Getting the price of gasoline down is one of the must urgent matters in the economy. High gas prices are placing stress on the consumer, and now the Fed has signaled its willingness to push the economy into a recession if that's what it takes to break high inflation. But is there anything that can actually be done? Does The White House have the tools at its disposal to change the supply/demand equation? On this special episode of the podcast, we speak with Skanda Amarnath of Employ America and Rory Johnston of the Commodity Context newsletter, to discuss concrete ideas for expanding oil supply in the short term. The transcript has been lightly edited for clarity.
Points of interest in the pod:
How to use the SPR to boost oil production — 3:56
The problem with a gas tax holiday — 10:18
The problem with a crude export ban — 12:44
How to derisk oil production — 18:09
What about climate concerns? — 21:30
Where did all the refining capacity go? — 24:40
The intersection of oil and monetary policy — 35:40
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Joe Weisenthal: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy: (00:16)
And I'm Tracy Alloway.
Joe: (00:17)
Tracy, I don't think we can talk about oil enough right now.
Tracy: (00:21)
No, no. It feels like oil is the — I don't wanna say missing link — but the link around which everything is revolving at the moment in particular. I mean the Federal Reserve basically seems to have pegged its monetary policy to gas prices. Not explicitly, but it certainly seems that way implicitly.
Joe: (00:39)
It feels like the Fed has really raised the stakes on oil because obviously high oil creates all kinds of problems. It's very difficult for consumers. It creates all kinds of challenges. But at the recent Fed meeting, you know, you heard Chairman Jay Powell say, look, consumers don't think about core versus headline inflation, right? They just think about headline inflation. And if inflation stays high or gasoline prices stay high, then that could lead to increased inflation expectations. The Fed does not want inflation expectations to get out of hand. And so the Fed will tighten in response to high oil prices. The Fed implicitly said, I think, it is willing to pay the price of recession to get the price of oil down.
Tracy: (01:23)
Yeah. And I've been thinking about this a lot, but it's also like gas prices just loom large in the American consciousness. And I guess politically as well. And I’ve got to say I was at my dad's house over the weekend and all I heard was grumbling about gas prices and the Biden administration for three days.
Joe: (01:43)
So anyway it has permeated the public. It is everything. The Fed has made it everything. On a recent episode, the one that we released on Monday with Peter Tertzakian, we talked about the challenges of eliciting a supply response and getting more oil out of the ground rapidly. But the stakes are very high. Clearly the White House is extremely stressed about this. Having recently sent a letter to oil companies, basically, you know, encouraging them to do more. So the question we have to ask is what, if anything, can be done in the short term to bring down the price?
Tracy: (02:15)
And I think this is the crux of the matter. Because we've had many discussions about this at this point, but this is a problem that was many, many years in the making — structural underinvestment in certain types of energy. And now everyone seems to be trying to figure out short-term ways to alleviate that bottleneck or that chokepoint.
Joe: (02:39)
Absolutely huge economic and of course, political stakes. All right, let's jump right into it. We are going to be speaking with two guests we've had on in the past, who know a lot about this space, both in terms of oil specifically, as well as various tools that the government might have to improve the supply side. We are going to be speaking with Rory Johnson. He is the editor of the Commodity Context newsletter, which is a fantastic read. He's also market economist and managing director at Price Street in Toronto. And we're also going to be speaking with Skanda Amarnath. He is the executive director at Employ America, a think tank which promotes tight labor market. So Rory and Skanda, thank you so much for coming on.
And Skanda I actually just want to immediately start it with you because you've been writing for several months now that you think the White House has tools at its disposal right now to increase oil production. They haven't been used, we'll get into the details, but why don't you just give us the very high level idea here of how the White House can use the Strategic Petroleum Reserve strategically to ease oil markets right now?
Skanda Amarnath: (03:56)
The tools we've laid out are really about addressing what I'd call the most proximate binding constraint on the US domestic industry. And that's one of a high propensity for low investment and capital discipline for some pretty understandable and rational reasons that have to do with what I'd call uncertainty price, risk, demand, uncertainty. And it's called to some extent also financing uncertainty, depending on where you are in the industry. And so there are tools available within the federal government that can, if you work with industry, you can actually provide that kind of certainty because the government has a lot of long-term storage capacity through the Strategic Petroleum Reserve, which is not trivial by the way, right. They have physical storage capacity and commodities is important if you're actually going to be able to fund more production, but also to provide the kind of price insurance.
