EUROZONE manufacturers report the sector has entered recession, based on preliminary results from the monthly purchasing managers survey. Partial results show the manufacturing activity index slipped to just 46.6 in October (14th percentile for all months since 2006) from 48.4 in September (24th percentile):
EUROPE’s temperatures are expected to be at or above the long-term seasonal average during the three months from November to January, according to the European Centre for Medium-Range Weather Forecasting. Mild temperatures through October and the relatively warm outlook for the first part of the winter have contributed to downward pressure on the region’s gas futures prices:
NORTHWEST EUROPE faces the first test of whether it can lower energy consumption this winter. After warmer than normal temperatures in the first half of September, temperatures were below average in the second half, creating the first significant heating demand earlier than normal:
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U.S. TREASURY securities with ten year maturity are yielding 3.53%, the highest since 2010, as traders anticipate the central bank will have to keep interest rates higher for longer to bring down inflation. Yields are rising at the fastest year-over-year rate since 1999. The increase is testing the downward trend in place since the mid-1980s. If the increase is sustained it will force a widespread re-pricing of most other assets:
HEDGE FUNDS and other money managers made few changes to their positions in the six most important petroleum futures and options contracts in the week to September 13. There were total net purchases of +4 million barrels with buying in NYMEX and ICE WTI (+10 million) and Brent (+3 million) but sales of U.S. gasoline (-5 million), U.S. diesel (-3 million) and European gas oil (-1 million):
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China’s continued drought in Yangtze basin (trans.)
U.S. Northeast fears fuel shortages in event of rail strike
LVMH to turn off store lighting overnight to save power
Eiffel Tower to turn off lights earlier to save power ($WSJ)
U.K. GAS AND ELECTRICITY consumption has not shown a significant decline so far in response to higher prices. I spent a large part of yesterday trying to find a price response in the available official consumption statistics without success. The charts are below. But there are some important limitations:
Electricity consumption data is only available through June and gas data is only available through March owing to publication delays.
Most of the rise in prices has occurred since April with another big increase scheduled to take effect from October.
Heating demand and bills are lower in the summer months reducing consumers’ sensitivity to prices.
Domestic and commercial consumption patterns have been distorted by the lockdowns in 2020/21 and then re-opening in 2022.
Electricity and gas consumption has been on a long-term downtrend as a result of improvements in insulation and efficiency.
Electricity and gas consumption shows significant annual variation depending on winter temperatures.
Once these factors are taken into account, there is no evidence of a significant reduction in gas and electricity use by households, offices and commercial premises so far. If reductions are going to occur, it will be later this year and into 2023:
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U.S./China navy competition and Northern Sea Route
EUROPEAN GAS OIL calendar spreads between December 2022 and December 2023 have fallen into a backwardation of less than $11 per barrel from almost $33 in mid-June, as traders anticipate the onset of a recession depressing consumption:
JAPAN LNG STOCKS at the end of May had risen to 2.36 million tonnes, the highest for the time of year for at least seven years, as the country’s utilities accumulate inventories to protect against possible supply disruptions in winter 2022/23:
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U.S. OIL AND GAS rig count rose +13 to 753 last week as higher prices spur exploration and production companies to contract more drilling teams. The number of active rigs has climbed by +509 from the cyclical low in August 2020 and is only -40 below the pre-pandemic level in March 2020. The number of active oil rigs is still -88 below the pre-pandemic level but gas rigs are already +48 above the March 2020 level.
