Adam Rozencwajg - Global Macro Series - October 26th, 2022

0:00:00 Adam

I do think that things have really fundamentally changed here, and I think the next number of years will be a little bit different. I think we have to let the dust settle to really understand the impact of the last two years. I think we’re in the process of fundamentally changing a lot of things that we took for granted over the last 40 year period.

I think we have to be a little bit more willing to broaden our horizons and accept things that look fundamentally different because I do think we’re in much more uncertain times. 

0:00:34 Intro

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Here’s your host veteran hedge fund manager. Niels Kaastrup-Larsen. 

0:01:27 Niels

Adam, welcome back to the follow up conversation you did with Cem and I, about a month ago, where we simply ran out of time because there was so much that we wanted to cover with you. First of all, how are you doing today? 

0:01:42 Adam

I’m doing very well, thank you. It’s good to be back. I can’t believe it’s only been a month. It feels like a year’s gone by. 

0:01:49 Niels

I know, busy time. What about you, Cem? How are you doing? 

0:01:52 Cem

Doing well. I agree. There’s a saying, what is it? Sometimes in days, years happen. That feels like the world we’re in right now. 

0:02:03 Niels

Absolutely. Time flies when you’re having fun.

Anyway, last time we started off talking about the supply challenges of the world that we are facing. Since we don’t have so much time today, unfortunately, maybe take five, ten minutes for you to just recap the highlights, what the issues are in your view, Adam, with the supply side, before we jump onto more the demand side of things. 

Since we last spoke, one big thing has happened, is that the OPEC+, I believe it was, announced a significant production cut, and also making it very clear that energy security comes at a price.

Do you want to just quickly recap the supply issues and then we’ll jump onto the demand situation. 

0:02:51 Adam

Sure. In many ways the supply issues have really been a long time in the making. Basically we’ve been underinvesting in the traditional oil and gas business now for probably pretty close to 10 years.

There’s a lot of different reasons for that. I think one of the reasons is that we could underinvest. What I mean by that is, starting in the 2010s, we brought on the shale oil fields and the shale gas fields, and each of those, both the oil side and the gas side was the equivalent of bringing on a new Saudi Arabia.

Instead of bringing on a new Saudi Arabia, which does 10 million barrels a day, it took them about 40 years to ramp up to that level. We ramped up in the United States in about 10 years, and we did it on the oil side and on the gas side. We had a huge, huge, huge new source of supply come online, and that provided ample excess energy into the system really starting in the beginning part of last decade.

That allowed us, to a certain extent, to under invest. For a period of time it allowed us to not really have to be too on top of the energy supply story. Every year that it happened, it ratcheted a little bit tighter and a little bit tighter. We’re now at the point where we’re spending 70% less than we were in the 2010 to 2014 period, and 30% less than we were in the 2019 period, which already that was too low. 

We’ve just been starving this industry for capital for a long time and now it’s coming home to roost. We’ve been in chronic under-supply in the oil market since the middle part of 2020. We first wrote that we’re entering an oil crisis

at that time. It might have been a strange time to do it because oil had been minus $37 a barrel a few weeks before. But in fact, what we were doing is we were laying down rigs, shutting down production, and we said, “Look, we just don’t have enough excess capacity to do that.” We’ve been taking down inventories ever since, living on borrowed time, and now we’re at the point where inventories are extremely low. They’re at 40 year lows, if not longer. 

The strategic petroleum reserves, which is what the government keeps in case of emergencies, have been whittled down, in the US, from 700 million barrels to 400 million barrels. It’s just been announced that they’re going to continue to release from the SPRs.

We don’t really see any relief in sight. That this idea that the shales are going to come in and save us is basically turning out not to be true. The rest of the non-OPEC world is in shambles. Now, that leaves OPEC and OPEC+. At exactly the sort of wrong time that you’d expect, you’re starting to see OPEC+ announce this massive 2 million barrel a day supply cut. 

I think it’s so interesting because you talk about some of the strange things you see if you do this long enough, and you go back to the summer of 2020, and you had half the world under lockdown, oil demand was falling so fast that no one could even really measure how far it had dropped peak to trough, and OPEC raised production. It was the strangest thing that they could have done. 

What happened was Saudi Arabia wanted to cut. Russia didn’t agree with them, and so they got into a bit of a spat and they decided to both boost production. You boosted production at the heart of Covid and you’re cutting production going into the winter of 2022, 2023 when we’ve completely run out of oil.

Cats are dogs, up is down. The sky is red a little bit right now. Nothing seems to be making a lot of intuitive sense. I think that what we know is that we have a very tight supply side going into the winter here. 