And so the Department of Energy has the authority to replenish their reserve. They're currently releasing oil, which is good, but just don't be under any illusion about how much it's really helping. It helps a little bit at the margin, but it's not gonna be the all powerful solution. But what would be valuable is actually to signal to producers who have been burnt by cycle after cycle in the last eight years or so by price crashes that have effectively led to really poor shareholder returns. And now the response has been, let's invest really slowly. Let's be pretty inelastic in our investment response to high prices, right? Unlike what we saw in previous episodes of oil prices running up. And so what we're trying to get at is through let's call it an insurance mechanism. It's a sale of physical put options and through financing mechanisms, offering leverage changing that shareholder proposition and those tools have been on the table.
The administration has had notice and knowledge of these tools. They've thus far been much more reluctant to really latch onto them. They've done some marginal things that have been helpful around the SPR regarding the willingness to maybe explore forward contracts to replenish the reserve, but the kind of insurance plus financing — pairing those two things together — would be very helpful and powerful. It doesn't solve every issue in the industry, but capital discipline is a big reason why we've not seen the big capex ramp-up in US industry. And look the US is the biggest producer. So it's not as if the US is some small fry producer relative to the global economy, right? It is the biggest in terms of country.
Tracy: (06:21)
So Rory, maybe I could bring you in here. You know, when Skanda talks about the need for price insurance for the oil industry, what exactly is the problem that we're trying to solve here? Because I'm sure a lot of people will look at oil above a hundred dollars a barrel — a lot of the big oil majors or energy majors are posting record profits — and they're going to see that and think, “well, why in the world would you need to underpin it further?”
Rory Johnston: (06:48)
Yeah. And I think one thing that's really interesting is to think about the way in which the SPR can be used to really kind of ameliorate this challenge we're facing. And one of the things we've often heard as a reason for lackluster interest and investment is “sure, the price of oil is very high, but backwardation is extreme, right?” So, you know, the price of oil 12, 18 months out is considerably lower.
And that's where they would effectively be hedging in their production. So that's really in some ways the price that matters more than the spot price. So what's interesting here, particularly when relating it to discussions of, you know, Chairman Powell’s worries about an unmooring of inflation expectations, consumers care about the spot price. Whereas producers probably care about a price, you know, 12 to 18 months down the line.
So the question is how can the SPR be used to kind of achieve some of that goal? A lot of the criticisms of the SPR I think are warranted in that, for instance the release at the end of 2021 by the Biden administration was very much just “oil prices are high. So let's open the taps, let the oil out and hopefully bring down the price of oil.”
That's a bad use of the SPR because it's, you know, using a finite resource. So it's a stock of oil to bring down the prompt price without really anything else. And all is equal that should, you know, reduce the investment incentive or investment signal to the patch. But what if you, you know, for every barrel you sold today, you bought another barrel like Skanda was saying in in the futures market, you know, 12 to 18 months down the line?
So then what you're doing is you're both bringing down the spot price and you're lifting up the back of the curves. You're flattening the curve, which both reduces that kind of inflationary pressure on consumers while also increasing the signal to producers to produce more. So I think that is the way the SPR should be used and it hasn't been used historically, because it's a bit more technical, a bit more Wall Street. And I know that Washington doesn't always like to go down that road, but I think it's a much more effective way of using that capacity resource effectively as a buffer battery rather than just as, uh, viewing it as like an emergency stock.
Tracy: (09:03)
So oil might be at $115 per barrel or whatever right now. But if you look at the futures curve or the curve of all the various oil prices out in time, you'll see that it's in backwardation, which means that people expect prices to come down over the long term, which is exactly the kind of thing that doesn't incentivize people to ramp up production, because they're thinking they can't forward sell future barrels at a higher price. Is that right?
Rory: (09:30)
Yeah, exactly. And I would just quibble a little bit about the expectation comment and I think it's not necessarily that the market's expecting the price to fall. It's that right now the market is willing to pay X amount for a barrel of WTI in 18 months, which is slightly different than like, let's say a market forecast. But just as an example, so WTI right now is trading above 110, around 120 or whatever, whereas 18 months out it's decently below a hundred. So I think that's the price signal that I think producers are really looking at.
And so the question is how can you kind of achieve both those goals? And I think the SPR and again, Employ America has done a tremendous amount of creative policy work around this space to kind of change up the playbook a little bit because it's not, you know, this is a new kind of crisis we're facing. And I think it's gonna take new ways of trying to solve it.
