Rory Johnston - Global Macro Series - February 8th, 2023

[00:00:07] Rory

It’s important to ground yourself in why you think these things are happening together because I think that informs a bit of your view of, is that going to persist, is all this going to unwind, which side is going to unwind? I think it just gives you a bit of tactical awareness of the space. I think a lot of people just passively consume this data. I think it’s always important to critically assess why those things are happening together.

[00:00:32] Intro

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

[00:01:29] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like and we want to explore their perspectives on a host of game-changing issues, and hopefully dig out nuances in their work through meaningful conversations. So please enjoy today’s episode hosted by Hari Krishnan.

[00:02:15] Hari

Thanks very much for the introduction, Niels. My guest today is Rory Johnston, Founder of Commodity Context, a physical commodities research firm based in Toronto, Canada. It’s a pleasure having you on the show, Rory.

[00:02:29] Rory

Thanks so much for having me, Hari.

[00:02:31] Hari

Can you please tell us a bit about your firm and how you came to start it and what your background might be?

[00:02:37] Rory

Yeah. Prior to starting Commodity Context, which is as you’re noting, an oil-focused research platform hosted on Substack at commoditycontext.com. Before that, I led commodity economic research at Scotiabank here in Toronto, which is one of the large Canadian banks and by most metrics, the most heavily weighted towards resources, western Canadian energy, Latin American mining, etc. So I had my education in the space there. I left at the beginning of 2020 to start a family, join a family office, take a slightly different tack.

[00:03:18] Hari

Wait. You started a family and you joined a family office at the same time.

[00:03:22] Rory

I did, a double family. Obviously, at the beginning of that as I was shifting gears, COVID hit commodity markets, which had been on a bit of a grind downwards (in various ways) for the better part of the decade and I think were fairly depressing for a lot of people in the sector and went completely haywire. First, my phone started ringing off the hook from old media contacts from my days at Scotia like, why is oil negative? What the heck is going on?

So I got pulled back into the oil side after very tentatively trying to leave for a hot second there. And yeah, I got pulled in and I kept researching and reading and following the space, so I didn’t sound like a moron talking to my media contacts. I was like, why don’t I write it down? So I started writing it down. I’m like, why don’t I publish this? And that’s essentially how Commodity Context started in June of 2021. It went on for a year as a free publication just to see what interest in this space was.

To my shock and amazement and gratitude, it was a decent uptick, a decent pickup, and so last year mid-2022, I turned on paid and turned this into my full-time grind. Now Commodity Context has over 16,000 free subscribers, hundreds of paid subscribers. Generally, the focus is I’ve got three main product verticals. I’ve got my main bread and butter of thematic pieces. So usually, once every two weeks; thematic deep dives on various things. The next one I’m working on is air travel and jet fuel demand recovery.

I’ve got monthly data reports called my data decks on global oil balances and the North American oil industry. And then every Friday, at the end of business, I publish Oil Context Weekly, which is a weekend wrap up of what’s happened in the market, what’s moved in the market, and what’s driving things and gets you all set up for processing the week that just passed and then getting started for Monday.

[00:04:23] Hari

What do people use your research for? Are they PMs?

[00:05:34] Rory

Generally, I’m quite happy that I have a reasonably broad swath of a fairly diverse group of people. I have your PMs and your analysts in industry, obviously, a bunch of institutional accounts. I’ve got a lot of personal accounts. I think there’s been a huge rise in personal trading and family office trading in this period, particularly in oil and gas names. So I think that’s been a huge area. Also, policy analysts and the government sector. That’s actually very frankly where my background is before starting to work at a bank. My background is global affairs, policy analysis, etc.

So I really wanted to have a product that could dig deep and become interesting, would be interesting to someone that’s an expert in the sector, but also communicate in a way that doesn’t alienate or scare off people who it might be one of 10 things they cover. I really lean into the name of the publication. I’m not a fortune teller. I’m not going to pump a view really hard one way.

