Over a Barrel with Spencer Dale

Yeah, absolutely. It relates to Craig's sort of fact of the day about oil Brent being above $100 for 21 days. My guess is that's true in terms of the Brent futures contract. But in terms of the physical price at which Brent been trading at, my hunch is that's been closer to 58 days pretty much since the Strait was closed. So just for those who don't follow this thing closely, there's two sort of two markets which normally move in sync but they're not moving in sync at the moment. So one the market which most people will look at will be on the front of the Wall Street Journal and the front of the BBC news here or for Brent will be the short-dated futures contract which gives you a price for Brent delivery in June. Now that includes an expectation that between now and June some good we may well get an agreement and oil may start flowing again. What matters in terms of actual oil prices in the physical market is how much does it cost me to buy a barrel of oil today for delivering the next 10 to 30 days. That price is significantly higher. On average the gap between those two has sort of averaged about $20 or $25 a barrel over the last... at one point we had oil in for 40s oil which is normal oil was trading as high as $140, $145 a barrel even when the Brent futures was over was 100. So, as you say, this massively steeply downward sloping curve. How do I think about that? I mean, one thing is the fact that they're not you can't arbitrage between these two markets because they're for different things. One is for delivery sort of almost immediately. The other one is for delivery well, it's not even delivery because it's only a paper market, but it's telling you a guess of prices in June. But even then I so so in some sense it gives you a sense that people do hope that the market will ease and we'll get some sort of agreement. But I guess two other issues here. One is that futures market you know the nature of futures markets as an all forward markets. They're impacted by a whole range of different sort of participants in that market. So I don't think you should think that's given you a real clean read of what people expect their price to be in June. It's been infected by a whole range of other things. Perhaps the simplest way of thinking about this is that steeply downward sloping supply curve. There is a massive incentive. If you hold any stocks today, sell them, destock, get that oil into the physical market. And in some sense, that's the price signal that the world is the physical market is talking about. And the reason why, and I realize this not a great way to start a podcast because it's really techy straight away, but the reason why this matters is because refineries which buy crude, they buy crude, the physical market. And so those refineries which then turn that oil into gasoline and into diesel, which affects the real economy in terms of how much it cost to fill your tank your car up, how much it cost you to heat your homes. And so that at the moment I worry that the price signal that most people are looking at in terms of those futures contracts is not actually revealing just how tight the markets are at the moment and just how big this oil price shock is.

No no and the key thing here is what we end up buying as consumers is a function of the crude price at which refineries buy the crude plus their markup which is known in the business as the crack which is this mark up above and that has also ballooned out and there's also a geographical split here Fabio and Craig in a sense of the epicenter of this shock was Asia so the tightness in the physical market started off in Asia because it takes a while for the flows which would have reached Europe to not reach Europe and so for those physical tight flows to the physical tightness to show up we're seeing that in Europe now we haven't seen that same sort of decoupling between physical markets and paper markets in the US yet, but this is a fungible market. And so what we're seeing is a significant increase in US oil exports in the last few weeks as essentially Asia pulled that US crude across the other side of the world. And so this sort of tightness that we're seeing in Asia and in Europe is coming US's way as well.

Yeah. The dated Brent is freight on board. Correct. It's ready to deliver at some port. Now all that freight on board is locked up in the Hormuz Strait. I think I mean some Craig is tied up in the Hormuz Strait but some of it is just shut in and this is the important point here is the amount of storage available in the Strait both in terms of vessels which were waiting to be loaded up plus onshore storage that was full up some time ago other than in Iran and so therefore you had this shuttering in of oil production. So much of the Gulf production now is now shuttered in. This matters a lot because it's costly to shutter in and then restart wells. Shuttering them and restart them again. Both physically is costly in terms of financial cost but also in terms of reservoir performance. And so you really impact the performance of your wells if you do this too often. The reason for saying this is for this shock to ease off, not only does the Strait have to open, it has to open in a way that the Gulf producers think it's going to be a lasting agreement. If you get an agreement where you say, 'Okay, for now we're going to open up the Strait, but we're going to carry on negotiating on nuclear,' for example, which is what we've seen over the weekend suggestion we may split these two things. If you're not confident that you're going to reach an agreement, if you're the Gulf producers, you may well say, 'I'm going to stop and I'm still going to keep my production shuttered until I'm confident that that oil will flow.' And to give you some sort of idea, I think most the consensus in the markets now is if we take account of the oil that's been lost already in terms of production and the fact that even if we have an agreement today, it would take several months before you get oil production back up to normal levels. We've lost roughly at least now baked in 1 billion barrels of oil is lost. The amount the estimate we think which is sitting in the Gulf ready to flow in terms of stored oil on both floating and on shore is about 250. So that will help but it's a long way short of being able to just solve this problem.

