Oil’s Not So Well

It's possible that a story that made headlines in early February will be forgotten by the time you read this. But it's also possible that it will be a turning point, and a development with major implications for the stock and bond markets, inflation, and everything related to the economy. Fasten your seat belts – just in case.

At first glance, this doesn’t seem like a big deal: Russia said that beginning in March it would cut oil production by 500,000 barrels/day. The markets didn’t go crazy. Oil rose, but only by 2%. Gold also took this in stride and so did interest rates. In other words, the markets essentially shrugged off the announcement and business went on as usual on Wall Street.

But this story may not be as simple or as harmless as it appears to be. And if we take a closer look, some pieces of a big picture begin to fit together.

 

Too Oily?...

Countries don’t cut their oil production very often, and that’s why when they do, investors pay close attention. Aside from the most recent Russian oil cut these was a much bigger one back on October 5, 2022. At that time, a coalition of oil-producing nations led by Russia and Saudi Arabia announced they would slash production by two million barrels/day.

The most recent production cut certainly disappointed many investors who were hoping the Fed was beginning to bring inflation under control. That's because, combined with China opening its economy, we are suddenly looking at a very different ball game, one where oil supplies are tighter and everything related to it could become much more expensive very quickly.

If such a scenario in fact unfolds, inflation could remain at the current high level or go higher. The Fed may be unable to cut rates any time soon and may even have to raise them.

 

.…Or Not Oily Enough?

On February 14, President Biden unexpectedly ordered the release of an additional 26 million barrels from the steadily-depleting Strategic Petroleum Reserve (SPR). Presumably, this move was made to help offset the 500,000 barrels/day Russia will remove from the markets and keep energy prices from surging.

But at some point, it will become politically unacceptable to drain more oil from the SPR for non-emergencies.

After this latest release, reserves will have dropped to 345 million barrels from the current 371 million barrels, bringing them to their lowest level since 1983. Reserves will be more than 200 million barrels lower than they were at the start of 2022. Can you imagine what inflation would be like without the addition of these reserves into the markets? Whatever the number, it would be substantially higher than it is now.

Other recent developments also are bullish for oil. According to Bloomberg, “The US slashed its forecast for 2023 oil production in the latest sign that world crude markets can’t rely on American shale fields to ramp up supply quickly enough to reduce higher energy prices over the next year.”

Also, at some point – possibly soon – the US may decide it needs to begin restocking their strategic oil reserves – literally to make sure there is enough oil for a “rainy day.”

 

What Rate Cut?

With the possibility of higher inflation and tighter oil supplies, some analysts believe the Fed may have to raise rates and keep them higher for an extended time. This means chances for a rate cut in 2023 appear to be decreasing.

“Lower Russian production together with China’s reopening should tighten the oil market further over the coming quarters,” UBS Strategist Giovanni Staunovo told clients. A separate report on CNBC went beyond this; it noted that recent developments in the oil industry “could lead to oil and oil products shortages.”

Bloomberg also appears to reads the market this way, and recently warned of the possibility of renewed “turmoil in the oil market, which had so far taken disruption to Russian supplies in stride.”

In mid-February, oil was trading in the mid-$70s, which appears to be a range the market is comfortable with. But a lot of events could suddenly rattle the markets and upset the relative calm we are seeing now.

For example, tensions between US and Russia have escalated to a very dangerous level, with both countries charging the other with invading their air space and making not so subtle threats; NORAD intercepted four Russian aircraft in the Alaskan Air Defense Zone. A Russian diplomat warned that war with the US is close.

America's relationship with China is not better. Spy balloons and unidentified craft said to have originated from China hovered over very sensitive US targets and some were shot down; separately, so was an Iranian-made drone flying over a major oil and gas field in Syria. And dozens of Chinese military jets and naval craft have encroached on areas Taiwan claims it owns.

In addition, fighting in Ukraine has escalated sharply; Russia is said to be steadily retaking large swaths of land it lost earlier in the conflict; having suffered huge and humiliating losses, they likely will not take kindly to further interference from NATO or other countries. These are just a few of the hot spots in the world. Despite them, oil and other commodities are quiet - at least for the minute.

So there are lots of concerns out there. Oil is not the only one, but it's on top of the list because if there’s a problem and the price soars, we'll all be paying higher prices every time we buy anything and that would really do a number on the economy.

Personally, I would feel more comfortable if the SPR were still at the level it was back when Trump was President, but as they say, "It is the way it is." Curious that despite all the amazing new technologies we use every day, the world is still so dependent on a product discovered in America back in 1859.

 Sources: bloomberg.com; cnbc.com; oilseek.com; zerohedge.com

By Gerald Harris