The focus really is on context – whether it’s a bullshit detector or a bit of just a sniff test to some of the narratives that are bouncing on the market because I think right now, there are many, many, many narratives that are bouncing around this oil market, and just trying to add a little bit of concrete. There’s plenty stuff we don’t know, but what do we know? I think just trying to ground us in and some kind of proper footing in this market.

[00:07:15] Hari

Is it important to have access to what the big energy companies are doing to do your job or can you do it purely on a data-driven and geopolitical-driven basis?

[00:07:27] Rory

I think all of this information is useful. I don’t have regular conversations with the CEOs of Exxon or Chevron, but a lot of that information is presented in their annual and quarterly reports. My focus isn’t particularly equities, except for what they can tell you on a broader sector level about what’s happening let’s say to US energy investment or what’s happening in the oil sands as a modular sector level. So I think it’s not essential, and I think quite frankly, a lot of people over-fixate on publicly listed equities because that data is available and there.

I think a lot of the industry data is messy, awfully formatted, and difficult to compare and contrast apples to apples. So that’s really more my focus. Again, I come from more of a bank economics department view and I worked with our fit groups and our equity research, etc. But I leave the equity research to the equity research analysts and I try to add something a little broader to essentially the price assumptions that are going into these models.

[00:08:38] Hari

The clients who use your research, let’s say the family offices, to pick one thing, do they focus more on trading equities and energy-sensitive equities or do they actually trade the futures directly?

[00:08:52] Rory

To my knowledge, I think most of the people in this space are expressing their view on the commodity through the equities, just because they’re the easiest, most liquid to access. But that’s my understanding. Yes.

[00:09:04] Hari

Understood. Now, I’ve tried a new type of show and I tried it with Marko Papic some time ago, and it’s basically to make a bunch of statements, partly to show that I’m no expert in the space so people can correct me, but also just to say some things that probably aren’t true just to see what an expert like yourself might say. So the format I wanted to choose today, and I hope the viewers don’t skewer me for this (it’s definitely not Rory’s fault, if it’s anyone’s, it’s mine), is to make a few statements and then just have you respond. I’ll play the role of the straight guy, or whatever the phrase is, and we can have a little bit of a back and forth based on these points.

Now, the first point centers around the unpredictability or the potential unpredictability of energy markets and what you can actually use as sensible or reasonable data inputs to draw some conclusions about where prices may go. Of course, this is never written in stone.

So let me start with point number one. Geopolitical analysis in the energy markets is basically useless because if something has happened such as a war in Ukraine or a China lockdown, complete lockdown, that’s already baked into the price somehow. The future evolution of politics is inherently unpredictable so there’s no point even bothering about it. Can you respond to that one?

[00:10:35] Rory

Yeah. I would say that a lot of my focus, leaning on this context keyword here, is I think geopolitical analysis gives you a sense of a parameterization of the possible. I think while it’s true that once Russia invaded Ukraine, as you know, I think the most clear and present example of this in the last year, yeah, I think if you had a really good bet on that prior, if you really thought that was going to happen, I think it gave you an edge. But to your point, all of this is inherently probabilistic.

You mentioned that you started this format with Marko, who actually has a really interesting framework around approaching geopolitical risk. That, I think, is the important thing, is to have a framework, to have a systematized approach to geopolitics. I actually came to the oil space from a geopolitical background. My background is actually not economics. I came from a policy analysis of global affairs and a global security background. So I came from this vantage of that everything is geopolitics all the time. As I’ve been educated in that space, if anything, I think I’ve almost switched in that balance.

The challenge, and I think the reason that geopolitics often gets a bad rap in this space, is it’s very easy to do bad [and be] flippant to your political analysis because it doesn’t lend itself naturally to a framework that you can parameterize and track and iterate on. So I do think that if you have a really good framework and you have a really good track record of approaching things in this way, like a Marko, I think that actually does give you an edge.

Because like right now, whether it’s Russia’s invasion of Ukraine that we are now currently in or Chinese government COVID zero policy, etc., I think having a sense or an idea of where that’s going to go and a reason for it that you can revisit and add new information to overtime, gives you a big edge because these narratives fly so wildly week to week. I think just being able to just simply fade the noise sometimes because of a framework gives you a grounding in reality.

