Re: Oil/Inflation-Supply/Demand Curves & OPEC+'s Fantasyland.

OPEC+ has sacrificed long-term gain to avoid short-term pain.

Two weeks ago, I wrote about OPEC+’s decision to jump into the Geopolitical Mosh Pit with its surprise cut of 1.65 mmbpd of Oil production:

Re: Oil/Inflation/USD-Clash of the Titans.

Unfortunately for all of us and ultimately for OPEC+, I believe the Fed will ultimately win this Clash of the Titans.

First, let me clear up some confusion between Supply/Demand SHIFTS vs. Supply/Demand Curve TILTS so I can chronicle the Fed vs. OPEC+ tit-for-tat VISUALLY.

Let’s start with the Fed’s Inflation Fight mission first. The Fed, armed with only the blunt tool of MONETARY POLICY, needs to LOWER THE AGGREGATE DEMAND CURVE FOR ALL GOODS AND SERVICES by engineering an economic slowdown and job losses.

This results in a DOWNWARD SHIFT IN DEMAND for EVERYTHING, but for the purposes of this illustration you can assume the x-axis to be for OIL specifically.

This is the negative feedback loop on Oil Demand that made me start turning progressively more cautious and bearish last year despite having a bullish long-term thesis. I note several key posts:

Re: Oil-Trying To Cut Through The Noise.

Re: Inflation/Macro-Asian Contagion 2.0?

Re: Oil-The Great China Re-Opening (Or NOT).

Note: Do not confuse Oil FORWARD CURVES with Economic notions of SUPPLY/DEMAND CURVES. The post below does a deep dive on forward curves and when they have meaningful signal content and when they don’t.

Re: Oil-Forward Curves & Holy Grails (or Lack Thereof).

Having the right ECONOMIC framework in thinking about Supply/Demand Curves kept me out of trouble in the Oil market during 2H’22 and certainly trumped the spurious “signal” of a continuously backwardated Forward Curve:

Now let’s revisit the recent OPEC+ surprise in response to this Downward Demand Shift for Oil.

Not to be outdone, OPEC+ (the Central Bank for OIL) decided to curtail production and SHIFT THE SUPPLY CURVE UP AND TO THE LEFT, which obviously spiked prices:

As I said then, I believe this move was short-sighted on OPEC+’s part in avoiding short-term pain at the expense of long-term gain:

Michael Kao @UrbanKaoboy

I've said it before, and I'll say it again: OPEC+ move to SHIFT Supply Curve to the left will result in more Supply AND Demand Elasticity. This cut was premature, imho.

Michael Kao @UrbanKaoboy

@IlliniProgrammr @kdubbsy @redmonkeygenes @bvfin216 Unemployment hasn't even picked up yet. Withhold judgment until it does and then see what happens. Be a permabull at your risk. I've been to this rodeo too many times. I think OPEC+ will likely need to cut again before all is said and done.

Let’s delve into what I mean by INCREASED SUPPLY ELASTICITY.

As opposed to a SHIFT in the curve (like a surprise cut), it results in a DOWNWARD TILT TO THE SUPPLY CURVE, which ultimately results in LOWER PRICES GIVEN THE SAME DEMAND AND LESS UPWARD PRICE IMPACT GIVEN THE SAME LEVEL OF DEMAND INCREASE:

Where does increased Supply Elasticity come from?

OPEC+ Spare Capacity for one, which is now extremely high, post-cut.

This chart is courtesy of Lakshmi Sreekumar of Capital One, who estimates total Global Spare Capacity to be close to 7 mmbpd now, post-cut:

Also, remember that China has been stockpiling its SPR even as we have drained ours, which also adds to future Supply Elasticity and will likely prevent fly-away prices even in a geopolitical emergency.

What about increased DEMAND ELASTICITY?

As I mentioned in my “Clash of the Titans” post, Oil Demand tends to be Short-Term Inelastic but Longer-Term Elastic as sustained high prices eventually lead to some level of SUBSTITUTION AND BEHAVIORAL CHANGES.