Oil and gas drilling is exhibiting a fairly normal cyclical recovery, though it is unfolding slower than other recent recoveries because some of the larger exploration and production companies have been constraining drilling and production programmes to keep prices high and boost returns to shareholders:
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U.S. INTEREST RATE traders expect the federal funds rate to reach 3.50-3.75% by January 2023 up from 0.75-1.00% at present as the central bank attempts to bring inflation under control. If they prove necessary, increases on this scale would result in a significant slowdown in the business cycle:
DATED BRENT calendar spreads are signalling exceptional tightness over the next two months. The extreme backwardation is consistent with the disruption of Russia’s exports and the maintenance season for platforms, pipelines and fields in the North Sea. But it could also be a sign the market is being squeezed. Strong fundamentals create ideal conditions for a squeeze. “Always squeeze with the grain of the market not against it,” as a veteran trader told me over lunch many years ago:
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Conclusion: Energy embargoes increase prices paid by consumers significantly in the short and medium term unless there are alternative supplies readily available to make up the deficit.
Corollary: Boycotts are an attractive policy instrument when excess production capacity (actual or potential) allows energy from sanctioned sources to be replaced by non-sanctioned ones.
Case Study 1: Coal during the English Civil War (1643-1644)
By the mid-17th century, coal had replaced wood as the principal fuel for domestic heating and manufacturing in London and other towns near the east coast of England.
Production was concentrated in Newcastle and the northeast from where it was carried by ship down the coast to London and other major consumption centres in the south.
But in January 1643, Parliament, based in London, banned ships from fetching coal from Newcastle, under royalist control, to deprive King Charles I of revenues and shipping with which to wage war.
Parliament had been assured by Scotland’s coal owners sufficient alternative supplies would be forthcoming to make up the deficit, but this proved incorrect.
Wholesale prices in London doubled to 30-40 shillings per ton in 1643/44 from 15-16 shillings before the ban in 1640.
In response, Parliament and the Lord Mayor and Aldermen of the City of London attempted to fix maximum prices, but this was unsuccessful.
Parliament imposed a forced loan on ship owners and consumers of coal to raise funds for the capture of Newcastle, and the City imposed a levy to raise funds to provide coal for the poor.
“Profiteering continued, and there was seen to be no substitute for north of England coal,” according to historian John Nef.
In June 1644, the Venetian ambassador warned the loss of coal shipments “will be unbearable next winter, as they have felled most of the trees” around London to meet the shortage the previous winter.
In July 1644, the ambassador predicted “there will be riots this winter” unless coal shipments from Newcastle resumed.
The coal shortage was relieved when a Scottish army, encouraged by Parliament and promised income from future coal sales, captured Newcastle in October 1644 and shipments to London resumed.
Sources:
Rise of the British Coal Industry (Volume 2) (Nef, 1932)
Declaration of the Lords and Commons Concerning Coals and Salt (1642)
The English Coasting Trade 1600-1750 (Willan, 1967)
History of the British Coal Industry (Volume 1) (Hatcher, 1993)
Case Study 2: Oil during the Iranian embargo 1951-54
Following nationalisation of the Anglo-Iranian Oil Company in 1951, Britain boycotted crude and fuel sales from Iran, and was later joined by most other western-owned oil companies.
In 1950, Iran had produced 660,000 b/d of crude, amounting to 7% of total production in the Western World, of which 150,000 b/d were exported and 510,000 b/d processed at the Abadan refinery.
Abadan was the world’s largest refinery and supplied one-quarter of all the refined products outside the Western Hemisphere.
Nearly all output from Abadan was exported (489,000 b/d) with most of the rest accounted for by the refinery’s own consumption (20,000 b/d) and only small volumes used domestically (1,000 b/d).
The boycott’s impact on crude oil supplies and prices was limited because Iran’s crude oil exports were relatively small and easily replaced from other sources.
Crude production from other countries in the Middle East (Kuwait, Saudi Arabia and Iraq) had already been increasing rapidly and accelerated further once the boycott was imposed.
Iran’s production declined by -31 million long tons between 1950 and 1952 but that was more than offset by increases from Kuwait (+20 million tons), Saudi Arabia (+15 million) and Iraq (+12 million).
There were also large increases in production in the rest of the world (+69 million tons) mostly from the Caribbean and the United States.
But the impact on refined fuel supplies especially aviation gasoline, kerosene and residual fuel oil east of Suez, was much more severe.