0:06:26 Niels

Yeah, absolutely. Cem, why don’t you kick it off with the demand side and we’ll just see where we go. I think we’re going to go a little bit wide. 

0:06:36 Cem

Yeah, absolutely. I’m going to quote from your most recent newsletter, at least I think it’s your most recent. I think this is particularly telling you, mind you a month or two prior to the OPEC+ decision, “Following the dual crisis of the 1970s the United States, among others, established their strategic petroleum reserves. The reserves were meant to protect against sudden unexpected supply disruptions, but they had a secondary feature as well. Having a strategic reserve made it difficult for aggressive states to threaten supply disruptions as a weapon, the so-called “oil sword.” The thinking went, disrupt crude oil production, but maintain that disruption for a long enough period to fully deplete the SPR. For the past 50 years the strategy was successful and the oil sword remains sheathed. Today, given their drawdowns, commercial and SPR inventories are the most vulnerable since the 1970s. Given the fragility of the world’s energy supply, it is no wonder tyrants and despots are moving to weaponized fuel sources. What is to stop a bad actor state from pursuing disruptive actions? Who has the capacity to do this other than the Saudis?” 

So that is my question. We got what you’re saying there, and the supply side is very inelastic. You’ve expressed that several times. There’s the demand side, which is more elastic, and then the supply side, which is very inelastic. I think it’s important to paint that picture. Given what OPEC+ has done, again you pretty much laid out the case for that starting to happen in this world.

I’ve talked about this as well, during the 1970s when there’s resource scarcity, these things cluster. OPEC+ does their thing. Wars happen. You get all of these different inflationary effects clustering.

Not a surprise here, and you called it out right there. What else can happen? I’m honestly surprised that oil’s still here at $82 given that happened. What are your thoughts on that? What else could potentially happen here? How bad can it get?

0:08:53 Adam

Sure, I think the reason that we’re here right now is that we’ve seen huge liquidation in the paper oil markets, and we’ve seen a huge amount of people positioning themselves basically for a recession, and for a huge slowdown in demand. We can talk about that. I do think that the problems in this market are squarely right now on the supply side.

There’s been times where really strong demand has been the driver of the oil markets. To a certain extent, that is a little bit true today in the sense that even now, everyone is getting demand wrong, and they’re underestimating demand, and it always comes in stronger than they expect.

I do think that the more acute problem here, like you said, the more inelastic side of this equation is certainly on the supply side of things. To be clear, I’m not entirely convinced that Saudi Arabia is acting as a “bad actor” here. I think more than anything else, and we’ve written about this in the past, we’re not really sure where Saudi Arabia’s total pumping capacity is. 

One of the things that we’ve said is that if their pumping capacity is less than expected (which we think it is), then every time they get up above ten and a half million barrels, you’re going to see them unexpectedly rest those fields because they’re pulling on them too strongly. The last time they got up above ten and a half million barrels is when they had that spat with the Russians in 2020, and they backed down pretty quickly.

It was within eight or nine months that they cried Uncle. Talk about an unexpected cut and pull back now. I’m not really sure what data they’re looking at that they could justify a 2 million barrel a day cut, other than they have to because of the quality of their reserves.

I wouldn’t go so far as to say that they’re really trying to be antagonistic towards the US. I know some people do say that, and we’ll know in retrospect. I think it might be something even scarier, which is the quality of their fields and their pumping capability.

What could we see going forward? I think what we could see is any number of things. People have asked also, I think it’s happened since the last time we spoke, that the Nord Stream Pipeline was sabotaged. The Russians blame the West and the West blame the Russians.

The truth of the matter is, if you think through on the game theory side of things, the Russians had a huge threat at turning off Nord Stream. It’s not clear that it works to their advantage to actually have the thing blown up, that you play that card, and they didn’t get anything for it.

Certainly the West, it doesn’t really make a lot of sense for them because it leaves Western Europe in quite a tough spot. I think the scary third option is that it was just some rogue, chaotic, actor. That’s what I mean when I talk about running down these SPRs. We don’t have a lot of buffer in the system.

Anybody can have an outsized reaction if they want to engage in something very disruptive. I think all you have to do is go back and look at what the Iranians did to the Saudi oil fields in 2019, at the Abqaiq processing facility in the Khurais oil field.

They launched a drone attacks. They were very targeted. They took out several storage facilities. It took out, I think it was 4 million barrels a day of oil capacity. That’s more than what we’re talking about with Russia’s impacts of sanctions and stuff like that. Can you imagine if that were to happen today?