I think it's cost. I think it's insurance cost, but it's also the human cost, Fabio. I mean, if you're one of the people responsible for shipping that freight through the Strait, you have a duty of care to the people on those vessels if you have insurance or you don't have insurance. And so I think I don't think people fully appreciate that just saying the Strait is open is not enough. It will be enough to get those 250 barrels flowing, but it won't be enough to get those wells opened, which is what you need to get to start getting back to something close to normal.

I don't have a good explanation for that. I think it's really striking. Now I think you could just about reconcile the US equity markets. If you think about the US, the US is a net oil exporter. So overall as economy as a whole, the US is better off as a result of oil prices being higher than being lower because it's a net oil exporter. And so you can just about imagine that some of that pain is borne by households in terms of higher pump prices, but that's offset by higher profits and that flows into equities. But if I look at global stock markets, at the end of last week, global stock markets were only down like two or 3%. which just seems just very hard to explain given already the severity of this shock. But more importantly, the risk that this shock could get an awful lot worse. And you saw I'm sure you saw the IMF World Economic Outlook which under their sort of distress scenario their worst scenario you had global GDP growth down to 2% which as you and I know we've seen global GDP growth of 2% only four times since 1980 one of those was the pandemic another one was the financial crisis so to all intents and purposes 2% at a global level is a severe recession. But the markets don't seem to be placing any weight on that when we still are seems to me quite a long way away from having both an agreement and one which we're confident will last for a long period of time.

I think the main thing the sort of textbook response to an oil price shock we all know so essentially we know an oil price shock is a price level shock so you look through that shock and as a central banker you don't worry about inflation being temporarily higher you only respond to concerns if that then starts to build into a sort of wage price spiral. That's really straightforward when you say it like that, Craig. But then you say, well, what is a first round effect? So, the fact that oil prices means it cost more to fill up Fabio's car today. Well, that's a first round effect. What about the fact that also that meant the transport cost was higher? So when Fabio brought his pasta because it had to be transported is that a first round effect or a second round effect. What about the fact that then also the wheat which is associated with the pasta went up because the fertilizer costs were higher and so you crop yield. Is that a first round effect or a second round effect? So one these things are just very hard to know exactly where do you draw the line here? So a practical thing is hard in terms of the communication. My old boss Mervyn King once talked about the Maradona effect and I'm not sure if you heard about the Maradona effect. The Maradona effect was this story where when Argentina beat England in a crucial World Cup game. I think it's a semi-final. Maradona fainted left and then fainted right and fainted left fainted right. And so the players, the England defenders moved around. When you look back in hindsight, Maradona had actually run in a complete straight line. He just had fainted left and right to confuse people. And so I think what we will try and do here is central banks behave like Maradona in the sense they say we will behave very aggressively to this price shock. If there's any sign whatsoever that inflation's coming through, I'm going to really raise interest rates and I'm really going to turn up that language hard to tell you that I'm really going to respond to that. And if enough wage and price setters hear that and respond to that, then the central bankers don't have to move. And so sometimes part of the story here is a sort of rhetorical device to make sure that you're clear to people that if needed, you will do it. And if that's credible, the chance of you actually needing to do it is that much less.

You're absolutely right. And I think as all of us as old central bankers would say is one of the things which has been I think most surprising in a good way coming out of the inflation scare we've gone through is that expectations have remained surprisingly pretty much most parts of the world in a way that I don't think we would have done if we'd said we're going to have inflation at seven eight percent. I think we would have thought we would have seen some slipping, but we haven't. But the question is how long can you keep doing this after a while it doesn't sound like bad luck. It sounds like there's a persistent sort of theme here and that's one of the challenges the central bankers will have to deal with.

