Breaking Down the Energy Price Shock and What May Happen Next

Episode 76 of The Investopedia Express with Caleb Silver (March 7, 2022)

Table of Contents
Table of Contents

Tense times in capital markets as the situation in Ukraine worsens by the day. Investors are caught between the headlines, but the trend continues to be lower as they bailed out of stocks for the fourth consecutive week and look to do so again this week. Crude oil prices spiked again last Friday after the White House said it was considering a ban on imports of Russian crude, and then prices on Sunday spiked $125 per barrel. The U.S. indirectly imports about 11% of its oil from Russia. Commodities from oil and natural gas to zinc, palladium, and wheat all traded wildly higher, sending the Bloomberg Commodities Index to its highest weekly gain since 1970. Gas prices in the U.S. topped $4 per gallon this weekend, the highest level since 2008. 

Western sanctions against Russia sent the ruble into a nosedive, tumbling 30% to an all time-low versus the dollar. In response, Russia's central bank more than doubled its key interest rate to 20%, it freed up a local bank reserves to boost liquidity, and it banned Russian residents and companies from transferring foreign currency abroad. The Moscow Stock Exchange was closed all last week to shield stocks from the brutal sell-off, but it may do little to help. Index creators MSCI and FTSE Russell both cut Russia's equities out of their widely tracked indexes, and companies across industries severed their ties to the country. That list includes Boeing, General Motors, Harley Davidson, Nike, Apple, Disney, Meta Platforms, and Airbnb.

Meet John Kilduff

J

John Kilduff is the founder of the Kilduff Group, a partner at Again Capital in New York, and the publisher of the Kilduff Report. He has 20 years of capital markets experience, in which he specialized in energy trading and market research analysis for over 15 years. Previously, Mr. Kilduff was senior vice president and co-head of MF Global’s Energy Derivatives Group. He is also a CNBC Contributor and regularly blogs for CNBC.com. Mr. Kilduff has previously appeared before the United States Senate Committee on Energy and Natural Resources to give an assessment of the energy trading markets.

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Oil prices are surging amid Russia's continued invasion of Ukraine, driving inflation to higher heights and throwing the global energy market into disarray, while Russia continues to pump 11% of the world's daily crude supply. Multinational oil giants are canceling their projects or joint ventures with Russia amid broader economic sanctions. But where will prices go from here, and what impact will they have on the global economy and right here at home? John Kilduff is the founder of Again Capital and the author of the Kilduff Report, which tracks global energy markets. And he is our guest this week on the Express. Welcome, John.

John:

"Good to speak with you, Caleb."

Caleb:

"We've seen crude futures trade as high as $116 a barrel this week, and we're speaking on Thursday. It may seem obvious, but if Russian exports are still taking place, why do prices keep rising? What are oil traders anticipating, John?"

John:

"The oil market is trying to calibrate and figure in just how badly the global market is going to be once we finally do lose... and it seems very likely that we are going to fully lose all the Russian output. Right now, the western alliance is trying to carve out Russian crude oil exports and other energy exports. But the banks and the trade houses and the other commercial entities out there that deal with these commodities are taken on a completely different approach, and they're not heating at all this carve-out. And so, we're already seeing millions of barrels of Russian crude oil in particular get taken off the market, and this is a new paradigm for us. Things don't look like they're getting better anytime soon on the Ukraine front, although there have been some hopeful headlines from time to time. So, that's the reason we continue to grind higher here. We're on the cusp of a major energy crisis."

Caleb:

"Break down for us how key Russian, and Belarusian for that matter, oil is to the global energy market. We know Russia accounts for about 11% of global production, and Europe and China are its biggest customers. But how has this conflict shaken those energy economies today?"

John:

"Well, the problem you have is that the government actions against Russia and against Russia's companies, including their oil companies and now Belarusian oil companies, are having the effect of taking those volumes off the market. We were already in a tight market before this situation arose, really needing more oil from Saudi Arabia and OPEC and even for the U.S. shale producers to step it up. But we are now in a position here where we're going to lose several million barrels of oil per day that just cannot be made up. I mean, so you're going to start to see spot shortages in various places around the world."

"And as you just mentioned, Caleb, there are several major conduits of Russian oil that feed Europe in particular, either by pipeline or ship, mostly by those two entities. The only saving grace here, if you want to call it that, is that the major supply of Russian oil to China is via pipeline. Hard to monitor and doubtful or unlikely at the moment that China will foreclose those purchases. But China has stopped buying coal and some other commodities from Russia, shifting over to supplies from Mongolia, for example. So, if China joins with the western countries to put Russia in a box? Now we have a real problem on our hands."