Joe: (10:18)
So the idea here, the core idea is to really bring markets into balance and elicit an increased supplier response. So just more gallons. We know this is creating a tremendous amount of political pressure and stress for the White House, and I assume in Canada for Trudeau's administration as well, although I haven't followed the politics as closely so far. Most of the ideas that get bandied about don't actually seem to address this. So let's talk about some of the other ideas and their drawbacks. So what's wrong, Skanda, with cutting the gas tax?
Skanda: (10:54)
When we think about gasoline, it is scarce in the sense that you can look at the inventory data to say it's scarce. We can see that the supply picture for crude oil and in terms of global refining capacity, there's a clear crunch that is tied to the Russian invasion of Ukraine. So we're dealing with real scarcity here.
And if we think about the gas tax as a prop for making it easier to consume gasoline, it's a subsidy for demand at a time when it's scarce. That typically doesn't check out. It may sort of cross-subsidize in some ways, through a bunch of intermediary mechanisms, the supply side. But it's pretty inefficient if it's gonna do that. And it actually, it creates a disincentive for actually adjusting your consumption for those people who can adjust their consumption.
I think obviously in the United States, especially, there are a lot of people who just can't adjust their consumption very easily because they're kind of dependent on an internal combustion vehicle for their livelihood. There are people in Westchester County who could probably take the train a little more. So there's clearly some ability to adjust consumption that you're taking off the table, when you sort of take these sort of blunt measures. All else equal, it's a subsidy for consumption and subsidy for demand when the root cause that we really wanna attack is on the supply side. If you want to bring supply and demand into balance, you'd want some adjustment on the demand side and some increase in terms of on the supply side.
Joe: (12:24)
So, alright, here's another one that people talk about. What about banning exports of energy? You hear that too. It's like, okay, the world demands a lot, but we have plenty here and we have plenty of capacity. Why not just keep it all here so that US consumers aren't fighting with global consumers?
Rory: (12:44)
I think there's two ways you could think about it. One, the US had a crude oil export ban for a very, very long time and, and repealed it about a half decade ago. That actually in some ways has actually been pointed to — that repeal, ironically, has actually been pointed to as one of the reasons that the US refining sector has kind of waned a little bit over the past, you know, five to seven years because the ban had actually artificially kept the price of Western, you know, West Texas Intermediate or domestic US feed stock at a lower price than global. So it was actually effectively a subsidy to refiners. Now what they're discussing and what's been kind of floated around from some of the, you know, leaks out of the White House and elsewhere is a potential ban or at least, limiting and cap on the export of refined products.
Because while the US, you know, does have all of these kind of, you know, imports and exports, it is actually a net exporter of gasoline, diesel, etc. And that is, you know, and a lot of that goes to Latin America in particular and elsewhere and banning that in particular would be, you know, a recipe for a diplomatic crisis. A lot of allies depend on that and it would just kind of, you know, it would further punish US refiners because right now, sure, now they don't have a discounted feed stock, but now they actually have really, you know, high value export markets that they're exporting to. If you take that away, then it's really going to be, you know, a one-two punch for domestic US refining.
Tracy: (14:11)
So could you talk a little bit more about the mechanism for making this happen? So if someone says ‘ESF’ or the Exchange Stabilization Fund, I mean, I have a very, very vague memory of it during the financial crisis, but what exactly is it and what has it been used for before?
Skanda: (14:31)
So the Exchange Stabilization Fund exists within the Treasury Department. It has been used for a variety of crises, but the statutory purpose is around sort of the commitments the US has to the IMF that promote stable exchange rates. So it could be in some cases very direct, and that even still with some controversy — say the Mexican Peso crisis of 1994/95, the Treasury got involved, made some short-term loans through the Exchange Stabilization Fund. It kind of got the moniker being a high discretion instrument, but to support stable exchange rates in 2008, Hank Paulson, then Treasury Secretary, used it to guarantee money market funds under the guise that stable money market funds would be better for exchange rate stability. I think that's a pretty legitimate argument, but it is attenuated, right? You have to acknowledge that you're trying to like keep money markets and keep what was a brewing and actually spiraling financial crisis at the time, keep that in check. That did create exchange rate volatility.
Something between the two is what we're calling for in terms of, well, it may not be directly an exchange rate intervention exchange rate, and balance of payments struggles that are again right now brewing and growing in terms of developing and underdeveloped countries. And in terms of sources for exchange rate volatility, commodities play a pretty big role, specifically oil and food.
