Doing what I do for a living, I tend to be popular when I don’t really want to be. After all, when the markets are going up and the economy is humming, who really cares what economic types have to say. It’s all good man. However, that changes, pretty spectacularly, when everything seems to be headed into the ditch. All of a sudden, I am the most popular man in town.
Not that there is anything wrong with that. In fact, I kind of like sharing my opinions, as I get to have so few at the house.
As you can probably imagine, given all of this year’s turmoil and uncertainty, I have given more public presentations, statements, and interviews about the passing scene this year than last. The year 2021 was possibly one of the more, shall we say, pleasant years in my career. The economy was booming and the markets followed suit. It couldn’t last forever, and it didn’t.
Of particular importance to people is inflation. Specifically, how much longer will prices continue to go up as much as they have. The answer is pretty simple: the end is nigh, at least in regards to inflation’s current trajectory. Admittedly, I have recently written on this topic Higher Prices; however, folks still seem to have the same questions and concerns.
Let me start with the good news. So-called “core” inflation data should be lower, on a relative basis, by the end of the year. This includes all items ex food & energy. While trying to do a monthly budget without such things would be a pretty neat trick, core inflation is a way of determining whether inflation is systemic in the economy.
Given the relative strength of the US dollar, the bloated state of domestic inventories (especially ex autos & supplies), the recent slowdown in the growth of the money supply (M2), and the Fed’s tighter monetary policy, it would be almost impossible NOT to have lower core prices in the not-so-distant future. Yes, stranger things have happened. However, all bets will be off IF core inflation didn’t moderate, potentially significantly as the year winds down.
Unfortunately, I am not as sanguine on energy prices.
On May 31st, Laura Sanicola, a reporter at Reuters, wrote an awesome article about the underlying reason why there has been so much pain at the pump. Global refiners falter. In short, the global economy currently doesn’t have enough capacity to meet pre-pandemic demand. Essentially, demand is going up and supply is actually going down. We all know what happens when that happens.
Here are some pertinent excerpts from the article.
“World fuel demand has rebounded to pre-pandemic levels, but the combination of pandemic closures, sanctions on Russia and export quotas in China are straining refiners’ ability to meet demand. China and Russia are two of the three biggest refining countries, after the United States. All three are below peak processing levels, undermining the effort by world governments to lower prices by releasing crude oil from reserves.
Global refining capacity fell in 2021 by 730,000 barrels a day, the first decline in 30 years, according to the International Energy Agency. The number of barrels processed daily slumped to 78 million bpd in April, lowest since May 2021, far below the pre-pandemic average of 82.1 million bpd.
The United States, according to independent analyst Paul Sankey, is “structurally short” on refining capacity for the first time in decades. U.S. capacity is down nearly 1 million barrels from before the pandemic to 17.9 million bpd as of February, the latest federal data available.
Russia has idled about 30% of its refining capacity due to sanctions, according to Reuters estimates. Outages are currently about 1.5 million bpd, and 1.3 million bpd will likely stay offline through the end of 2022, J.P. Morgan analysts said.
China, the second-largest refiner worldwide, has added several million barrels of capacity in the last decade, but in recent months has cut production due to COVID-19 restrictions and capped exports to curb refining activity as part of an effort to cut carbon emissions. China’s throughput dropped to 13.1 million bpd in April, the IEA said, down from 14.2 million bpd in 2021.
Other countries are also not adding to supply. Eneos Holdings (5020.T), Japan’s largest refiner, does not plan to reopen recently closed refineries, a spokesperson told Reuters.”
It is an ugly picture painted with a dirty brush. Essentially, IF the US wants to have lower prices in the present, it is going to have to make a deal with the devil, that is if China and Russia are the devil. You will have to answer that for yourself. In any event, if you want more to read, Bloomberg also had another good piece on the subject on June 19th titled: “Massive Oil Refining Capacity Idle in China as Prices Soar.” The link to that article is here: China sticking it to US…again!
So, what is to be done? At least here in the United States?
