million barrels a day from Iran.

So there’s still uncertainty there. There’s still a ton of uncertainty too on, are we going to see more supply from the OPEC groups like Saudi Arabia and the UAE who could add potentially two million barrels a day to the market? But we had this most recent OPEC meeting and they chose to stick with their relatively small increase of 400,000 barrels a day, each month. And reality is they haven’t even been meeting that. So, I think in the context of all the other uncertainties around where additional supply will come from, it’s helpful, but it doesn’t sort of fill the whole gap in that people are looking for.

Peter Tertzakian:
Two million barrel a day Russian gap. I mean, the numbers that I’ve seen thrown around are bigger than that. I mean, well…

Jackie Forrest:
There’s people that say three or greater. I guess the reality is though we have not yet seen a drop in the oil loadings. So, there has been no shortage yet, but it’s anticipated in April. We’ll see that. But there’s huge motivation for refiners to take Russian crude. I’ll just tell you about an article in Bloomberg a few weeks ago, an Hungarian refinery made a $33 per barrel margin in March 10 times higher than the month before because they were buying the deeply discounted Russian crude. So, our refiners in India and Asia who could be making that kind of money by buying Russian crude, are they going to demand it because it’s so deeply discounted?

Peter Tertzakian::
Well, sure. And there’s the energy security dimension to it too, where they want to stock up in the event that there is more problems here down the road. So, I think you’re going to be seeing the purchase of Russian crude behind the scenes, by countries that are agnostic to this whole Ukraine, Russia thing or in the worst case supportive. And they’re paying for it under the table one way or the other.

Jackie Forrest:
Yeah. Well, and that’s interesting. And now nowadays we can really monitor this stuff through these loadings of crude oil. So, I think what every analyst will be doing this month is watching those crude loadings. And if they don’t come down, then the supply outage is not going to be what people think it is.

Peter Tertzakian:
Right. Yeah, with all the sophisticated satellite technology and there’s a tanker tracking in the whole marine world, you can just go online and type in the name of any ship and you can see where it is on a map.

Jackie Forrest:
Yeah. So as long as the tankers are continuing to load, the oil is getting into the market. So I think that’s something to really watch obviously, this Iran deal. But to me, this situation will come back to that situation with Saudi and UAE. I think a and Candace talked about it as well. We just don’t know where sits here, but this is a big deal. Are they no longer aligned with the US? And is this a signal that they’re obviously being very careful to not cross Russia at this point. Or is it maybe just a negotiation thing where Saudi’s looking for more help in Yemen to counter that Iranian-backed Houthi rebels in the situation they’ve got there. They had a attack on some of their oil infrastructure recently. So, is it a negotiation position? Are they angry about their Iran deal? If the US were to stop pursuing that, would they be able to add that supply? Or is this a more serious change? We just, nobody really knows.

Peter Tertzakian:
Yeah. Well, President Biden is not friends really with the current prince of Saudi Arabia, MBS, he’s friends with his father. And there’s a whole, I mean, I don’t pretend to be any sort of expert on all these relationships. But the relationship between the US and Saudi is tense further exacerbated by the war that’s being fought between Saudi Arabia and Yemen, which is really a proxy war between Saudi Arabia and the Gulf states and Iran on the other side of the Gulf of Hormuz. So, it’s all very complicated and the Americans and others have been not so accommodating and backing the Saudis overtly in that war as well. So, there’s all sorts of complications and intricacies in the geopolitics of the Middle East.

And now you throw the geopolitics of East versus West in the Ukraine Russia situation. And you have a situation where there are many variables in trying to understand these oil markets. And it can go either way, it can go spiking up if the military situation in the middle east gets worse or the markets tightened up there, or it can, as you said, it can go the other way, if all of a sudden, more Russian oil, more Saudi oil come out of the market. And meanwhile, the West is cranking up in the Permian, et cetera, et cetera so that’s what I’m saying. It’s like your ride at Disney world it’s up and down.

Jackie Forrest:
Yeah, for sure. But I will say that the West has always relied on that spare capacity being available to help them out. And we’re not seeing that today.