If that same drone would attack? Obviously, if they did it then, they can do it now. I think that where it’s going to come from and who’s going to do it, you have absolutely no idea. But man, oh man, the world looks awfully shaky right now. Russia and the Ukraine are gathering people’s attention.

The situation in Iran, the situation in Syria, the situation in some of the former Soviet satellite states, like in the various Stans are all starting to heat up now too. I think this is one of those things, it’s impossible to predict where. To the extent that you lower the global buffer to be able to protect against these dislocations, the more susceptible we are in a very complex system. 

0:13:01 Cem

Yeah, I think we’re going to have to dive into the demand side here. The supply side has become pretty clear, I think. The reality is that since we had those conversations about how bad the supply situation is, we’ve drained the SPR more. We had the Nord Stream Pipeline bombing as you mentioned or attack, the OPEC+ cut (again, which we can argue if that’s a real cut or not), and the issues in Iran, as you mentioned. Think about that. That’s all supply yet, Oil is still at $82.

Let’s get into why, and that is the demand side. At least that’s the question. That’s at least what must be the way I think about it. I think you’ve laid this out as well, is that supply is very inelastic. Unless that demand piece pushes, it can’t move. Once it moves, it can move very quickly. There can be a big gap. The demand side is critical right now in what is, potentially, a pretty volatile dynamic. 

Obviously, the argument out there is China is still in lockdown. The demand side from the biggest source of demand in the world is a fraction of what it was, to the point where they’re not even releasing statistics anymore. They just (in the last several weeks) said they’re not even going to release statistics on how GDP is. They’re always questionable. Now they’re not even trying to fake it anymore. 

Obviously, the Fed is out there trying to crush demand, otherwise, to lower inflation.

How do you see the demand side for energy? Talk to me a little bit. Let’s start there and then I have a couple follow-up questions. 

0:14:52 Adam

Sure. I’ll start with what we’re not seeing. In the most recent International Energy Agency data, which does operate with a little bit of a lag (a month or two, not six or nine months or anything like that). It is fairly real time, but a little bit of a lag, demand is still actually really strong. In fact, there’s a big headline that they had revised down Chinese demand. They did, but they actually revised up rest of world demand, such that the global demand situation didn’t change very much. Inventories are still drying, so demand is running ahead of supply. Most importantly, we still have a balancing item.

Now, I don’t know if we’ve discussed this balancing item or not, but the IEA puts out monthly data: supply data, demand data, and inventory data. Presumably that all has to balance, it’s a tautology. Change in supply or the delta between supply and demand has to be explained by inventories. There’s nowhere else for oil to go. Sometimes it doesn’t and they have to introduce a balancing item. I think they call it miscellaneous to balance. We facetiously call it ‘missing barrels’ because they’re barrels that were produced, they weren’t consumed, they didn’t end up in inventory, so they’re missing.  Where could they be? 

We’ve often written that missing barrels almost always end up being revised away by having demand revised higher. When you get a big missing barrel number, it’s usually a fairly good clue that perhaps demand is running stronger than expected. The balancing item, through the second quarter, was running a million barrels a day.

If you add a million barrels to the quoted demand figure, you’re really, really high. Even now, even after the IEA revised down China, you look to oil numbers for next year. I think there are awfully close to 102 million barrels a day for the year next year (which is really sharp, like 2 million barrels a day growth year on year). The fourth quarter of this year it will be up well through 101 million barrels. 

You know the demand numbers, as of now, are still really, really strong. Now, could they weaken? Could we go into a full global recession? They certainly could, but keep in mind those numbers were released when China was under lockdown. That was not unexpected, that was not new, that was incorporated in those numbers, and it was done with relatively weak GDP data. 

It’s important to remember that the starting point here is very, very strong demand. Now if we don’t have enough supply, and with inventories where they are, at some point price is going to be used to ration demand. That sort of almost has to happen. Is that bearish for crude oil? I guess at a certain point it is, but I think it’s a very different story. When people call and they say, “I think prices are too high, we’re going to see demand destruction and oil markets are going to go into surplus.” I don’t think our clients, and prospective clients, and friends, are painting a bullish picture. I think they’re talking about how that would be really bad for crude oil. 

I said take those same facts and reframe them a little bit. What if I told you that we were running out of oil, for the time being, that we had a massive structural shortage and so we were going to use price to ration what we have left? Does that sound bearish or bullish? I think that’s the world that we’re going to, unfortunately, be in. We saw it happened last cycle as well. Back in the 2000 to 2010 period before the shales really kicked in, and there was a real concern that we were beginning to run out of oil.