Caleb:

"Well, how might Iran play into this equation if it signs back under the nuclear deal? They've been basically offline in terms of imports into the U.S. and other markets. How might Iran play a factor here?"

John:

"Well, we got word this morning from several sort of inside sources that there's a deal at hand for the Iran nuclear deal. And I can tell you straight up the initial headlines on that, which claimed that the deal could be struck over the weekend, was good for 10 bucks to the downside for crude oil prices, for WTI in particular. So, it'll be a very important help to the global supply-demand balance."

"But again, I fear that it's not enough. It's only going to end up being a net 1–1.5 million more barrels of crude oil on the market steadily per day. There's a chunk of or an overhang of Iranian crude oil in floating storage and also millions of barrels that China has in what they call bonded storage. Ready to go, ready to get paid for. So, that'll help, but it's obviously not going to break the back of this rally anytime soon."

Caleb:

"What about the U.S., John? We import very little oil from Russia, and most of it's indirect. But why do we even do that, and how do we use it? Explain the the relationship between the United States and Russian oil?"

John:

"Yeah. This is one of those data points that's gotten way overblown. That the Russians supply to the U.S.... first of all, we went about... from 2014 up until about the last year, there was zero, OK? And then we've had maybe couple of hundred thousand barrels on a weekly basis for a period of time. So, it's really gotten overblown that the situation is that we get an occasional cargo from Russia, is how folks should look at it. Several refiners on the Gulf Coast buy it. The crude oil from Russia is actually well suited to our refiners along the Gulf Coast. And the way the pricing has been of late, it has made economic sense for our refiners to take some of it in. Again, it's a drop in the bucket."

"And also to this fuel oil that Russia sends our way, a similar situation. Well suited to where refinery operations along the Gulf Coast. It sort of highlights one thing though, Caleb, I'll tell you that's, I think, much more important than the fact that we did get some Russian crude oil we haven't been getting some of late, is that most of really our shale production is useless to our Gulf Coast refiners. It's of a gravity, a weight to thickness, and sulfur content that doesn't fit in their manufacturing process. So, it really goes overseas. It's of no help to us. So, we remain energy interdependent, not energy independent."

Caleb:

"You hear that word thrown around all the time. The U.S. is energy independent. It produces more oil than it needs. It's an exporter now. But that's not exactly the case. Explain for our listeners what the real situation is in terms of U.S. production, how we use it, what we export, what we import."

John:

"First of all, we get several million barrels a day from Canada, and thankfully it's from Canada and not other places. But our Gulf Coast refiners, really the breadbasket of the United States refined product industry, where the bulk of the production of gasoline and diesel fuel and jet fuel takes place, we're built for heavier, 'sour' crudes, they're called. Crude oil from, say, Venezuela. Another problematic supplier, crude oil from Saudi Arabia, the Middle East. Those types of sources where the crude oil is, again, heavy and sour. Shale production that's so ballyhooed is great for refiners in Asia. The Chinese, for example, are big buyers of it. South American refiners are big buyers of it. And from time to time, Europeans."

"But again, this is all chemistry and the chemistry of the shale, the chemical makeup of the shale oil doesn't work for our Gulf Coast refiners. Other countries do. Their crude does, but we supply others with our crude. It does all help. Don't get me wrong. Without the U.S. shale production, we'd be in much worse shape. But again, it's this interdependency that I talk about, not independence."

Caleb:

"Absolutely. So, Investopedia readers and everybody's been looking up this term 'backwardation,' when the spot price of a commodity is trading higher than the futures contracts. And we've been seeing it in oil lately when the summer contracts, looking out July, August, and even into September,  they're down near $90 a barrel for oil. How long until we see those futures spike or until we see that backwardation change?"

John:

"Well, it's going to take some time. One thing I like to always talk about, the futures curve, when you're looking at it like you just did for your readers, and if they look at it today or in the coming days and see that price discrepancy, what that is reflecting is the best market knowledge we all have as we sit here today. There's no guarantee that we're going to be at $90 when August rolls around. We could be a heck of a lot higher. Or in fact, we could be a heck of a lot lower. But backwardation in a commodity market is a reflection of real tightness here and now. And so barrels of crude oil in this case are highly valued. There's a scarcity premium being priced in."

"So, because it's so dear right now and you almost can't get enough of it. The front of the market here is getting priced up in a big way, with the assumption in the market being that, 'Down the road here, over the course of the next several months, more supply will come on the market, the Iranian barrels, more U.S. shale, other players.' Brazil is set to really ramp up some of their output, for example. So, it's a glimmer of hope. But for now, it's the scary times that we're in. Price structure, term structure for crude oil."

Caleb:

"Barring a nuclear conflict, and then all bets are off the table, John, but if Russia continues its invasion into Ukraine for several weeks or months, how high do you think oil could spike? And what are the knock-on effects of rising oil across other commodities and GDP's of countries like the U.S.? 