[00:12:59] Hari

Taking China as an example, again, I’m not the expert, you would set a base case which would be a path of reopening or a speed of reopening, and then you take the data points as they come in and make adjustments to that. So you might be looking at air travel or any number of things, whatever the politicians are saying, interpreting that. It’s my understanding that if you set a path for the reopening process and you have a price level or a demand level associated with it, an incremental demand level, then you would adjust that over time as the data comes in. Is that the approach you’re taking?

[00:13:39] Rory

Yeah, that’s exactly right. I think that for something like a Chinese reopening, and with geopolitical analysis broadly, it doesn’t always lend itself nicely to base case forecasting. It lends itself to scenario planning and I think that if you have a couple of different core scenarios with a bunch of very regimented parameters to them, you can tell over time which one you’re trending towards. I think that gives you a sense.

So like let’s say Chinese reopening as an example. Mid, let’s say, September of last year, there was a lot of debate about, will China ever reopen. Is this going to be a permanent lockdown of the country? Is COVID zero tied to the legitimacy or perceived legitimacy of the Chinese Communist Party or Xi Jinping himself? Personally, and this is my error, I did not think they were going to reopen as quickly as they did. I read a lot of compelling analyses.

I think this is, again, where geopolitical and political analysis can lead one astray. One of the best comps to COVID zero, a policy that for all intents and purposes from the outside looked insane; that was completely bizarre in its commitment to keep that level, particularly given the fact that the latest variants were so much more contagious but less deadly and all of these things. You saw Chinese workers spraying disinfectant on roads, just bizarre theatrical stuff. But the comparison was to the one-child policy, where that policy stayed in the books for so long, so much longer after everyone knew it was a ticking time bomb or unsustainable. I found that compelling. That turned out to be wrong.

There were other people that nailed the call. I think that if you had a really good view of what was going on and how the Chinese politburo was discussing and handling these factors, it did provide you an edge in at least fading some of the calls that China would never reopen. I think there was always this, is it going to be a spring? Is it going to be a summer 2023 kind of situation? I think that was more of the story. I expected it to be a more gradual process. I expected it to be a couple of months of gradual sentiment and communication that calms changes from Beijing.

But essentially, there were protests, there was an upheaval, and then all of a sudden, a week later, they were releasing these points for reopening. That seemed to just snowball from there. So I think that is an example of a call that I personally did not get right, but I think that some did. I think that if you were a China expert, that provided you some grounding in at least fading one side or the other extreme there.

[00:16:43] Hari

So if I’m an energy money manager, if I’m investing in energy, is the following idea correct? I don’t know what the fair value of oil is, let’s say. But I do think that I have an out-of-consensus view on where supply or demand will come in, which will affect the price at the margin. So assuming that the price is reasonably fair now and I have a different view that I got from Rory from Commodities Context, I can use that as a way to lean on a long or short position simply based on the idea that that is a piece of information that isn’t baked into the price that may lead to a directional move in my favor. Is that the thinking?

[00:17:23] Rory

Yeah. I think that you’d compare that to whatever your proxy for consensus supply and demand outlook would be. So whether that’s the IEA, or the EIA, or OPEC monthly reports, that outlook for, let’s say, 2023. Which outlook do you find yourself trending towards? Are we expecting to see deficits this year? Are we expecting to see surpluses? How does that balance? Even more importantly, what underpins those surpluses or deficits?

I just recently did a piece that compared all the major outlooks from the major monthly forecasting agencies, and you can see that a lot of their assumptions are very similar. I think that’s important because you can say, okay, these are what I call consensus, or what I call agency consensus assumptions. US production will grow x barrels a year, Chinese demand will grow x barrels, OPEC will do this, or whatever. But then you start to see, okay, their differences are in the extent of China’s growth or the extent of non-Chinese Asian growth. Then you can start to really pick apart the supply-demand balances. Only at that point should you then begin to layer on your own assumptions.