Lost output from Abadan had to be replaced by increased refinery processing in the United States and the Caribbean and to a smaller extent in Western Europe.
Much longer supply routes from western refineries to markets east of Suez strained available tanker capacity.
In response, tanker transport and foreign fuel marketing was coordinated by international oil companies with direction from the U.S. government.
“The Voluntary Agreement Relating to the Supply of Petroleum to Friendly Foreign Nations” was created by the U.S. government to permit the exchange of information and coordination of supplies.
Under the Voluntary Agreement, which conferred antitrust immunity, a Foreign Petroleum Supply Committee involving the international oil companies was organised to coordinate supplies.
During the boycott, the British-owned Anglo-Iranian Oil Company brought legal proceedings against oil buyers breaching the boycott for trafficking in stolen property.
Japanese companies were reported to have purchased Iranian oil at discounts of as much as 50% to the official price.
The boycott was eventually lifted in 1954 when the Anglo-Iranian Oil Company was replaced by an International Consortium, with the agreement of all parties.
Sources:
Oil in the Middle East: Discovery and Development (Longrigg, 1968)
Middle East Oil Crises and Western Europe’s Oil Supplies (Lubell, 1963)
Probable Developments in Iran through 1953 (NIE-75/1) (Central Intelligence Agency, 1953)
History of the British Petroleum Company (Volume 2) (Bamberg, 1994)
Case Study 3: Oil sanctions on Iraq 1990-1996
Following the invasion of Kuwait in 1990, the United Nations imposed a comprehensive economic embargo on Iraq (Security Council Resolution 661) including a prohibition on oil sales.
Iraq’s production declined by -90% from 2.8 million b/d prior to the invasion to 280,000 b/d in 1991 and remained stuck around 500,000 b/d until the oil-for-food program was launched in late 1996.
Initially, the loss of output from Iraq (-2.6 million b/d) and occupied Kuwait (-1.4 million b/d) caused real oil prices to more than double between June and September 1990.
But following the release of IEA strategic petroleum reserves and the successful expulsion of Iraqi forces from Kuwait, prices had roughly reverted to pre-invasion levels by March 1991.
Other Middle East producers proved willing and able to increase their production to offset the losses from Iraq and Kuwait and later from Iraq-only under sanctions.
Iraq’s output fell by -2.3 million b/d between 1989 and 1996 but that was more than offset by output from other producers in the Middle East which increased by +6.6 million b/d over the same period.
Total Middle East production increased by +4.3 million b/d between 1989 and 1996 and global output was up by +5.7 million b/d, despite sanctions on Iraq, minimising the impact on prices.
As a result, the period of most intense sanctions on Iraq during the early and mid-1990s was characterised by relatively low and stable prices for consumers.
Sources:
Statistical Review of World Energy (BP, 2021)
Case Study 4: Oil sanctions on Iran 2012-2015 and since 2018
The United States has imposed multiple rounds of sanctions on Iran since the revolution of 1979 but the most intense restrictions on oil exports were in force between 2012 and 2015 (when sanctions were also imposed by the European Union) and since 2018 (when the United States terminated its participation in the Joint Comprehensive Plan of Action).
During the most intense period of sanctions, Iran’s oil exports were reduced by up to -1.4 million barrels per day, according to estimates compiled by the U.S. Congressional Research Service.
The sanctions-driven reduction in Iranian exports (actual and prospective) likely contributed to the period of very high prices between 2011 and 2014 and more moderately in 2018.
Real Brent prices averaged $120 between 2011 and 2014, the highest in the history of the oil industry, and were also comparatively high in 2018 compared with 2015-2017 and 2019.
But sanctions on Iran also coincided with the first and second shale drilling booms in the United States which resulted in very rapid growth in U.S. oil production.
U.S. oil production increased by an average of +1 million b/d each year between 2012 and 2014 and by an average of almost +1.5 million b/d each year in 2018 and 2019.