No, and I think that's quite a theme which is sort of starting to be talked about in energy markets. Are we seeing a sort of structural increase in oil and gas price volatility? Now, part of that is sort of driven by just the events we've seen over the last few years in terms of the pandemic, then Russian Ukraine war and now the Iran war and related to that, this sort of fragmentation of the energy system and increasing weaponization of energy. And so with that weaponization of energy is part of that story. It then relates to as you say the increasing introduction of wind and solar into the energy system not just in other parts of the world in the US as well but in the US all of the growth of power generation in the US last year was accounted for by wind and solar. So this is not it's happening in the US just as much as it's happening other parts of the world. That wind and solar is variable. We know if the wind's not blowing or the sun's not shining it's not going to be generating energy. Often on the other side of that are fossil fuels. So fossil fuels are having to do the smoothing to smooth out the variability of wind and solar. So that adds greater variability into fossil fuel demand. And then add on top of that we are moving to an energy transition in terms of the growth of oil and gas over time. If you look over the last 20 years, half of the growth of global oil demand was driven by China. China's oil demand looked pretty much like it's now peaked. So the idea that we can just extrapolate forward the fact that oil demand will grow by a million barrels a day or a million half barrels a day every year going forward. We're no longer in that world and so that's a more uncertain process.

Yes, we can come back to that as well. I mean, so you add all those in and you say, well, what should you do in this world of structural volatility? And I think there's sort of two complementary responses. So, one is to try to mitigate that volatility and the other one is to try to insulate the real economy from that volatility. So, in terms of mitigation, some of the things you can do to mitigate that volatility are the things that everybody's talking about now. So I think we will see a significant diversifying of trade routes for that Gulf production. So we'll see more pipelines be built which avoid the Strait. I think we'll see those Gulf producers build up storage capacity outside of the Strait often close to demand centers. So which would provide greater stability with sort of supply chains will move away from just in time to just in case type supply chains with more resilience and redundancy. I think that's all sort of straightforward. I wonder if we're going to get a little bit more imaginative policies. So this was floated a little bit in the last administration. Why can't at the moment countries hold strategic petroleum reserves and we hold those countries hold those strategic petroleum reserves to release supply in terms of emergency which is what we're seeing at the moment. But you could also use them to dampen volatility. You could actually sell oil when prices are high and buy oil when prices are low. So this will dampen that volatility. I also think we may start to move to a well we're going to try and incentivize capacity markets for oil markets. We're used to having capacity markets for electricity but why not capacity for oil markets? So for example, one of the sort of areas that we see at the moment is that refineries which are in the Atlantic basin are gradually declining and gradually being closed down because demand for refined product in the Atlantic basin is being fired down. But one of the themes at a conference I was at last week is oh my goodness we really need those we really need those refineries now. And so can we get to a world where we start to incentivize some of those physical assets which would normally just been retired to be sort of mothballed providing capacity going forward. Now all of that costs money but if we're in a world of structural volatility that we may need to do that to dampen that. The second part that just is the insulation that will help but it won't completely solve the volatility in wholesale markets. And so I think the challenge for energy companies but also for governments is how do you insulate the real economy from that volatility and so I think part of that will be sort of starting to generate long-term fixed price energy contracts. So we start you can actually buy your energy on a 5-year type contract akin if you like to how we do fixed-term mortgages. Many households and particularly in the US will have long-term fixed rate mortgages which insulates them from the interest rate cycle. We don't think that's odd at all. If we are moving to a world of greater volatility in wholesale prices, I think we may well start seeing long-term contracts for energy as well as for mortgages.

No I think that's exactly the way to frame it and just relating to that oil price shock in 1973. One thing I learned from that is supply shocks scar. They have scarring effects. The share of oil in the global energy system peaked in 1973. The share of oil in global energy never got back to the level it was in 73. Obviously the total volume of oil has increased a lot but its share has never got back. So it does scar and so the narrative for an acceleration in the transition it is very clear. You're sitting here in countries in Europe, different parts of Asia where you're importing huge amounts of oil, importing huge amounts of gas, you can see that prices are going up, squeezing households by just you think I need to reduce my dependency on that oil and gas and just another fact of Craig's facts of the day. Three-quarters of the world's population live in countries which import oil and gas. So this is a big amount of people being impacted in this way. And so the natural story for that would be well I want to reduce my imports of oil and gas. To do that I need to produce more domestic energy. For most economies and most countries they're importing oil and gas because they can't produce their own. And so therefore if they need some alternative energy they need something else. Much of that will be low carbon energy, wind, solar, nuclear in some parts of the world like Japan.

That's what accelerates the energy transition. And that's a very clear narrative that you can see in many parts of Europe at the moment and perhaps in China as well.