I think we’re back into that world of shortage right now. Demand is looking very strong. It’s being driven by non-OECD growth. It’s being driven by continued development in the emerging market world, which is very different than demand coming from the OECD (from the West). We have a lot more demand elasticity than the emerging markets do.

Obviously China’s a big wild card, and I think some of the developments that we’re seeing in China are different than they’ve been in the past number of years. I listened to a few very interesting China speakers yesterday at the Grants Conference, and some of the changes that we’re seeing do seem to be quite real, but there’s other pockets of growth and strength in the world as well. 

We can’t forget that India has come out of nowhere to be the third largest line item in the IEAs global oil data and that’s growing very strongly. In other parts of the non-OECD world, and in Southeast Asia as well. There is quite a bit of uncertainty in the world. Probably more than we’ve seen for a period of time. I think that’s fair to say. But we’re coming from a very strong demand backdrop and a very, very tight supply picture. I think it’s something you just have to monitor really, really closely. I think it’s something that is not being priced in rationally right now. I’ll say what I mean by that in a second. I think it’s largely coming from liquidation in the paper markets from speculators and things like that. 

What I mean by not logically consistent, if you really think that demand for crude is going to be hit to the extent that people are talking about right now, we’re not seeing the same indications of other stress and strain in other parts of the financial markets. Whether you’re looking at things like the TED spreads; whether you’re looking at things like the future implied inflation rates and things like that. I don’t think that the chaos that you would need to really have demand destruction enough to push this oil market into surplus would be pretty, pretty severe. I don’t know that that’s what people are pricing across the board. 

I think what’s happening is people are really using the crude market and they’re selling the hell out of the oil futures, and the oil stocks, in order to try to express a view. Looking at the fundamentals, I just don’t see it right now.

The other thing that’s really helping demand (and it’s quite impactful) is there’s up to 700,000 barrels a day of natural gas to oil switching. There’s a lot of capacity around the world to switch certain power generating facilities from burning natural gas to actually burning various crude oil products in order to generate electricity.

We are seeing, given the fact that we have an acute gas shortage, notably in Europe, we are seeing gas to oil switching. That’s one of the reasons why Western Europe has been able to refill their gas inventories to the extent that they have, which has been almost nothing short of a miracle here going into the winter. I think it’s wonderful that it’s happened. A lot of that’s been because you’ve switched from gas to oil. That’s been a big tailwind to the oil market demand as well, that really nobody had that in their models more than a year ago. 

0:21:58 Cem

I’m going to add on what you’re saying.

This isn’t commodity specific. This is really inflationary. If you look at history in the sixties and seventies, the reason we had secular (that’s the important word, secular) inflation was because it was a very demand push economy. 

We were doing tons of fiscal stimulus via the Great Society Program. We had the Vietnam War, so there was tons of spending going into production to fund the war. You had a baby boomer kind of bubble, a demographic bubble coming in, pushing demand because they were in their primary household formation years. Does that sound familiar to anybody?

I think that’s important to note, that these things rhyme for a reason. The millennials are a new bubble. They are at 40% of wealth creation of where the baby boomers were at this point in their lives, and they’re entering their prime demand years. Not surprisingly, they’re turning to politicians, and this is globally and saying, “Hey, look, we need help.” 

“We can’t afford housing. We can’t afford A, B, and C. We’re trying to create homes.” That’s what the fiscal policy wave is about. I think it’s fair to say, and we’ve been calling this for a while, the recession that the Fed is trying to drive to cyclically (and that’s another important word here, cyclically) compress inflation, is going to be met with more fiscal to help the demand side. 

We haven’t seen that dynamic for 40 years. I think people are still playing the last 40 years game. I really do. I think there’s this real possibility that we continue to be in a structurally inflationary period, and we’re meeting that with cyclical measures from the Fed to help slow, in the short-term demand.

Everybody’s thinking about this in two dimensions. It’s not just cyclical. That’s how we’ve played the game for 40 years. These structural effects are very important. Demographics are destiny (you’ve heard that before). The reality is there are demographic effects that are going to drive structural inflation, in my opinion.

Once that gets going, then people start pulling forward demand, which we know about, long-term inflation expectations go higher. People start buying anything that’s a solid asset, and borrowing because real rates are negative. We’re seeing this play out, people are burying their heads in the sand.

Actually, in my opinion, the demand side of anything is likely to be stronger than people expect. Maybe not cyclically, because you don’t fight the Fed in the short-term, but structurally I think we’re heading for a much bigger (and I’m talking over the decade), a much bigger push.

Given that the trade is getting crowded, and that there are cyclical issues, we’ll see in the short-term. I do think the long-term beauty of this trade is very, very strong. 