That's what really matters for import bills for a number of countries. And it's where oil price spikes, especially we haven't really seen the big declines yet in terms of the supply risk from Russia and what the implications are like, if we want to attack those root causes, there's a pretty strong case, I'd say a stronger case than the money market fund usage. And I should also mention Steve Mnuchin did pretty much the same thing, probably through a slightly, through sort of Fed facilities, using the Exchange Stabilization Fund before the CARES Act passed to effectively backstop money markets through Fed facilities using the Exchange Stabilization Fund.
So we've used it for those three purposes. This is a little, yeah, I say less attenuated than that. It's within the discretion of the statute. And I would say you can make a very strong case that supporting stability and supply demand balances and reducing likelihood of price spikes in key commodities can be very justified and legitimate. And at this point, the Treasury has $221 billion in that account with the ability to actually use it pretty flexibly. I think there are a lot of people who will shudder at the notion of using it for this purpose. But I think it's also a time when we really need to think seriously about what the supply implications of supply risks are on exchange rates and financial stability.
Joe: (17:06)
Let me ask you another technical question about your plan. So the implicit question is, how do you de-risk production now? Because as Rory pointed out the shape of the futures curve could tell investors where they can hedge in or what the market is paying for oil 18 months out. And it's not as attractive as spot.
So the price that we see on the screen — $110 West Texas — isn't necessarily the price that investors could get. And so, okay. You want to lower the short end, which is what retail pays the pump, and you want to put a floor under the long end, so that companies will produce more. And that creates that sort of like, you get that supply response, where do you price that long end? So you're talking about the idea of like, you're the government can give a put and so de-risk production. How do you price that? What is guaranteed if I am an oil company and I'm looking at this plan? What is like the sort of economics that the government is potentially offering me here in order to drill more and produce more?
Skanda: (18:09)
There are advantages to sort of doing a forward contract in terms of simplicity, right? We look at the forward curve, we try to use that to price. And I think that's a pretty helpful and legitimate way, as Rory laid out. And we lay that out in our original proposal that this is something that it comes with — you take a smaller profit margin effectively, when you lock in as a producer forward prices, but it's certainty. And if you can leverage that up, that's still pretty valuable. But if you've seen the oil and like number of E&Ps that have talked about lifting their hedges specifically, they don't want the burden of locking in lower forward prices when they could ride high right now on current spot prices. And so for those that have free cash flow and are not capital constrained, so they don't really have a need for financing and they have enough retained earnings to accelerate investment as they so wish, they may not be as interested in that.
I think they would still be interested in sort of downside price protection, such that they have the option. Like optionality is valuable, even if you are — so let's say, we actually don't know how long oil crude oil markets are gonna stay tight. If they're going to get tighter, for how long they're going to get tighter, like it may be a year. It may be a few months, maybe it's it's multiple years. And in that environment, if spot prices are high, you can still sell at high prices, but if prices crash and that could happen because of recession, that could happen because of OPEC, that could happen because of maybe electric vehicle adoption, right? There's all those uncertainties that are very real.
And I think all the major CEOs are getting those questions from their shareholders and internal management of “what do we do in those environments?” Well if you have actual downside price protection — and price risk is by far the biggest risk to really think about in this industry — then I think it's a pretty valuable thing to say “okay, we can actually accelerate some investment in exchange for having the downside insurance that you need.”
So to me, to actually make that financially viable, the optionality is kind of critical. And I think I've talked to at least a few people who work at E&Ps to kind of understand the financial math here to a degree that would suggest the optionality is valuable, even if I'm not someone who hedges in terms of forward contracts. It doesn't solve every problem in the industry. There's obviously other things that matter, but I think this is getting at a pretty key source of uncertainty and risk.
Tracy: (20:37)
I have a non-technical question, I guess it's a question about optics, which I've increasingly come to realize are very, very important for the way policy is actually made. But when we talk about the Biden administration essentially providing a backstop or a way of incentivizing further oil production, that just seems to be such a massively different position to the way Biden came in, where he was basically saying, we're gonna really crack down on the fossil fuel industry. We're going to encourage renewable energy, turn down emissions and all of that. How do you you manage the optics of moving from a clean energy policy to a policy where you're essentially incentivizing or trying to incentivize more production of fossil fuels?
Skanda: (21:30)
The principle of resilience is an important one to keep in mind. That actually we do need to walk and chew gum here because we did have a huge geopolitical shock. I think there were certain stances that were likely taken because it was politically convenient during the primary election season in 2020.