I think the challenge is sometimes you’re like, “I think China is going to reopen, it’s going to be big. Because of that, I’m really bullish.” But a lot of the agencies (a consensus) already build in a big Chinese demand boost. So is your assumption bigger than that or smaller than that or is it just on par? Because if it’s just on par, then you actually don’t have an against-consensus view, you’re actually right in the middle.

I focus a lot on supply and demand and decomposing these balances because there are so many pieces to them, so many pieces to these global supply and demand balance models, that it’s very, very easy to get lost in some of that minutia and lose the forest from the trees. But I think it’s important to know which particular tree you’re disputing, while trying to make this overall macro call.

[00:19:38] Hari

How are these production and demand forecasts made? What’s the methodology? Is it just a simple regression or extrapolation or is it based on surveys? What do these guys actually do?

[00:19:49] Rory

It’s mostly based on surveys, and that’s what’s interesting. I like to picture data relevant to the market broken down into three chunks. You’ve got supply and demand balances, which are lagging often by usually two to three months. I publish my Global Oil Data Deck, which was just published in January and that covers November balances. So I think just to give you a sense…

[00:20:17] Hari

I could argue that supply is probably stickier than demand. Is that correct?

[00:20:23] Rory

Yeah. Supply is usually easier to peg down. I wouldn’t always say stickier per se, because I think supply itself can be very volatile. But I think that you typically have a better sense of supply, and there are fewer revisions to supply after the fact, because generally, there are far fewer producers of oil than there are consumers of oil, just definitionally. So I think what you often find is, particularly non-OECD demand data, often gets revised. Even after it’s initially available, like let’s say on a two or three-month lag, you’ll still see revisions to that after the fact.

Just to finish this thought of the three different chunks, you’ve got these lagged supply and demand balance numbers. I think the important thing to note here is the other thing that people over-fixate on in this market is the weekly EIA numbers, the weekly petroleum status report published by the EIA. That’s something that I think is really, really, really valuable for inventories, and I think, really, really confusing and distracting for virtually all the rest of the data in the report. The reason for that is that the actual data, the actual accurate data that the EIA publishes, is still published on that two to three-month lag.

Today, we are getting published data from the EIA from what they call the Petroleum Supply Monthly, which is the much more accurate monthly report, and that will cover November. But we still have weeklies for supply, demand, imports, exports, refinery runs, etc., as of last week. But what you see is those weekly data are imperfect estimates of something that won’t be actually nailed down until months later and then will continue to be revised after the fact, and people just over-fixate. The other challenge with the weekly data is everyone just loves to throw a chart up and show weekly data because it looks more impressive, it’s higher frequency, it looks whatever.

[00:22:22] Hari

More to sell.

[00:22:24] Rory

Exactly. It’s a great way to sell. I, particularly at the beginning of my career, fell victim to this quite frequently. What you realize is that that weekly also isn’t back revised, which is a huge challenge because you’re compounding errors. A great example of this was this past summer, the weekly demand data, what the EIA’s weekly petroleum status report calls products supplied, it’s essentially a measure of wholesale demand (essentially supply that disappears from the observed and surveyed system), what that showed or what it purported to show was that demand in the summer of 2022 was lower than the demand in summer 2020, which just seemed nonsensical.

I think everyone was like, “Oh, this is the Biden administration torturing the numbers to try and talk down oil.” But no, what you realize, when you look back at the numbers from summer 2020, was that the EIA based on its methodology was materially overestimating supply then, and that by the time you got to summer 2022, they were moderately underestimating demand. So you got this double compounded error. Demand in 2022, summer was likely slightly weaker than 2021 but nowhere near as weak as 2020. I think that’s just one of those errors people ran with and I saw like 100 stories written about this. I think it just comes from a basic misappreciation for what the weekly data tells you and what it doesn’t.

[00:24:00] Hari

So you have a level of confidence in the various data releases that come out, and that informs your research.