Rapid growth in U.S. production likely emboldened U.S. policymakers to impose stringent sanctions on Iran as well as blunting their impact on prices.
The entire period spanned by sanctions since 2011 also saw very large increases in output from other producers in the Middle East.
Between 2011 and 2019, production increased in Iraq (+2.0 million b/d), Saudi Arabia (+0.8 million b/d) and the United Arab Emirates (+0.7 million b/d) more than offsetting losses from Iran.
Knowing alternative supplies were available, including from domestic producers, likely encouraged the Obama and Trump administrations to pursue more stringent restrictions on Iran’s oil exports.
Stringent sanctions on Iran contributed to high prices for consumers but the impact was moderated over time by growing output from other Middle East producers and especially the U.S. shale industry.
Sanctions on Iran were an important spur for the shale revolution; conversely, the shale boom and reintegration of Iraq into global markets helps explains the severity of U.S. and international sanctions.
Sources:
Iran sanctions – Report for Congress (U.S. Congressional Research Service, 2022)
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TEXASELECTRICITY CONSUMPTION has increased at a compound rate of +1.70% per year over the last five years, notwithstanding the pandemic and recession in 2020. Electricity sales to end-users in the state totalled 433 TWh between April 2021 and March 2022 (the latest data available) up from 398 TWh between April 2016 and March 2017:
U.S. PETROLEUMINVENTORIES including the strategic petroleum reserve depleted by another -5 million bbl to 1,681 million bbl in the week to May 27. Stocks have fallen in 74 of the last 100 weeks by a total of -436 million bbl since the start of July 2020:
U.S. EAST COAST DISTILLATE stocks fell by another -0.6 million bbl to just 21.0 million bbl in the week to May 27. Regional distillate inventories are now -23 million bbl (-52%) below the pre-pandemic five-year average and the supply position shows no sign of improving:
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Extreme cyclical volatility has been the defining characteristic of the modern petroleum industry. The influential economist Paul Frankel was convinced the industry would always need what he called eveners, adjusters and organisers to dampen the boom-bust cycle, with a group of leading producers acting in the interest of the industry as a whole (Essentials of petroleum: a key to oil economics, Frankel, 1946 and 1969):
“The basic feature of the petroleum industry is that it is not self-adjusting … All these facts make for continuous crises: “the problem of oil is that there is always too much or too little”. Hectic prosperity is followed all too swiftly by complete collapse, and redress can only be hoped for from the efforts of the “eveners”, adjusters and organizers, whose success derives from the very peril to which the industry must succumb if they were not to lay down the law.” (p. 67)
“Unless my reading of the oil industry’s structure and history is altogether wrong, there is no question that there has been, always and everywhere, an overwhelming tendency towards concentration, integration and cartelization … It is, as I hope I have proved, due to the very fact that all-out competition, where it is allowed to prevail in the oil industry, leads either straight to general bankruptcy or to the monopoly of a survivor.” (p. 127)
“As there is always too much or too little oil, the industry, not being self-adjusting, has an inherent tendency to extreme crises; this fact has called forth the ingenuity of planners within the trade. As no individual unit can evolve a rational production policy on its own, some sort of communal organization is almost inevitable. Paradox though it may appear, oil, competitive par excellence, is usually controlled by some “leading interests”. The major companies have in the past played a vital part, with the independents as an indispensable corrective …” (p. 144)
“In this book the word Cartel is not only used to cover international combinations of big companies. Cartels are, as far as my arguments are concerned, all “associations based upon contractual agreement between enterprises … which, while retaining their legal independence, associate themselves with a view to exerting a monopolistic influence on the market.” (p. xv)
In the last 150 years, the role of eveners and adjusters has been played by a series of organisations and combinations, including Standard Oil (1870s-1910s), the Achnacarry “As-Is” Agreement (1920s-1930s) between the oil majors, the Seven Sisters (1940s-1970s), the Texas Railroad Commission (1940s-1970s), the Organization of the Petroleum Exporting Countries (OPEC) (1970s ―) and most recently an expanded group including Russia and Mexico (OPEC+) (1990s ― ).