But the world has changed and their stances should be willing to adapt to the current moment especially. It probably was too far to begin with to say that, okay, we're gonna sort of block leasing and try to keep investment down in the oil industry in the US. And at the same time, it's also, you can just say the world has changed. I think that's okay. And like, why is it okay? Well, one, this kind of oil price volatility is not actually very helpful for a lot of reasons, whether it's social stability, whether it's even stability for the energy transition, because in the end, petrochemical products are also relevant for that purpose.
And so if oil prices spike because Russian supply rapidly comes offline, that's going to have a lot more economic dislocations than just about the price of the pump. So stability is good. And stability in a way that's actually preventing price crashes is actually, I'd say more in the spirit of trying to adjust consumption patterns for the better.
So if you're providing the kind of price insurance I'm talking about, that prevents the sort of price crash scenario in which we see gratuitous oil consumption and also one in which industry kind of gets financially cleaned out. So those are the kinds of things that I think the administration should see with clearer eyes and try to be able to bridge that gap. But it does, like say we have to walk and chew gum here. And I think that's something that if we don't, we're gonna have these really messy handoffs between oil and gas to whatever the future of sort of clean energy ends up being.
And you can make those investments, but those latter investments in clean energy do take time. The technology is still uncertain in certain dimensions. And so we should not expect those things to come online and somehow displace oil and gas instantaneously the technology and the production structure is just not there yet compared to the timeline it takes to be able to ramp up and ramp down US oil production, which is a unique phenomenon in terms of geology and technology coming together to turn what was once long-dated investments that had to happen are now on a much shorter cycle. It takes, I'd say, nine to 12 months before when you see rig counts going up to when you see production going up. And if you think about the decline rates itself also are higher in shale as opposed to the past. So these are sort of unique opportunities to really thread that needle. Unfortunately, I don't think that there's really been a lot of serious movement in the administration towards threading that needle
Joe: (24:22)
Let's bring in another dimension. Rory, one of the constraints that's getting a lot of attention and you already hinted at this is refining capacity. What's the problem? Where did the capacity go? And can you just sort of give us the sketch of like why the refining aspect is difficult right now?
Rory: (24:40)
Yeah. So I've been in the industry over a decade now, and the entire time prior to this year, refining has more or less been a boring kind of backwater of the overall oil industry in that it has been chronically oversupplied. Over capacity and margins have been kind of generally bad.
Mix that with the fact that, you know, having a refinery, it's a very highly polluting, emitting facility. A lot of communities don't want them around. They’re typically very old. The classic refrain is that there hasn't been a new major greenfield refinery built in the United States since 1977 which is a very, very long time to go without new facilities.
All of the capacity growth we've seen has basically been bolted onto existing facilities. And just to put in perspective, the extent of the crisis we're currently facing, normally crack spreads or what we'd call refining margins — the difference between the price of crude oil and the value of the refined products themselves — normally that's between, you know, $10 and $20 a barrel.
So on top of the price of oil, consumers are paying that $10 to $20 a barrel of refining cost essentially at the pump that is currently at, you know, in the United States, between $50 and $70 a barrel. Three and a half times normal.
And that's why while oil prices are very high, consumer pump prices are exceptionally high. And that's a big part of the reason why. So it was generally undesirable to invest in new refining capacity for a whole bunch of reasons, particularly in the West, North America, Western Europe, etc. At the same time, you had this capacity pressure from a lot of particularly emerging markets. There's a major refinery that's been coming online for a while now in Nigeria.
And the other areas that you have a lot of capacity coming online is China and India, where, you know, a lot of the incremental demand growth is expected. And they’re are going to be very new, highly sophisticated refineries. So they have been putting this pressure on. You saw this kind of tidal wave of capacity coming online.
So everyone was slowly winding down or at least disinvesting from their refining assets in the West. And then that trend was pushed into overdrive during the initial bout of Covid when obviously demand completely collapsed. And everyone was like, “Okay, well maybe we're planning on retiring this facility in a year or two. Let's just do it now because this seems like a terrible time to kind of try and hold on when we're so close to the end.” So I think what's really happened, unfortunately, is we have this capacity coming down the line globally.
And then we had this bridge of these kind of old facilities that were gonna kind of get us across the finish line. And that bridge has more or less been collapsed by Covid and now we're in this period of exceptionally high and exceptionally volatile refining capacity constraints that have been pushed into further overdrive by things like the Russia shock.