John:

"Certainly, if this Russian situation persist, which looks like it's going to, the western countries are going to have no choice but to square off and foreclose Russian oil exports. Full stop. That will get us up to at least a $125, potentially beyond. Again, we're going to have some relief from the Iranian supply if it comes back. Also, some other countries out there having big problems like Libya and even Iraq right now, can we get some of those supplies back online to full strength? It'll ease things, and that's sort of $125 area could be the top out point."

"And it's a conundrum in terms of analyzing this situation in terms of the U.S. economy because we do have a significant exploration and production industry these days, and we're also really the top producer now and one of the top exporters of crude oil. So, that's a positive input. But we're still two-thirds a consumer economy and really, except for the folks in Texas and New Mexico, to a degree, the rest of us are going to be suffering, and they are the only ones who will be doing rather well. The rest of the world economies too are gonna get hit really hard. China has already announced an increase in its fuel pricing starting tomorrow. Those folks can hardly afford it. India, too, will struggle mightily. And the heavily industrialized, energy-intensive economies of Japan and South Korea, they're going to take big hits as well."

"So, this is a potential energy shock, it's an energy shock in the making, that could rival the 70s. And we all kind of know what happened then. You had a period of severe stagflation, recession, and it's a drag. Overall, even with our U.S. Gulf Coast or Texas output, this is going to shave points potentially off U.S. GDP, which is already close to zero, according to the Atlanta Fed real time numbers. So, we're hanging in the balance here in terms of economic expansion/contraction, and this could be the knockout blow."

Caleb:

"Coming right on the heels of a pretty good recovery from the pandemic, the economy was looking fairly strong. Oil stocks, John, you know, have been the best performers in the U.S. and the global equity markets for several months, even before Russia's invasion of Ukraine. Investors always take things way too far in either direction amid the volatility. In your eyes, are oil stocks overbought, are they overpriced? How are you looking at those?"

John:

"They're not necessarily overpriced or overbought yet. We're getting close to that, but to the extent this $100 a barrel price sticks around for a time, they're going to be minting money. I mean, there's just no other way to put it. I know it's a little indelicate, but they're going to be making so much money I wouldn't be surprised if they become vulnerable to a movement in Congress for the return of the windfall profits tax. The numbers are going to be that eye-popping. So, I think they still have some room to run. I'll tell you, I think people... we all have a short memory of the hell they went through in the height of the pandemic when oil prices went negative, where ExxonMobil and Chevron in particular had to basically hock everything they had to keep to cover their dividend, which to their credit, they did. And they have sort of got garrisoned balance sheets to sort of withstand anything that may come again."

"But for now, you stick with it because the earnings reports now over the next couple of quarters here are going to be unbelievably large. I mean, we could be see a return, for example, to ExxonMobil being one of the most profitable companies in the world, which it was back in the day. And ExxonMobil's got a two-pronged home run here, or a grand slam home run, in that not only are they benefiting now from the high crude oil prices, but they're also finally benefiting from their acquisition of XTO, which was a major natural gas producer, and natural gas prices have just been in the toilet, pardon the pun, since they bought that thing several years ago. So, watch Exxon here in particular."

Caleb:

"It's a crude oil issue, but it's also a natural gas issue, and you're feeling that definitely in western Europe. But prices have just been spiking across the board. At the same time, John, we've seen a lot of bearish bets on oil stocks and ETFs just lately, either through the futures market or inverse ETFs that bet against the rise of stocks in that sector. Are those bets misguided?"

John:

"No, you can certainly make an argument for this being at or near the top. Certainly, the economic damage that could be wrought by this price spike, this price surge, could be significant in terms of economic contraction, which would hurt demand, which would ultimately hurt prices. Also I'll tell you if you were to pull up the crude oil chart for WTI, I mean, it is just a rocket ship parabolic move higher that, from a technical analysis perspective, screams out for retracement... a lot of those gains and really settling back down towards $100. These last $16 or so came fast and furious on headlines that were certainly alarming, but didn't really necessarily change things on the ground supply wise, all that much just yet."

"So and, the 10 buck reversal today from the high is the signal to just how speculative the last phase of these gains are. So, they aren't misplaced, but I do think this is not going to be any kind of wrecking machine price-wise for Exxon, Chevron, the Diamondback Energies, and the rest in that patch. As long as we even just stay above 80 bucks, Caleb, they're going to do fabulously."

Caleb:

"Yeah, I was going to ask you, what is the magic number for profitability for these Big Oil majors? Whether you're an energy company like an ExxonMobil or Chevron, or whether you're just a driller like a Diamondback, is there a number out there? Is it 80 bucks, is it 85 bucks, that is the magic number? Anything above that? Pure gravy?"