Peter Tertzakian:
So, spare capacity is now coming out of the strategic petroleum reserve. Which was instituted in 1974 ish, I think by the International Energy, then new International Energy Agency as a response to the oil crises and first ’73, then ’79. So let’s talk about that at the parallels.

Jackie Forrest:
Yes. Let’s talk about that. All right. So back to my article in The Globe and Mail, which we will put a link to we’ll revisit. Well, first of all, what I did is revisited a lot of the oil shocks in the last 50 or 60 years. And I really found that the oil shocks of the ’70s had a lot resemblance till now. So there was the 1973 oil shock where Arab countries reduced their exports to nations who supported Israel in the Yom Kippur War. And then in 1978, when the Iranian revolution happened, followed by the Iraq War there was a huge loss of supply. For example, the Iranian oil production, when that revolution happened, felt by four million barrels a day or 6% of the global oil production.

So bigger than what we’re talking about today. And then when the war with Iraq started, it took another two million barrels a day out. So overall there was about a 10% drop in global production in that kind of 1978, early ’80s period. And when you adjust the price with today’s inflation adjusted dollars, it averaged about $120 over that whole period. And it spiked up to about $140 at one point. So, they did have very similar prices to today in terms of what the economy had to deal with at that time.

Peter Tertzakian:
Yeah. I always used that 125 plus certainly 140 is the breaking point. That’s the point at which on a real dollar basis, inflation adjusted where the economy can’t hack it anymore and you need real change. So, right now with the price of oil, we call it 100 to one 20. It’s sort of in the, I would call it amplified nuisance own where it is forcing some changes, but it’s really, the changes are coming more, not so much from price, but more from the perspective of worry about supply, complete outage as much as we had in ’73.

Jackie Forrest:
Yeah, and for a long duration that was over a number of years. Now the other thing that’s really similar between now and that period is the level of inflation in the economy. So between ’77 and 1979, the inflation averaged 8% per year. And that’s pretty much where the US is today and Canada’s not far behind at around 6% per year as of the latest data point measuring February inflation. So this is the worst since that time, actually, we’ve never seen inflation at this level that we’re seeing today. We have to go back to this exact same period and to slay that inflation dragon back then the US Federal Reserve, aggressively increased interest rates. And so did other central banks around the world. And at one point interest rates touched on 20%. So, can you imagine if people’s mortgages that were floating suddenly they had a 20% interest rate? But that’s what happened back then. Is that people… And they did that to try to slow down the demand for things and stop the inflation in the economy.

Peter Tertzakian:
Well, actually I remember as a young person who was renting back in the early ’80s and just had started work a 30 something at that time was talking about getting a mortgage of 23%. And to be honest, I was naive enough, not even really into not as being a renter. It just seemed ridiculous to me, but, and also couldn’t fully fathom it, not being a homeowner.

Jackie Forrest:
Yeah. I’m sure it deterred a lot of young people from buying at that point. Now this caused a double dip recession. We actually had a recession in the ’80 and again in ’81. However, the US continued with this policy because at the time Paul Volcker who was the chairman of the Federal Reserve, he believed that the damage from that recession was going to be smaller than if they continued to let inflation rise. So, today we’re in a similar situation, we obviously have the same background interest rates. We have the Federal Chairman, this time Jerome Powell saying things, “We need to take necessary steps to ensure that high inflation does not become entrenched. We’re fully committed to bring inflation back down as it’s taking a toll on everybody.” And they’ve announced they’ve already done their first increase of 0.25% with possibly another six increases this year. So, we’d be seeing maybe interest rates over 2% by the end of the year. And honestly that may not be enough. It may have to go higher than that.

Peter Tertzakian:
No, I think it’s going to go higher than that. It’s really to slow the economy down is why they crank up the interest rates and to cool down the inflation that’s associated with it because inflation comes from a supply poll typically. In this instance, it’s much more complicated than that, which is why you sort of have tension in terms of whether the central banks are going to raise the interest rates or not because there’s a lot of fragility in the world economy already right now, as a consequence of post COVID, as a consequence of this new cold war, that’s emerging Russia, rest of the world, et cetera. So, I think they’re going to be very careful. I don’t foresee 20% interest rates anytime soon.

Jackie Forrest:
No, I don’t either.