OPEC as a cartel
OPEC’s commitment to act as a market and price stabiliser is set out in its founding statute, approved in 1961, which commits the organisation to three objectives:
coordination and unification of the petroleum policies of member countries;
stabilization of prices with a view to eliminating harmful and unnecessary fluctuations;
securing a steady income to the producing countries; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on their capital to those investing in the petroleum industry.
OPEC dislikes being called a cartel, but its behaviour is similar to other cartels at other times and other markets, for example coal cartels in England between the 1580s and 1840s, so the characterisation is accurate (Monopolies, cartels and trusts in British industry, Levy, 1927).
Since 1982, OPEC has set production quotas (called “allocations”) for members to share out available market demand (the “call on OPEC”) fairly and avoid destructive competition for market share leading to over-production, excess inventories and slumping prices.
OPEC has never controlled all global petroleum output; its share of worldwide production peaked at 50% in 1973 and has generally been around 40-45% in recent decades.
But OPEC has controlled a higher share of the export market and its share has been enough to give it significant influence if not complete control over prices in the short and medium term (periods lasting up to 2-4 years).
Since the 1980s, OPEC has repeatedly sought to associate other producers with its production policy, with more or less formality and with mixed success.
OPEC has formally and informally reached out to Britain and Norway (1980s―), Mexico and Russia (1990s―) and U.S. shale firms (2010s―) to make its policy more effective and bring them within the market-sharing system.
Like other cartels, OPEC’s main impact has been to reduce production compared with the free-market alternative, keeping prices higher than they would have been without the cartel.
Low-cost producers in the Middle East have restricted output compared with a laissez-faire scenario, leaving some market share for higher cost producers in Alaska, the Gulf of Mexico, the North Sea, ultra-deepwater off the coast of Africa and Latin America, and U.S. shale.
Voluntary production restraint by the lowest-cost producers keeping some high-cost producers in business is characteristic of cartel behaviour.
As in other industries, cartelisation has kept prices higher across multiple cycles, but it has also supported a greater diversity of producers geographically and in terms of technology.
“One of the industry’s central features, the huge disparity between costs and reserves in the Middle East on the one hand, and everywhere else on the other, remains what it was in the late 1940s when U.S. Interior Secretary Harold Ickes was wondering how to fit low-cost Saudi Arabia into a structure dominated at the time by high-cost Texas” (p. 335)
“the essential dilemma, with the emphasis on security rather than protectionism, remains: to reconcile diversity of supply with price. You can have high prices and ample diversity of supply, but they, both supply and price, must be managed; or you can have competition, low prices, but supply, dangerously, in the hands of a few – who would drive out high-cost diverse sources and might then not continue competing among themselves.” (p. 335)
“non-OPEC producers are of course delighted with the OPEC price umbrella and keep as quiet as church mice about it”. (p. 336)
“The West has never wanted free, competitive markets in international oil” (p. 337)
Price stabilisation
OPEC’s statute commits it to stabilising prices, presumably by increasing output when there is a shortage and reducing production in a glut.
But there is limited evidence the organisation actually operates like this, with policy generally aimed at short-term revenue maximisation rather than price stabilisation.
OPEC’s often-cited spare capacity is the result of past forecasting errors when it comes to investment and its attempts to keep prices high by restricting production rather than a commitment to price stabilisation.
If OPEC has tried to stabilise prices, it has not succeeded: prices have been more volatile since the 1970s and 1980s than in prior decades.
The standard deviation of annual prices has been much higher in the five decades since 1970 than it was in the previous 50 years.
OPEC fought price/production wars in 1985-86, 1998-99, 2014-16 and 2020, increasing rather than reducing price volatility.
Prices or inventories
For political, diplomatic and legal reasons, OPEC frames its decisions in terms of balancing production, consumption and inventories rather than achieving a particular price target.