John:

"Everything above 50 is really pure, pure gravy. The breakeven has been driven down in the shale players, for example, to below 40 dollars. Some of them are as low as 30 now. So, that gives you some idea, cost of production in the Gulf of Mexico or internationally still in the single digits, obviously, for Saudi Arabia. But I mean, beyond that, you're talking teens to mid twenties. So, you start to do the math and you can see the environment above 50 bucks is terrific for these guys, $80, they're living large to use a phrase, and up here it's just minting money. Above $100 is just boom times. Boom, boom, boom times."

Caleb:

"John, you've been following the oil markets and the commodity markets for years, and I've been following your research for such a long time, what is being missed in this conversation? What is nobody focused on that you think is a key issue that investors and commodity investors need to know about that you've been watching?"

John:

"This Ukraine situation obviously makes the whole calculus difficult, if not inscrutable. But before this happened, I think we were in the process of peaking price-wise. I think there's a lot of supply coming back on the markets from U.S. shale. ExxonMobil's Guyana property is starting to show real results. Our Gulf of Mexico production. There's also a big slug of spare capacity between Saudi Arabia and UAE. At some point, I have to believe pressure will be brought to bear on them to tap that and get this market stabilized. So, I can't say we've seen the worst yet. There's still a chance for us to grind higher here, up towards $125, but this won't be forever. And as a matter of fact, with any luck, even by the latter part of this year, prices could be materially lower if this Ukraine situation gets diffused. And I think that's what's being overlooked."

Caleb:

"We've seen the extremes in prices across all asset classes, oil and natural gas the latest. But it's happening in wheat. It's happening in zinc. It's happening everywhere you look, mostly because of this invasion. John, you know, we're a site based on our investing terms and you're a commodities expert. What's your favorite investing or commodities term and why?"

John:

"I suppose the backwardation term you just used, or the opposite of it is contango or carry, are two words that are certainly central to understanding commodity markets like crude oil, where the phenomenon of those start to feed on themselves. So, for example, with the backwardation, you're seeing the real steepness of this curve right now. That's because now there is no incentive to put oil in storage today because the curve is telling you you're going to lose money on it. So, it becomes a bit of a desperate situation."

"The opposite is true from time to time when we go into contango or carry, and you start to hear all about hedge funds and others renting vessels, filling them with crude oil, just parking them off the shores of, say, Singapore. And you start to see those spectacular pictures of that phenomenon happening, or even people saying, 'Can I fill up my swimming pool with it?' And then, again, it really feeds on itself. Those are the best of times for consumers, not so great for the oil companies, but it's a situation in the contango world where you can lock in profitability and just make some easy money. So, I think those those two words describe phenomenons that ebb and flow here over the years for for the energy market."

On Friday, the University of Michigan will release its preliminary reading of consumer sentiment for the month of March. It is expected to remain near decade lows after falling last month due to concerns about rising inflation, falling confidence in the government's economic policies, and the most pessimistic long -erm prospects for the economy in the past decade. Remember, that was before Russia invaded Ukraine and gas prices topped $4 a gallon. 

Caleb:

"Count on the commodities market to produce some of the coolest terms we have in the investing and finance landscape. John Kilduff, the founder of Again Capital and the author of the Kilduff Report. Follow John's research. It is so smart. I've been following it for years. We really appreciate you joining the Express this week, John. Thanks so much."

John:

"Thank you, Caleb."

Term of the Week: Stagflation

It's terminology time. Time for us to smarten up with the investing and finance term we need to know this week. And this week's term comes to us all the way from Ireland, courtesy of our pal Eamon over there on the Emerald Isle. Eamon says he listens to the Express every week and we appreciate that. Eamon wants us to talk about stagflation this week. And no, it's not another word for a boring bachelor party. According to my favorite website, stagflation is an economic condition characterized by slow economic growth and relatively high unemployment or economic stagnation, which is at the same time accompanied by rising prices or inflation. Stagflation can also be defined as a period of inflation combined with a decline in gross domestic product (GDP we like to call that).

While there were concerns that the U.S. would enter a period of stagflation due to soaring inflation and a slowdown in hiring, the labor market is getting stronger every month here in the U.S. We're still missing a few million jobs compared to pre-pandemic days. But hiring has picked up. Wage growth was strong until last month, but still not strong enough to combat inflation. So, if the economy slows from here and prices keep rising, then yes, Eamon, stagflation could be back in the cards. But for now, we should keep our eyes on hyperinflation. It's a good suggestion though, Eamon, and we're going to be sending you some lovely argyle socks for your next stroll along the Cliffs of Moher. What a beautiful country you live in.