Peter Tertzakian:
But I do see higher rates. I do see oil contributing to those higher rates. And I also see probably a recession, which is what we’ve had back in the ’70s, into the ’80s.

Jackie Forrest:
Yeah. So, I looked at the last four times we saw oil price get over this $100 to $120 range. And in three, out of four of them, there was a recession. Now we had… We just talked about ’74. Well, we didn’t talk much about ’74, but ’74, there was a recession. There was inflation plus the high energy prices. Then the late ’70s into the early ’80s. Then we had the financial crisis. We had very high oil prices. However, there were other underlying issues with the banking system. However, I don’t think high energy prices helped at all in that scenario.

The one time when we had very high oil prices that we didn’t have a recession was that 2014 period and there was a number of years. There was about three years where we sustained prices near about $130 a barrel for three years. And that’s inflation adjusted for today. So, in today’s dollars, we were able to do that. But that was a different environment where we had very low inflation, very supportive monetary policy. Remember after the financial crisis, how much money was sort of thrown into the system.

Peter Tertzakian:
Thrown in and it was also the constant reduction of the interest’s rate easing of the policy.

Jackie Forrest:
Yeah. So, we had a very positive macro environment on everything else other than the energy prices. So, everything else was very cheap and interesting what to ended that period was technology. So then after that many years of high price, new supply came on. And a lot of it due to the shale oil and the technology that was developed that brought down the price of oil.

Peter Tertzakian:
Well, these are just numbers, but we do know in the home at the consumer level, when the price of energy goes up by 20 to 50%. Price of gasoline tiers gone up for, it was a buck litter, I don’t know about a year ago now it’s a buck 50. So there you go. That’s 50% in Europe. It’s even higher than that. And so, let’s talk about pain at the consumer level and what happens.

Jackie Forrest:
Yeah. So, in the past, anytime we’ve had these periods, we’ve had… well, actually in the ’70s, there was actually real panic at the pumps. We haven’t had that where people were worried about just literally running out of gasoline. And there were times when stations wouldn’t open little bit like you experienced in the UK this fall. Where there was no gasoline signs and the station was closed. We haven’t seen that but the high prices have always caused things like people striking. In the ’70s, US truckers actually launched a violent nationwide strike and protest of the high fuel prices. So, generally politicians they’re not very popular when energy prices go up. So, they do things to reduce the pain. So, we saw this in Alberta, actually beginning, April one, not an April fool’s day joke that one, but Jason Kenney taking a victory lap there by reducing the price of gasoline by in the range of 13 cents, by getting rid of the gasoline tax.

Peter Tertzakian:
Temporary reduction in the fuel tax, that’s typically added to every leader of gasoline. This is happening in many countries around the world.

Jackie Forrest:
Yes. So, it’s not just here at all and we’re going to see more of it. And then of course in the past strategic oil reserves will be tapped. We obviously seeing that in a big way today. Now the ironic thing about all this is the real thing that’s going to blunt the oil shock is people using less. So the more you take away that price signal, the more they’re incentive to just go about their daily lives like they were before. So, I understand why politicians do it and it probably is necessary for political stability. However, it doesn’t necessarily help with the supply and demand problem.

Peter Tertzakian:
These are regressive policies and even goes further than that. We’ve talked about it on prior podcasts here, since the Russian invasion of Ukraine where countries go back to burning coal. Go back, people go back.

Jackie Forrest:
Yeah, people don’t want to, they just find alternatives. Now, traditionally, if you got oil prices in this range, you might see oil demand slowing in the range of 1% because of the price signal, assuming governments, they’re not probably able to get rid of all the impact. And that comes from people starting to choose to cancel trips, carpool, use public transportation. Now the question around I’m thinking about is, is it possible this time it could be much larger? And I know you followed that IA 10 point plan that they said could reduce oil demand by 2.7 million barrels a day in four months so that’s huge. That would be equal to what people think maybe the loss would be from Russia. If you could accomplish that, there would be no oil shortage.