0:25:19 Adam

I’ll add something to that, which is something that I don’t think gets enough appreciation. Maybe it’ll sound funny when I say that. The rise of the emerging market consumer, and middle class, is really, really astounding. Now, the reason I say that’s a bit of a funny thing to say is that people might roll their eyes and say, “Well, no, I hear that all the time, and that seems like it’s been a story now for 20 years.” I don’t think people do appreciate the extent of it.

We’ve gone back and we’ve looked at all sorts of commodity demand at different levels of real GDP over time. It turns out that there are three distinct phases of economic growth in a lot of these markets. You start out very, very poor – subsistence living. A change in GDP doesn’t have an immediate impact on commodity demand or really on any demand (you can extend this beyond commodities). 

Similarly, there’s a period of time when you’re really rich. We all have seen that through the Fed’s wealth effect in the last decade. That doesn’t necessarily lead to increased consumption either. You save it away.

But there’s this period in the middle where every incremental unit of additional GDP that you earn has an unbelievably high energy intensity, or an unbelievably high propensity to consume. We call that the S curve. It starts out really low and then it hooks up in the middle part and then it flattens out.

It looks like an S. We’ve been studying that ever since I’ve been working for my partner, Lee. We’ve been doing that for 20 years now. Why do I say it’s not fully appreciated? Over time there’s always been a relatively consistent number of people in that middle part of their notch, in the middle part of the S-curve,  It’s always been about 600 to 700 million people. Japan entered into it and then they fell out, then Korea then entered into it. 

We don’t go so granular. We don’t go city by city. We take a whole country and we average their GDP per capita. We ascribe that to everybody in the country. That’s not a hundred percent accurate, but I think the intuition is correct that, over time, it has been a fairly steady number of about 700 million people. Now you’ve hooked it up to about three and a half billion people who are going through that middle part of their S-curve.

Yes, we talk about the rise of the emerging market consumer, but just stop and think about it. The impact is at least four to five to six (if you want to add all of India) times as many as we normally experience.

So we’ve set up a whole world that can accommodate 600 million people that are going through that middle class experience at the same time. Now, you’re upwards of several billion people. First of all, one thing I will say is that won’t happen again. Once that’s done, that’ll be behind us, but it hasn’t happened yet either. We’ve never been in this type of an experience before. So, people have been, poo pooing the demand impact from this cohort, now, for the nearly 20 years that I’ve been doing this. I think that’s been a mistake and it’ll continue to be a mistake. That’s why I say it’s a strange surprise.

I do think that the growth of the emerging market middle class will continue to be a huge tailwind to demand. I sound like a broken record cause I’ve been saying it for most of my career, but people didn’t get it then. They say, “Oh fine, I understand it now,” but they still don’t understand it. It’s a huge, massive, off the chart number. 

0:29:11 Cem

Demand is not a monolith; the world is not a monolith; it’s not one thing. You could have demand in China fall off a cliff and you could have demand in the US go up. I’d love to dive in a little bit to what potential opportunities may exist if we are entering (which seems increasingly likely) some type of bifurcated world. Where trade is breaking down a bit, but there’s more onshoring and fiscal driven kind of demand in the US and and other Western countries. 

What does that do? Where are the opportunities for that, especially given that we’re at war with Russia and pipelines only connect to certain parts of the world? What dislocations and what opportunities do you think exist as a function of bifurcated demand or some type of bifurcated system? 

0:30:06 Adam

Yeah, look I do think that things have really fundamentally changed here and that I think the next number of years will be a little bit different.

I think we have to let the dust settle to really understand the impacts of the last two years, but I think we’re in the process of fundamentally changing a lot of things that we took for granted over the last really 40 year period. I think that includes ever decreasing bond yields, ever increasing bond prices, things like the 60/40 portfolio, things like increased globalization. Certainly no one’s traded this type of a market going in the other direction. I think a lot of people haven’t really even thought about it. 

I’m not going to pretend to be the one with all the answers. A lot of these things have different cross currents. But I think we have to be a little bit more willing to broaden our horizons and accept things that look fundamentally different than have been the case. I do think we’re in much more uncertain times.

The simple answer is that we’re going to need more things. We’re going to need more resilient supply chains, we’re going to need more resilient natural resource supplies as well. It’s not going to be a question of oil. It’s going to be “our oil” and “their oil.” People are probably going to want to develop more strategic stockpiles, although we seem to be going in the opposite direction, but hopefully that goes back in the other direction. I think you’ll see resource nationalism. I think you run the risk of export bans, and you’re seeing that already in certain things on the crop side. There’s the threat of export bans in energy markets. I don’t think you’re going to see them quite yet. I think if US natural gas prices converge with world prices, I think the Biden administration could easily end LNG exports. It would be disastrous for Europe, but it could certainly happen.