INCREASED DEMAND ELASTICITY RESULTS IN LOWER PRICES GIVEN THE SAME SUPPLY AND LESS UPWARD PRICE IMPACT GIVEN THE SAME LEVEL OF SUPPLY DECREASE:

OPEC+ cutting now with Oil prices still relatively high while the Fed is still committed to its Inflation Fight (despite what markets may be pricing in) means that the transmission mechanism for demand destruction will also potentially be more effective, i.e. $90-$100 Oil now could be just as demand destructive as $150 Oil before the Fed and global CBs embarked on global tightening, which dampens demand for EVERYTHING, not just Oil.

Note that what I mean by Demand Destruction is MORE LONG-TERM DEMAND ELASTICITY as opposed to a short-term DOWNWARD DEMAND CURVE SHIFT/SHOCK.

Also note that one very possible path this can lead down is successive tit-for-tat rounds of Downward Demand Shocks (engineered by the Fed) followed by additional Supply Cuts which increases Supply and Demand ELASTICITY. This is how Backwardated Oil markets can wind up in Contango again.

The reason why I think this is a real possibility is because the recent downward shifts in CPI/PPI were mainly from the LAGGED EFFECTS OF LOWER OIL, but OPEC+’s actions will now likely result in FORWARD UPWARD SHIFTS in CPI/PPI:

In other words, had OPEC+ left things alone, the Fed would have likely backed down from its Inflation Fight sooner. NOW I FEAR THAT THE FED WILL BE FORCED TO STAY HIGHER FOR LONGER THAN MOST BELIEVE — ESPECIALLY SINCE IT WAS OIL INFLATION THAT STARTED THE INFLATION CONFLAGRATION IN 2021, GIVEN OIL’S CRUCIAL ROLE AS PRIMARY FACTOR OF PRODUCTION IN SO MANY AREAS OF THE ECONOMY.

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Let’s recap now and see what’s changed from my Oil Base Case thesis.

Prior to this OPEC+ action, I thought the Downward Demand Curve shock would ultimately be followed by an even more INELASTIC Supply Curve (from less investment in the space), increasing the chances of what I call the SUPPLY/DEMAND SINGULARITY:

In this scenario, the eventual Fed Pivot results in an UPWARD DEMAND SHIFT AGAINST AN INELASTIC SUPPLY CURVE. I thought there was a possibility of this happening as soon as 2024.

Now that OPEC+ has tried to avoid short-term pain, I worry that it has also borrowed from long-term gain, PUSHING OUT (BY YEARS) AND POSSIBLY EVEN NEGATING THE SUPPLY/DEMAND SINGULARITY THESIS.

In this world, the Fed stays vigilant longer and OPEC+ MAY HAVE TO CUT AGAIN BEFORE YEAR-END, RESULTING IN MORE LONG-TERM SUPPLY/DEMAND ELASTICITY.

What does this mean for Oil Prices? My guess is that it will result in a LOWER LIKELIHOOD OF FLY-AWAY OIL PRICES and be harder to predict / range-bound for a longer period of time.

The Supply/Demand Singularity Thesis is one in which OPEC+ loses control of the market. THIS NEW REGIME OF MORE SUPPLY/DEMAND ELASTICITY REDUCES THE CHANCES OF A SUPPLY/DEMAND SINGULARITY EVENT AND RUNAWAY PRICES BECAUSE OPEC+ LIKELY MAINTAINS CONTROL.

Meanwhile, OPEC+ is publicly predicting DEMAND GROWTH of 2 mmbpd just as the globe is staring into the teeth of a potential SYNCRHONIZED RECESSION. I wonder if they also believe that the Tinkerbell flying over Sleeping Beauty Castle after the fireworks show is real?

Welcome to OPEC+’s FANTASYLAND!

I hope to be wrong about this, but unfortunately I think the Fed has the upper hand in this Clash of the Titans, and OPEC+ may have prematurely emasculated its chances of a more durable longer-term bull market in Oil.