Art Berman Newsletter: November 2021 (2021-10)
Oil prices corrected strongly downward last week. WTI fell -7% and Brent dropped -6% between October 26 and November 4. Analysts didn’t offer much explanation but instead focused on how much higher prices are likely to go. A meaningless bump in the road. Bank of America now thinks that Brent will be $120 per barrel by June 2022.
WTI price fell -$5.84 (-7%) from $84.95 to $78.81 from late October to early November (Figure 1). Price recovered +$3.02 (+4%) from $78.81 to $81.83 after November 4. I expect more downward price corrections as the end of this long price rally approaches. The principal reason is inflation.
Calls for $90, $100 or $120 oil prices fail to adequately reflect the effect of inflation on the global economy and oil prices. Figure 2 shows the latest inflation data for the United States through August. The correlation between inflation rate and WTI spot price is compelling especially since 2015.
That should be no surprise to those who understand that energy is the economy and that oil price is the leading indicator of inflation. Inflation will probably slow global economic growth and limit oil demand at current oil prices. Pimco’s Erin Browne recently said the the current energy crisis is a real inflation “risk that is being underestimated by the market right now.”
The U.S. inflation rate is the highest among the G-7 countries. It was +1.25% more than the G-7 average of 4.06% (Figure 3). . The U.S. average inflation rate since 2000 is 2.2% and the G-7 average is 1.75% so present rates are nearly 2.5 times the twenty-year average.
U.S.inflation for September was the highest monthly level since July 2008 just before the Financial Collapse (Figure 4). It was more than 4% more than the 2020 baseline of 1.24%. By comparison, the July 2008 level of 5.6% was only 2.8% higher than the 2007 baseline of 2.85%.
The significance of the information in the last three charts cannot be understated.
Figure 5 shows the relationship between oil demand growth, inflation and U.S. treasury yield for the last 50 years.
2021 oil demand growth is the greatest in data history. The best analogue was in 1986 after WTI prices fell from $117 in 1980 to $36 in 1986 in 2021 dollars per barrel. Demand growth and inflation soared. Oil demand crashed.
The 2021 annual inflation rate is estimated to be the highest since 1990. At the same time, the 4% gap between inflation and treasury yield is the highest in 50 years. It was 3.1% during the first oil shock in 1974, and approximately zero during the second oil shock and the 2008 Financial Collapse.
Inflation is noted by oil analysts but always seems secondary to their confidence that oil prices will continue to increase for the near term. They don’t appear to acknowledge the significance of Figure 5.
Economists have been debating the causes and implications of inflation for months now but somehow the price of energy is almost never mentioned by those experts.
John Mauldin is a notable exception. He recently wrote that, “Energy prices affect everything. They are a necessary input to all other production. Some things are more energy-intensive than others, but without it we are all back in the stone age. The price matters for the same reason tax rates matter. Both are unavoidable costs, so we can produce more of everything if they’re low or at least stable.”
A recent Bloomberg headline proclaimed a new era of oil prices as “higher for longer.” Some of the biggest commodity desks on Wall Street, it stated, now believe that the era of cheap oil is over for good.
I don’t see how that view is consistent with current inflation, treasury yields and oil demand data.
There is a case for under-investment. Supply is tight because outside capital has contracted for oil companies. Investors feel that they were played by shale plays and by poor E&P poor returns for a decade. The energy transition away from fossil energy has gained momentum.
Talk of a commodity super-cycle has returned as shortages of almost everything including natural gas, coal, aluminum and copper have emerged in recent weeks. RBC Capital Markets and Goldman Sachs have proclaimed a structural bull market for oil.
The problem with under-investment and super-cycle arguments is that the market has to be wrong for them to be right.
At the same time, Citigroup believes that oil prices above $60 are unsustainable. ““Mid-term, cost indicators keep pointing to a fair-value range between $40-$55 a barrel.”
Last week, Citi’s Ed Morse said, “Next year is going to be a very big surprise…The growth in U.S.production…is going to be bigger than anything…from an individual OPEC country…If we look forward to a year from now…is [OPEC] going to be restraining production again to fight what might otherwise be a $20 lower price?”
The cliché is that the cure for high oil prices is high oil prices. I suggest that inflation is the cure.
Figure 6 shows inflation, U.S. treasury rate and real WTI price in September 2021 dollars per barrel. It suggests that oil price has been more sensitive to inflation since about 2003 which coincides with U.S. interest rates falling below about 4%. The U.S. began systematically devaluing the dollar after the inflation that followed the 1980 oil-price shock. The financialization of oil markets began in earnest during the period of peak oil concerns in the early 2000s.
U.S. debt has increased +$6 trillion (+28%) since 2019 from $22.5 to $28.5 trillion (Figure 7). That seems to be the main focus for economists and it is important. At the same time, money is a call on energy and debt is a lien on future energy so debt is really a reflection of how energy affects society.
I believe that data supports what Ed Morse has said namely, that current oil price levels are unsustainable.
I’m not predicting an imminent collapse in oil prices. The above figures show that there is considerable uncertainty about the lags between inflation and oil-price. The time scale is, after all, annual. I am saying that higher for longer seems like an improbable outcome based on what we know today.
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