All of that leads to reduced efficiencies across the board and that should result in more demand, all things being equal. You’re not able to run such a lean supply chain. Of course the flip side of that is what does it do to growth? Does it impact global potential growth to the point that offsets the demand? I don’t know, and nobody knows. So, I think we’ll have to wait and see on that.

I think, certainly, what it’s going to do first and foremost, in the short-term, is that it’s going to really decrease efficiencies, and it’s going to increase the need for redundancies across the board because we are going to enter into a situation where it’s going to be our oil versus their oil, and things of that nature.

0:32:40 Cem

Yeah, that’s a very interesting point that people will, in a more insecure world, need to build their buffers. That is an incremental source of demand. That’s a very interesting point that I hadn’t really considered. I do find it interesting, the last time we spoke about the gas and Europe versus the US, the dislocation we’ve seen and now there’s a little bit of catching up, but obviously you would expect that those two converge over time.

I do think in particular when we talk about demand, the demand side in the US is actually not only strongest, but it’s also likely (with more onshoring, with the increased bifurcation) to increase. There’s a compelling reason why, on the demand side at least, those two things should normalize as well.  It’s the beauty of free markets, especially over time, that takes a bit of time. I do think that is a very compelling trade over the medium term as you’ve highlighted as well. 

0:33:42 Adam

Yeah. I think you talk about demand and Lee and I just gave two speeches over the last two days, so I’m going to pull from a little bit of everywhere.

The truth of the matter is here that Europe is in a real predicament for this winter, particularly as Russia shuts off its gas. Now, bears might say, “Look, I don’t know what everyone’s talking about. Germany’s at 90% filled in its inventories and things of that nature.” 

Yes it is, but it did that in a number of different ways. First it shut down 19% of its industrial output. The second is that it switched from gas to oil wherever possible, which is not really feasible given the oil inventory situation though. It burned a ton of coal, which nobody wants to do, but that did happen.

I think the most important thing that everyone seems to forget, is that happened with the Russian gas flowing. Everyone’s patting themselves on the back but they hadn’t had this supply disruption until quite recently. Yes, Germany was able to fill its gas reserves. 

I’m incredibly happy that they did so, because I think that it gives them the best position here to go into the winter. We do forget a couple different things, first and foremost, all through a winter withdrawal season I think people are thinking, “Okay, you have this inventory level that’s there, and now every winter we just draw that down.”

You forget that you also inject into it. You have supply, so it’s a buffer. If your supply is disrupted, that inventory comes down in a huge, huge hurry. The truth of the matter is that Europe will succeed or fail this winter really based upon the weather. We’re 2022, and firewood from the United States is making its way to Europe very quickly, and everyone hunkered down and saying, “Let’s all pray to God that we have a nice mild winter to see it through to the other side.”

This is like medieval times. This really shouldn’t be the case. It’s 2022 and it’s Germany. These are modern times and incredibly sophisticated countries full of engineers. Unfortunately we’re still in a very precarious situation. The fact that US gas prices haven’t converged with European gas prices, and the fact that European gas prices have backed off here a little bit.

First of all, I think that’s great that has happened. It’s not necessarily great for gas companies, but I think it’s very important for Europe that we have been able to fill inventories and we’ve seen a little pressure come off, but nothing has fixed this problem. This is an incredibly systemic problem. It’s very, very, very dangerous. 

US gas prices haven’t converged with European prices. Okay, fine. The truth of the matter is you still have United States prices for natural gas that’s, let’s basically call it, 20% of the cost of gas elsewhere in the world. That arbitrage just can’t persist over, over the long term. Something will find its way to close that. 

0:36:49 Niels

Let me interject here and just ask you a couple of things. Obviously from a European perspective being based over here, now I hear talks about the fact that we have decreased our demand.

People are being bombarded, rightly so, with advice as to how you can save. Some people simply can’t afford to have their heating on and that in itself obviously drives down demand. My first question is do you have any numbers? Are there any statistics out already showing if there is less demand already that shows up from what we are doing over here in Europe?

0:37:34 Adam

So I think the numbers that I’ve seen really revolve around the industrial capacity furloughs and things of that nature. I had read somewhere in the 15% to 20% range, and that potentially could get as bad as 30% to 35% throughout the winter if, in fact, Russia cuts off supply and weather doesn’t cooperate.

That would be the hardest number that I’ve seen. Natural gas demand is difficult to model because there’s a number of different variables, including the weather. We don’t tend to have the same real time model data on the gas side that we would on the oil side.

