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Opinion

Money Matters

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As the late Milton Friedman often said, “money matters,” and in the coming months, quantitative tightening by central banks, interest rate rises and concerns over the solvency of some financial institutions — bank and nonbank — will have an important impact on the oil market. Financial regulatory actions will increase the already high cost of holding petroleum stocks. Some firms will find banks unwilling to extend additional loans to acquire inventories even if prices increase. Some may even see their credit lines cut. These companies will be forced to reduce purchases or sell stocks. This will shatter dreams of higher crude prices too.

Interest rates will likely rise more in the coming weeks. The increases will almost certainly cause oil stocks to be reduced, as experience tells us that inventories decline when credit tightens (see graphic below). Yet, to our knowledge, no oil market analyst or consultant is projecting a global stock decline of this magnitude, with some still seeing oil prices surging above $100 per barrel, spurred by China’s reopening.

That looks like wishful thinking. Economic historians would remind those expecting much higher oil prices of the 1979 “Volker Shock,” when the federal funds rate nearly doubled to around 20%. As Charles Kindleberger and Robert Aliber explain in their 2005 book on financial crises, this shock “almost immediately shattered anticipations of accelerating inflation.” They add that “previously the Federal Reserve had stabilized interest rates and market forces had determined the rate of growth of credit; under the new policy the Fed sought to limit the rate of growth of credit.”

The situation today is similar — even if some equity markets commentators still assert that central banks, particularly the Federal Reserve, will slow or stop the interest rate hikes. On Jan. 6, Bloomberg reported that several Fed officials had highlighted the need for further increases despite reports of slowing inflation and wage growth: Separately, the Wall Street Journal’'s Nick Timiraos quoted James Bullard, president of the St. Louis Federal Reserve Bank, as saying interest rates needed to rise above 5% this year. Minneapolis Federal Reserve President Neel Kashkari warned those expecting an easing by the central bank “are going to lose the game of chicken” they are playing. These statements point to a steeper decline in global oil inventories than most anticipate.

Indeed, we expect commercial stocks to fall back to around 60 days of coverage by the end of 2023, which translates to a global inventory decrease of 1.4 billion barrels. Such a decline would require a stock reduction rate of almost 4 million barrels per day. Nor would we be surprised either to see OECD inventories decline to 50 days of coverage by the middle or end of 2023. Put another way, OECD stock holdings will decline by 400 million barrels if history repeats, as is likely.

High Prices Fantasy

Those envisioning very high prices also ignore a fundamental transformation in the global oil market over the last 50 years that has altered market behavior: A half century ago, most oil moved through an integrated system. The large companies producing crude oil from their own fields in the US or elsewhere, and via concessions in oil-exporting countries, did not pay cash for their crude. Oil was only monetized when it was sold to consumers such as airlines, power plants, maritime consumers, railroads, or individual consumers such as motorists.

The situation is drastically different today. In 2023, most oil is monetized when transferred from crude producer to refiner. Very little moves in integrated systems. Aside from a few oil companies that retain an element of integration, most now are nonintegrated and must pay cash for oil. Such purchasers will be more cautious, and if history repeats as the graphic above suggests, these companies will reduce inventory holdings by as much as 20%.

The unwillingness or inability of the customers of US refiners to purchase gasoline will be one factor driving the refiners’ buying decisions. Refiners sell most of their gasoline to independent marketing companies such as Costco, Couche-Tard, Pilot, or Casey’s General Stores. Some of these retailers can tap larger credit lines, but others cannot. As a result, product inventories could be reduced. The impact of rising interest rates and marketer reluctance to hold stocks can already be seen in the weekly US gasoline inventories, with stocks today near the bottom of the normal range, according to data issued by the Energy Intelligence Agency.

The doubling of crude prices envisioned by some would also almost certainly force many distributors to cut their purchases, which in turn would lead to lower refinery runs. Purchase reductions would also boost backwardation in gasoline prices and retail prices. The higher prices would speed decreases in gasoline consumption. Higher prices would also likely raise inflation and, if so, redouble the credit-tightening efforts of central bankers.

In short, the dreams of high crude prices should be disregarded. Under such prices, financial institutions will not provide the credit the oil industry needs to buy the incremental crude volumes. Indeed, these institutions are already likely pulling back on such lending to the industry.

Sovereign Wealth Help?

The lending constraints on buyers of crude oil and products could, however, be offset by the oil-exporting countries tapping their sovereign wealth funds. The International Monetary Fund reports that Middle East oil and gas-exporting nations can expect to earn an additional $1.3 trillion in revenue for the next four years from higher oil prices. The Financial Times notes that investors and bankers “squeezed through the corridors” of hotels and offices in Qatar during the recently completed soccer World Cup, “pitching deals on the hoof” to the managers of these sovereign wealth funds. As one banker told the FT, “You have the world and his wife coming here looking for capital. It feels like 2008.”

Historically, the Middle East’s sovereign wealth managers have been focused on new technologies and new industries rather than traditional oil and gas. Nothing indicates that that thinking has changed. Gulf countries must act, however, if their government planners want to push prices up to levels of, say, $150/bbl. Essentially, their financial institutions would need to underwrite the inventory accumulations of oil traders, independent refiners that do not own crude production, and downstream marketers who hold products. They must, in short, replace the commercial banks in OECD countries and elsewhere that now finance stock holding.

Absent such financial innovation, central banks in the US, Europe and Japan will remain a brake on rising oil prices. Higher interest rates and tougher bank supervision that limits lending will constrict oil price increases.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

Topics:
Oil Futures and Derivatives, Oil Prices, Macroeconomics
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