By avoiding overt discussion of prices, the organisation’s members aim to deflect criticism from consumers and minimise the risk of antitrust litigation.
As a practical matter, however, production, consumption and inventories are connected inextricably by prices, so this is a distinction without a difference.
Setting an explicit target for production and inventories is inevitably the same as setting an implicit target for prices (in terms of desired direction if not level).
OPEC and sanctions
OPEC has generally been more effective at limiting output and raising prices when output from one or more major producers inside or outside the organisation has been disrupted.
Economic collapse, mismanagement, corruption, civil conflict, war and sanctions have all played a key role restricting competition at various times.
In particular, U.S. and international sanctions on Iraq, Iran, Libya, Venezuela and Russia have reduced competition at different times and given OPEC more scope to raise prices.
In every case when OPEC has successfully lifted prices, at least one major producer was under sanctions, making it easier to reach an output agreement and reducing the scope to cheat.
As a practical matter, OPEC and sanctions have been inextricably linked. OPEC policy cannot work without sanctions, while sanctions have generally assumed compensating output increases from OPEC to limit the price impact on consumers.
OPEC and consumers
OPEC policymakers often claim to seek “stability” and a “fair” outcome in the interest of producers and consumers.
For their part, oil importing countries have displayed confused and confusing attitudes towards the cartel and its production strategy.
After the oil embargo and price shock of 1973/74, the major western consuming countries created the International Energy Agency (IEA) as an anti-OPEC.
OPEC has been strongly criticised by consumer countries led by the United States during periods of high prices in 1973-75, 1979-1981, 2000-2001, 2007-08, 2012-2014 and 2018.
But the United States has also appealed to OPEC to cut its production, limit the accumulation of excess inventories and halt downward pressure on prices during slumps in 1985-86, 2015-2016 and 2020.
The United States is one of the world’s largest producers as well as its biggest consumer, so in recent decades its internal political and economic balance has favoured moderate prices around $70-80 in real terms.
Real prices around this level are high enough to ensure the profitability of producers in Texas and other states but low enough to keep fuel affordable for motorists.
The White House tends to intervene when prices diverge too far from this level by pressuring OPEC to reduce or increase production.
“U.S. politicians must secretly love the cartel. When oil prices are high, as they are now, they can hide behind OPEC, deflecting any responsibility. When oil prices are low, as they were in 2020, they can ask it for help to bail out America’s high-cost petroleum industry”
Stockholm syndrome?
Over the years, many economists, commentators and policymakers have argued OPEC’s production strategy has served the interest of consumers as well as producers.
Without OPEC market management, prices would have been even more volatile, creating even greater problems for consumers, in this view, which has also been promoted by OPEC itself.
The argument rests on a counterfactual, which is always difficult to test, but the evidence in favour of it is limited.
Prices have been higher in real terms in the OPEC era because of the limits on output growth, which has clearly been in the interest of all oil producers.
OPEC has been indirectly responsible for initial development and later protection of higher-cost producing areas (the North Sea, Alaska, Gulf of Mexico, China and U.S. shale).
Like other cartels, the case for OPEC being in the interest of consumers as well rests on the claim it has reduced damaging volatility.
But prices have been much more volatile during the OPEC era than they were in the decades previously.
OPEC members have worsened volatility by fighting several fierce price/volume wars (1985-86, 1998-99, 2014-16 and 2020).
They have also contributed to volatility by delaying output increases when prices are rising and allowing inventories to fall critically low (2007-08, 2011-14, 2018-19, 2021-22).
Other capital-intensive industries such as gas have developed without an international agreement or cartel to stabilise their markets.
The argument that consumers as well as producers benefit from OPEC has always struck me as an instance of “Stockholm syndrome”.
OPEC looks after the interest of its members by maximising the revenues they earn; non-OPEC oil producers also benefit from the tendency for higher prices.
OPEC’s benefits for consumers are less clear and there is no evidence it has made prices less volatile.
JKempEnergy.com 