Peter Tertzakian:
Well, you could. I mean, but just before we get to that, just to point out that Europe is already at that point. I mean, the prices are so extreme over there it’s happening. Here eight time zones away this is a land of plenty. And by the way, in Alberta our fuel taxes have been momentarily reduced. So, I point out to people we don’t feel the pain of this energy situation like the Europeans do. And I can’t speak for other countries, but in developing countries as well, this is a very serious situation where already people who can’t afford the basics, all of a sudden have to pay more. So I want to your point about political stability is a super important one because if the price of gasoline and diesel and things go up, it doesn’t take much before you get social unrest. We’ve already seen the equivalent of trucker protests in places like Greece and Spain, at least I’ve read the articles about that. I think governments basically have to introduce these regressive policies just to keep the civilians or shield the civilians from this kind of pain.

Jackie Forrest:
Yes. And unfortunately, a lot of those developing countries, they may not have a fiscal means to do that.

Peter Tertzakian:
Right, especially post pandemic. So, it’s the situation’s really actually very new still. I think, I don’t know what, we’re six weeks into the Russia Ukraine situation. The full effects of it have yet to be felt whether it’s the economic lag and potential slowdown in various parts of the world, including potentially here to right at the consumer level, the energy prices.

Jackie Forrest:
The last point I want to talk about is that the other thing, when you look at these past oil shocks is they did really change the future of energy policy. In the ’70s energy security became a big focus. There was encouraged growth in supply of domestic oil and gas, but also alternative energies like geothermal synthetic fuels, cars were regular related for fuel efficiency, power plants with oil were replaced. So, there was a lot of changes and actually, if you look at US oil demand per person, it dropped 15% over 10 years as a result of some of these policies that were put in place because of those oil shocks.

Peter Tertzakian:
Yeah. Well, a lot of the substitution that happened was the displacement of oil and power plants, as you just said, because a lot of oil was burned in power plants, not only in the United States, but in many countries around the world and in Europe. And so, the rise of nuclear power, which was a policy initiative to get off oil and nuclear power was ready and waiting. The first power plant was in the late ’50s. And then in ’60s, there was a small build out, starting to occur by the price shocks. It was a technology that was ready and waiting to be scaled up very quickly.

So, that’s an example of centralized displacement and substitution of oil. Now it’s a decentralized problem in for example, the transportation market. Because you have to swap out entire capital stock of fleets of vehicles and trucks and heavy trucks and marine and everything. And so, it’s just harder. It’s much more behaviorally dependent today getting off oil than it was in the ’70s. ’70s, you could just swap out the power plant and at the light socket people didn’t really understand the changes in the background.

Jackie Forrest:
Yeah. No, that was an easier switch. Okay. Well let’s switch just to finish off the podcast with what’s likely to happen now. So my takeaway from my article was first thing will be people in Europe and other of countries will look at friendly sources of hydrocarbon supply. US Canada, Norway, UK, Australia. These are places that have very stable geopolitical environments that I think will be favored for supply in the future. In the short term, we’re going to see more use of coal as we’ve already talked about. However, I do think governments will prioritize the production of domestically produced clean energy as well. It’s going to take more time for that to make a difference. It’s more of a tenured timeframe, but things like electric cars, energy efficiency, energy storage. Alternatives, like geothermal, biofuels, hydrogen, all of those are get a lot more supported and 10 years from now, I think they’ll be much more substantial sources of energy than they would’ve been without this crisis.

Peter Tertzakian:
I don’t disagree. I think you’re going to see diversification into all of those alternative energy pathways. The issue again, is that this energy crisis is immediate. And I think it’s going to take, I’m just going to throw a number out here. So three to five years of regressive scrambling and policies, before we get the momentum to go more progressively into the transition into future. So, there’s going to be some lost time as a consequence of all this.

Jackie Forrest:
Yeah, no I grace. So, in the short term it’s going to be painful. There could be a recession. We talked about that the pain of high energy prices. Consumers are going to have to deal with that and countries as well because when they cut these taxes, they lose income as well. And you’re probably going to have higher greenhouse gas emissions. As people do things like burn more coal, but as we get out further in the background, I think we’re going to see growth in some of these alternatives and we’re going to be in a position where we have much more diverse and secure energy supply because it’s going to be coming from more suppliers and more types of energy.

Peter Tertzakian:
Right.

Jackie Forrest:
All right. That will wrap up the podcast.

Peter Tertzakian:
Great.

Jackie Forrest:
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