I’d have to go back and see what the weather has been like the last several weeks. Make those adjustments to demand in order to get to the core, what I would call (what would that be) actual impact on demand from people trying to be proactive going into the winter.

0:38:37 Niels

Sure. That’s fair. The other thing I was curious about, you talked earlier about the oil side of things, and I guess one thing I’m not entirely clear on myself, and that is, has the way oil is being traded changed? Meaning is Russia essentially moving its oil supply directly to China? 

Then in Europe, we are now focusing more on getting our oil from the Middle East, or have there been some kinds of shifts? The reason I ask is that I don’t know if you could say it’s conspiratorial or whatever it is, but there are people talking about how all of this conflict is somewhat tied together. Meaning, are we really just focusing on Russia, and if we bring them to their knees (and I’m not saying we are), but if we were, as the West, and we were to damage their ability to supply oil, we would then actually indirectly damage China. Then they wouldn’t be able to get the energy they need and so on and so forth. There are many players in all of this, and I’m interested in what you see because you follow these flows, and I’m not sure whether they have changed or not? 

0:40:06 Adam

Sure. First and foremost, it’s important to know what you know and know what you don’t know.

I’m not a physical oil trader, and so I’m sure you could get somebody from Glencore, Vitol, I don’t know. Maybe you’d have to distort their voice and put a black square over their face. I don’t know if they’re willing to talk or not, but those are the guys that really do see the flows move around.

I think the story, anecdotally, is that a lot of Russian volumes are moving to China at fairly wide discounts and fairly wide margins. I tend to avoid some of the conspiratorial sides of things. I remember it was before I was active in the markets. When the United States went into Iraq and everyone said, “Oh, it’s all for the oil fields.”

I haven’t met any Iraqi American oil tycoons that made out like bandits after those actions either. I think that it is probably best to stay away from some of the conspiratorial things. The truth of the matter is that the actions, at least to date, have resulted in China being able to buy oil 30 bucks, probably, below the spot price. Which, as of today, is below the price of crude before Russia invaded the Ukraine. There’s probably actually a big windfall to China and probably to India as well, who’s been very, I would say, strategically ambivalent in this whole thing and kind of playing both sides off the middle to a certain extent. Probably because they are buying a lot of Russian crudes.

I think that the truth of the matter is, when you look at energy flows from Russia and you look at the potential disruptions in the market, more disruption lies in front of us than has actually occurred to date. If you look at sanctions, if you look at stopping the flow of Russian crude, you know that’s all due to really take place at the end of this year.

Similarly with the gas side of things, until Nord Stream was sabotaged a week, or two, or three ago at this point, Russian volumes into Western Europe were basically unchanged. I think that all this disruption and all the potential havoc and all the potential conspiracy theories and everything like that, most of that does lie in front of us as opposed to behind us.

I think that is something that people would be well advised to appreciate. 

0:42:37 Cem

I know we have a short timeline here, but last thing here, we’re getting to the elections, I don’t think that’s not an inconsequential thing here in the US. Actually, to your point earlier, I think the OPEC+ move was… I think was more because of the timing of it. We don’t have to go down that rabbit hole. 

The midterms matter because after the election happens, that frees up policy in the US to change, in some ways, not only because you’ll have likely an incoming change of leadership, but also politically, certain stances that the current administration has, they may have to hold for political reasons. Which, all of a sudden, there’s now a two year window they can shift on. AKA the Keystone Pipeline would be one of them.

These are types of things, more supply side responses from the US that are less environmentally friendly, I think are probably more likely after the election. Again, I’m trying to give the contrary, and give a little bit of potential bear case to what can go wrong. What is the timeline and why do you think that’s not important? Also, I’d love to get your opinion on LNG distribution. How long does that take to change, to actually rebalance things, et cetera? 

0:44:05 Adam

First of all, you said, what could go wrong and why am I not worried about it, and why is that not important? I think you really underestimate how much I worry about things, because I worry about what could go wrong all the time. 

I think that, first and foremost, from a policy perspective, there has really been, to date, nothing that the administration has done that has suggested any type of a cozying up, or any type of an understanding to try to support the oil industry at all.

People have asked me several times now that now that the administration gets it, now that things are so bad and they’re trying to help the energy industry, what’s that going to do? That has not been the case until yesterday. The talks have been about banning exports, have been about super normal profits, have been about lowering taxes on gasoline, which helps the consumer, but does nothing for the oil company.

If you look at all the rhetoric and all of these soft power things like Biden snubbing the oil companies, inviting them out to the White House and then he refused to see them because he saw the wind companies at a different meeting at the same time at the White House. Everything has really been antagonistic towards the energy business.