Because in addition to being a major exporter of crude oil, Russia is also a major exporter of refined products, mostly kind of partially refined feedstock, but also diesel. And finally, the other thing that's kind of together at the same time here is that China is also normally a fairly large exporter of refined products. But for a variety of domestic reasons, one of the most notable ones being a stated intention to reduce the emissions in China, they've actually been running their refineries less hot and basically banning exports. Not fully banning, but drastically restricting exports.
So I think when you're looking at what can be done, one of the the simplest things theoretically would be to try and press Beijing to loosen those refined product export restrictions.
Alternatively, the other thing, and we've been talking about policy options here, one of the policy options that has been generally been kind of derived, I think by the industry, but I think is actually pretty interesting is this idea floated normally associated with Secretary Yellen of a buyer's cartel or a price cap on Russian exports.
And this would be effectively a way of saying, “okay, instead of having full blown kind of Iran style secondary sanctions on anyone purchasing Russian exports, you will only sanction barrels that are purchased above a certain price threshold so that you can still reduce pressure or you can kind of reduce pressure on the overall global price system while also still depriving Moscow of war revenue.” So I think this is, you know, we're trying to find all these different ways to address this situation. I think the same general philosophy could be applied to refined exports from Russia as well.
Tracy: (29:32)
So one of the criticisms of government intervention in a market has always been that it might inadvertently end up exacerbating booms and busts versus actually smoothing them. And we've seen this dynamic a number of times in places where there is a lot of government intervention. And I'm thinking mostly of China. And one of my favorite examples there is the government trying to smooth out the pig price cycle post-African Swine Fever. So, you know, prices went up because there was a shortage of pigs and then the government tried to ramp up pig production and prices collapsed. And everyone who had decided they were going to become a pig farmer and expand their pig production facilities suddenly was losing money. So I guess my question is how do you ensure that these types of support measures smooth the cycle rather than exacerbate them on the way up as well as on the way down?
Rory: (30:28)
I mean, the issue here is that we're in an acute crisis today. So I think there's this question, like there's an example for instance, of over a hundred year old refinery in Texas that is slated for retirement next year. And the kind of estimates I've seen are that it would cost $3 billion to get it up to kind of get it back to some kind of, you know, reasonable state of operation. And while $3 billion is obviously a tremendous amount of money when the overall kind of consumption base globally and particularly in the United States is paying, like I was saying, kind of three to five, you know, three to four times the refining margins. It's very easy to cover, you know, the economic impact of $3 billion on that scale very quickly. So I think the hope is that you can kind of get a short-term stopgap solution that then you can kind of let the market take back over.
Because again, we're mostly trying to combat the effects of this, you know, exogenous shock of Covid that pushed all of, and this is a classic theme on your podcast, especially of accelerating these preexisting trends. And that had happened for, you know, in the bad ways of kind of a wind down of the industry. So I think the hope would be to kind of do something temporary as a stopgap. And then also I think when we can start to think about things like Skanda’s proposal on the SPR, I think that is a way that you can kind of change the kind of operational conception of an asset like the SPR to be more flexible and more useful in all of these instances, because you're not, if you're just shifting the shape of the curve, that's by definition, not going to exacerbate booms and bust, you are flattening that boom and bust.
Joe: (32:13)
Just to be clear Skanda or Rory, is there anything the government can do right now to expand domestic refining capacity? Are there facilities that were recently closed that could be reopened? Are there other facilities that could be expanded? Like what can be done there?
Skanda: (32:32)
Refining as an industry, it's very hard to sort of make a buck over time. You typically have one or two years in which the bulk of the payout really materializes. And so when you think about the amount of duration in your capital structure, you need to be able to actually manage that. This is not gonna be something that's solved through any kind of short-term financing or anything like that. It's something that you do need to sort of directly fund, that some people may not like that, but that is something that if it costs $3 billion, like that's something that's that's got to be considered if you really want to kind of keep existing capacity online. There were a number of refineries that were closed in the last five years.
So this has been a sort of secular phenomenon and nothing really related to the political cycle. It's not easy to be able to turn on a existing refinery. You should really have an engineer on to talk about what it would take. I've talked to a couple of them who have talked about effectively restarting a refinery in certain countries, and it does take time. It's not impossible. It could be on a timeline that's still is relevant for sort of bridging the gap between where refining capacity is now and where it likely will be in a few years when, especially in emerging markets, we see refining capacity emerge.