Frankly, despite the administration’s sharp admonitions, I am not sure the domestic energy industry can do much to alleviate the recent pain at the pump, at least not in the near future. You see, domestic refiners are currently operating at around 94% capacity, which is essentially full-tilt, and will likely hit 96% by the end of the summer. No More Capacity! Basically, they are putting it out as quickly as they can.
However, you want to know the worst part? The overwhelming odds are US refining capacity will go down even more by the end of 2023. In no uncertain terms, refining crude oil is dirty, expensive work, which seems to be at loggerheads with the federal government.
Consider this announcement from the EPA: EPA Not a Partner. The first paragraph says it all: “On June 3, 2022, EPA announced the denial of 69 petitions from small refineries seeking small refinery exemptions (SREs) from the Renewable Fuel Standard (RFS) program for one or more of the compliance years between 2016 and 2021.”
What does that mean, in English? It means small refineries are going to have to have to purchase a bushel basket of “renewable fuel credit prices” going all the way back to 2016, obviously retroactive, in order to avoid massive penalties or even shutdowns. But what is a credit? It is essentially a monetary offset, although some would argue otherwise, when small refineries don’t add biofuels (like ethanol) into their products. Since some of the smaller, older refineries aren’t well-equipped to handle biofuels (remember refining is a very specific and very volatile process), the EPA’s announcement essentially means small refineries are going to have to come off the hip to avoid having to come off the hip even more meaningfully.
Frankly, it was/is an amazing example of bureaucratic nonsense during the middle of an energy crunch. I try not to be too political in this newsletter, but putting the screws to 69 small refiners when the US economy already doesn’t have enough refining capacity is, shall we say, interesting. Then there is this headline from/about LyondellBasell from late April 2022:
“In a move that will cut carbon dioxide emissions and focus the company on petrochemicals and plastics, LyondellBasell Industries will close its Houston refinery by the end of next year.
The century-old refinery has the capacity to refine 268,000 barrels per day of heavy, high-sulfur crude oil into fuels, chemical feedstocks, and aromatics. The refining business generated $7.2 billion in 2021 sales, 15.5% of Lyondell’s total for the year. It employs 1,200 workers and contractors.
Still, the refining operation has lost money for the past three years. Lyondell announced in September that the complex was for sale and says it would still consider a transaction. The firm took an impairment charge of $624 million in 2021 related to the sale decision.”
As I type this, the company hasn’t had a viable offer for the facility. Trust me, I don’t mean to depress you with this newsletter today, though I might have done a good job of it anyway. It is what it is.
So, what is the solution? Frankly, we need to be realistic. It will be a month of Sundays, if not longer, before the U.S. economy can wean itself from fossil fuels…if it ever can. As such, we need to have an efficient refining and energy sector that can react as quickly as it can, to changes in the market and economy. In order for this to succeed, Washington needs to be a better partner and not an adversary. Let me put it this way; our nation’s energy policy has been a little inconsistent.
As we all know, there are three ways to drive down the price of anything: 1) decrease demand; 2) increase supply, and/or; 3) a combination of the two. Currently, demand is outpacing supply. Unfortunately, it seems domestic refining capacity/supply has peaked and will lessen over time. While the push for EV will eventually reduce demand at the pump, we will not be able to rid ourselves of fossil fuels completely. As such, we need to determine where to get the necessary capacity.
At present, it seems we have a number of options. First, we could remove the sanctions on Russia. Second, we could go to Beijing with “hat in hand” to get more distillates. Third, we could increase US capacity instead of reducing it. Finally, it could be a combination of all of it.
In the end, do we want higher prices at the pump or not? The choice is ours; however, complaining about them at the highest level isn’t going to get anything accomplished. In fact, the results could be horribly ironic. With that said, any energy policy that doesn’t plan for greater production and refining capacity in the United States will eventually leave consumers with higher prices at the pump…and elsewhere.
You know, after reading this, I just might be the most unpopular man in town.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows not only on this day but on every day, and thank you, as always, for indulging me this week.
Chief Economist & Most Unpopular Man in Town
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.