There’s been nothing that has been favorable. Yesterday, you could argue, was perhaps the first time that anything was said positively, and what the White House announced was that they would look to rebuild the SPR at between $67 and $72 a barrel. I have no idea where those numbers come from. They seem very strange to me.

Anyway, between $67 and $72 a barrel, they’ll be buyers of crude, presumably to refill it. That’s 300 million barrels a million barrels a day for a whole year, 2 million barrels a day for six months. Big numbers at $67, $72. They actually did include language, that said, that should give producers comfort that the price can’t really drop below that.

There’s the idea that the Fed put might be gone, but now you have an oil put. That was the first thing that I could really point to that wasn’t a backdoor antagonistic thing to the oil industry. For instance saying, “Oh, we’ll get more production because we’ll tax the hell outta these guys if they don’t invest.” That’s not very favorable to the oil industry. 

Maybe there’s a beginning of a change there. I think it’s a little bit early, and maybe I’m showing my politics, but I wouldn’t give them the benefit of the doubt just yet. That is the first thing that has been done that could be considered a positive from the administration. So, we’ll have to wait and see until after the election. 

As far as LNG infrastructure goes, we do have about two Bs a day coming online in the next kind of 12 to 18 months. After that, I think we go into a little bit of a lull. We’ve never really tested how fast we can build these things. They are big and costly. We do have a history now, a 10 year history in the United States of building them. We’re not starting from scratch anymore. How fast could we get them permitted and built? My gut feel would be 24 to 36 months if we really threw a lot at it. Maybe you could go faster on some smaller scale projects. It’s not going to be overnight. It’ll be, it’ll probably be a couple of years. 

Then as far as what really worries me, people talk about a recession and how that’s going to impact demand and things like that. Looking at the numbers and looking at the backfill from these non OECD people coming through their S-curve, that doesn’t worry me so much. I think the supply side is actually so bad that the market will stay tight even if that happens. 

What would worry me a little bit more is the likelihood of a large systemic shock. Something along the lines of the GFC, given the fact that there’s so much leverage in the system and given the fact that bond durations were so high going into this and interest rates are rising, it does strike me like there’s the potential somewhere in the system. We obviously had the UK pension issue take place a couple weeks back, and in retrospect, that’ll either be isolated or that’ll have been the Bear Stearns moment in this cycle. That worries me. That worries me. 

I think in that type of a situation, also frankly, resources snap back faster, like in 2008, where they came back a lot quicker in 2009, but there could be a massive leg down to everything or something like that obviously happens.

I think the likelihood of that, the doomsday clock has probably moved forward a little bit. 

0:48:56 Niels

Now Adam again, like last time we didn’t quite get to all the things we wanted to ask you about. There are things like other commodities, copper, there is the whole food crisis that I also thought we were going to get to.

So we obviously are going to have you back soon again. Also actually I do think it’s worth talking a little bit further about, certainly in Europe, where they just over a weekend decided, “Yeah, let’s just get all the super normal profits from these energy companies to pay for all the other social spending we want to make.”

There’s some huge problems or issues, let’s call it that. We’ll definitely have to get you back before Christmas, if you have time. I know there is a chance for our audience to to check out more of your information, because you’re having a conference soon. Tell us a little bit about that before we close out today.

0:49:53 Adam

We are. We’re having our second annual investor day investor conference on November the third in New York. We have a virtual option. We also have an in person option, and my preference would be to see everybody in person. As much as I enjoy talking with you guys virtually here, it would be nice to do this all in person one day.

So if anyone’s in the New York area planning to travel, please do come. For those who cannot, please look at the virtual options. Both can be found on our website, gorosen.com. We have a very good lineup. We decided to really go big this year. Not only will you hear hour after hour of Lee and I, but we also brought in some of the people that have really been instrumental in forming our views.

You can hear the primary source, and hear all the ways that we got it wrong, and things like that, that we misunderstood what they were saying. Anyway, I think it’ll be a great event and yeah, please go look at our website if you’re interested. 

0:50:52 Niels

Yeah, I definitely would encourage everyone to do that. I can’t wait to see what comes out of that. For sure. In any event, you should definitely follow and subscribe to Adam’s work as well as to Cems of course. As you can tell from today’s conversation, we are living in a true global macro energy driven world, and it is perhaps more important than ever before to stay well informed. 

From Adam, Cem, and me, thanks so much for listening. We look forward to being back with you as we continue our Global Macros series. In the meantime, take care of yourself, and take care of each other. 

0:51:26 Ending

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