And so in that time there's probably something useful to be done. It's just important to be a little bit humble about it and that there is a refining bottleneck, there's only so much you can do. You can try to fund some of the existing capacity and make sure it doesn't get shelved too quickly. And probably there's stuff on the trade side with China — I don't want to go too much into the motivations, but the fact that we're in a global refining capacity crunch and they have kind of intentionally decided to not run their refineries at quite the same pace that we're seeing in the US, there may be something to do there in terms of diplomatic and trade channels.
Tracy: (34:19)
So Joe and I were talking about this a little bit in the intro, but the Fed is raising rates until inflation comes down, energy and gas prices seem to be a big part of rising inflation. What exactly is the impact of raising interest rates on oil and gas prices? Because on the one hand you would expect raising interest rates to bring down consumption and reduce prices that way. And at the same time you would expect lower prices via demand destruction not to be necessarily a good thing for encouraging future production increases. So how do you square the sort of the overall impact of rate increases on prices here?
Rory: (35:04)
Well, what's really interesting here in particular is, you know, even in years where we've had very serious recessions, like back in the 2008/2009 financial crisis, you didn't actually see that much of an outright contraction in global oil demand. It was really more of a flattening typically, obviously in the beginning of Covid you did, but that was a very particular kind of recession.
So I think theoretically, what you would do is you would more or less buy time for supply to catch up rather than bringing outright demand back down to the supply level. So it would help, but it would help in a very disruptive and kind of economic and socially deleterious way. The other irony here, like you were saying, not only would you theoretically by bringing prices down, reduce the incentive to invest more in new supply.
But I think one of the things I was saying last time I was on the podcast was oone of the things I think will drive eventual E&P reinvestment will be the performance of their equities. And what we've seen by this aggressive move by the Fed has obviously taken a tremendous amount of air of the overall market, but that includes oil and gas equities, which while still performing very well have actually fallen back considerably over the past week or so. So that again, I think pulls back in the wrong way. It's one of those things that you could theoretically get to that goal, but kind of in a roundabout and kind of deeply ineffective or inefficient manner.
Skanda: (36:38)
I'll just tack on two key mechanisms to really think about here. One is even though the price of oil in the US has obviously gone up quite considerably, it's actually much higher for countries that are not gonna peg to the dollar, right? So actually the dollar effect, so we've seen dollar appreciation that is effectively, oil is much more expensive, has actually increased even more in a number of developed and developing countries. And so that's one part of demand destruction where it's actually the burden for other countries and not the US, through some of the Fed's actions and the Fed’s forcefulness right now. And so that's one part of it. The other part that I would just highlight is yes, maybe the Fed tightening at the margin leads to lower inflation and lower prices through some sort of demand channels, but it is going to cram the supply side too in the process because every single E&{ is probably getting the question now of, are you sure that your capital plans can withstand a recession, especially since like the return performance has been so poor? And I think that's a very rational question. And it's one that I always say the Fed's pretty much encouraging them to ask this question, which I guess maybe it solves some sort of big macroeconomic inflation challenge, if you push it hard enough, like Volker. But it's actually not good for the supply side responses that they claim to be hoping for because it leads to greater reluctance to invest.
Joe: (37:55)
So this is where I was going to go, Skanda. I mean, big picture, you've been really sounding the alarm pretty intensely on this topic for a while. Why the urgency? How big of a deal is it? What are the stakes that we're talking about?
Skanda: (38:18)
I think it's so urgent. And obviously we are a think tank focus on full employment. And yet we're sort of talking about oil. Oil price shocks are macroeconomically relevant. Commodity price shocks are macro economically relevant, and they can actually lead to greater business cycle instability. And over time, if that instability is not managed, it leads to recession, higher unemployment, slack labor markets that are bad for everyone.
There's two channels I think are really important to think about. They're both very highly salient to this current moment. One is, let's leave aside the Fed for a second. Oil prices going up. If oil prices spike further from here — which I think there's clearly a scenario in which that can materialize — that is one in which you'll see more consumer spending be dedicated towards the price of the pump, food.
These are the areas where we've seen commodity price spikes in general, but I'd say in elastic sectors. And so non-discretionary. That takes away demand from discretionary sectors. All else equal, consumer discretionary sectors is where there's actually a lot of labor. That's also tied to it. So we'll see employment demand at risk of turning the other way, where we actually see there are layoffs potentially in those sectors and that itself is important. And it's something that I think a lot of people who say “well, the US is a net oil exporter now” or “we're energy independent”. And yet it kind of misses the fact that the elasticity of investment in the energy sector has really changed. Again. I remember in 2015 and ‘16, everyone was very bullish about the economy.
It's like low oil prices are good for the consumer while missing the fact that actually it was fixed investment that rapidly declining because of oil prices declining. And there was a high elasticity at that time. So the elasticity of capital expenditures to the price of oil was exceptionally high between 2014 to ‘16. And those macro implications almost led to a recession.
The Fed ultimately backed off their sort of hiking plans. And I think that was actually pretty critical to keeping the expansion alive, but it was largely missed by the Fed, the Obama administration and most of the main economists at the time who are focused on this. They thought it was going to be a big consumer benefit and a big win, but it really required the Fed to back off their hiking plans for business cycle stability to materialize.
Now you're seeing the opposite where actually the elasticity has gone down. So expecting a big capex boom in the energy sector to offset whatever is happening in the consumer discretionary sector may not happen, especially because we've seen that rig counts have not increased at the same pace as you would expect, given oil prices. You're not going to see the same fixed investment boom that you might have otherwise have expected or seen in prior oil price increases. And so that is itself a source of instability. The second part is what Jay Powell effectively admitted, which was that oil prices do weigh on their thinking now that they are thinking about energy inflation and whether that actually takes them away from their target for longer.
And that kind of plays out through just oil prices going up and then the Fed just responds. But also like there are gonna be growing pass through issues that we need to take seriously. Pass through from price of diesel to the price of retail goods is a tricky thing to model. It's sort of, sometimes it shows up and sometimes it doesn't, but typically the bigger the price spike, the more non-linear the response and the more likely you see pass through materialize. So we're kind of flirting with a lot of risks in this direction and the Fed responding to those risks with tighter policy is more likely to translate into sort of recessionary financial conditions,
Joe: (41:46)
Rory and Skanda. So great to have you both huge topic. Great conversation. Thank you for coming on Odd Lots.
Skanda: (41:53)
Thanks so much.
Rory: (41:54)
Thank you.
Tracy: (41:55)
Thanks so much guys. Yeah, that was great.
Joe: (42:08)
Tracy, I thought Skanda’s answer there, you know, setting aside how you elicit the the supply response, the stakes are really high.
Tracy: (42:17)
Totally. But you know what? I had an epiphany over the weekend, which was basically that everything comes down to cycles, right? And booms and busts and we always overshoot going down and then undershoot going up, and it just feels like people especially have a tendency of internalizing whatever their last experience is. Which means that everyone reacts very slowly to a changing environment, which is why I think it's hard to incentivize more production in things like oil and gas or lumber, which we've spoken about before. Infrastructure, everything like that.
Joe: (42:52)
Well, I was thinking about this after our last episode with Peter Tertzakian which is, if you think about like a game theory matrix or whatever, in the 2010 to 2020 era, we had this like really like good one for consumers where there was a lot of incentive, especially after 2014, to pump more even though it wasn't that profitable. And, you know, I was thinking also, you could say that was the state of housing pre-Great Financial Crisis. Like that's what we had between 2003 to 2007, just like this massive increase in home building etc.
And we've never been able to get that back. We've never had like a big home building boom outside of those years. And so, you know, we had this huge costly oil and gas boom from 2014 through 2020, it's gonna be really hard to get that back with respect to oil and gasoline. But in the meantime, the costs are very high. The risks are very high owing to the effect on monetary policy or, you know, just consumer buying power.
Tracy: (43:52)
So you could see why you might want the government to come in and try to smooth these boom bust cycles a little bit. But on the other hand, you know, I asked that question about optics. You know it comes down to that and I think it's gonna be very, very hard for the administration to sell something that's basically, you know, ‘we're going to subsidize or incentivize oil and gas’ versus something like a tax holiday on gas, which is much more, I think, politically pleasing because you're aiming that at consumers.
Joe: (44:22)
Right. I mean, that's still unclear to me whether there is a significant force within the administration that actually like wants increased production. I think at this point there is, but it's tricky. I think there are other things that maybe don't move the needle as much that are more politically popular, like the idea of a gas holiday. But in terms of like, ‘will we use public money to subsidize and backstop energy producers?’ that still seems like politically a tough sell, but again, stakes seem pretty high.
Tracy: (44:53)
Yeah. Alright. Shall we leave it there?
Joe: (44:55)
Let's leave it there.
You can follow Skanda Amarnath on Twitter at @IrvingSwisher and Rory Johnston on Twitter at @Rory_Johnston.