[00:24:07] Rory

Absolutely. I keep getting distracted as I’m going through these three buckets. The supply and demand data has lagged and is an estimate and will continue to be revised. So you’ve got the least confidence in that set of the data. That said, it also, at least on space, is the most comprehensive. Then you have inventory data, and that’s actually where I think that the weekly data…

[00:24:33] Hari

So hold on, comprehensive and wrong, basically,

[00:24:37] Rory

Yeah, but wrong in a useful way. I think that’s the important thing here. We’ll talk in one second about why I think that is so useful, but let me just get to these other two because I think they inform how I handicap that monthly supply and demand data. The weekly data is much more accurate for the areas that we do have and I think that’s where the weekly petroleum status report and the weekly US inventory numbers are very handy. That is, for the most part, survey data that is kind of accurate and you will see that it doesn’t deviate materially from the monthly releases, like slightly here and there, but materially, that’s the story.

If you have a scenario where your supply and demand balances imply massive inventory builds but you’re seeing material draws in observed inventories, then you probably know that your supply and demand estimates are probably off to a degree, or at least they might be. I think that’s your first warning sign. The challenge with inventories is that while the US is highly frequent with its entire inventory set nationally, the other high-frequency weekly inventory data that we get from, let’s say, ARA, Europe, which is the major ports around Amsterdam and Rotterdam and the data from Singapore, it’s a far, far smaller pool of oil that’s being sampled and you have much, much more unknowns.

As an example, one of the big trends of this past year has been considerable building of Chinese inventories of both crude and refined products, and we have zero publicly accessible data on Chinese inventories. So that is the challenge here is that it’s more certain, but it’s less comprehensive. I think that’s where I differ from the supply and demand data. Finally, your final piece of data is market signals. At the end of the day, that is the most “correct”. What are prices doing? What are calendar spreads doing? What is the shape of the curve doing?

If you have, let’s say, an oversupplied model and you have inventory builds at least observably, but then you have deeply, deeply backwardated calendar spreads or a deeply inverted curve or downward sloping for backwardation, that also gives you a signal of, well, this doesn’t always line up. My method and my kind of approach to this is to take all of those pieces at the same time and try and make sense of them. Just coming back and defending the supply and demand balance estimates, I think what people often do is they will just project forward from wherever they’re standing right now, but they generally do not know where they’re standing right now.

I know this because I don’t know exactly where we’re standing right now and I spend copious hours every day trying to figure it out. If you look back at November and you say this is where Chinese demand was, this is where OPEC supply was, this is where shale was producing, etc., it provides you the most recent, reliable flag in the sand of where these major components of the supply and demand balance are. If you assume that in the intervening months, the intervening period, you’ve had this massive change in balances, you need to figure out which one of those segments shifted, because I think that gives you a different approach.

If Brazilian production, let’s say, dropped materially in one month, well, that’s not going to be a thing that continues on in the future going forward, that it’s one facility that had a turnaround or whatever. You know that’s going to bounce back. So I think knowing the reasons for oversupply or undersupply on a lag basis provides you insight, and again, parameterization of what the major moving of risk variables are now and into the future.

[00:28:36] Hari

But before we leave the supply and demand topic, I have one hypothesis I’d like you to confirm or deny. Let’s say there’s a big dispersion in the supply and demand estimates from the various data vendors. Is there information baked in that? Is that an indicator of perhaps future volatility in the oil markets or is it signal-less?

[00:28:59] Rory

I think it’s important. I think this is both true about historical and forward-looking estimates. In your context, I think you’re mostly talking about forward-looking forecasts of OPEC and IEA and EIA. Chinese demand is a great example here. All three of those agencies, none of them agree on what the level of Chinese demand was in Q4 of last year, which is important because when we’re talking about one of the major variables this year being Chinese recovery and a return of Chinese demand, well, where you were in Q4 last year or last year in total matters a lot in terms of what the potential nominal barrel upside is.

But I also think that various analysts like these different estimates more or less than others. So if you have big dispersions, and right now as an example, you have OPEC seeing growing deficits into next year while EIA sees growing surpluses, I think that right there is a great example of, well, they both can’t be right. In all likelihood, they’re likely both to be wrong and probably meet somewhere in the middle. But that, in my opinion, is usually what happens. OPEC is a great example, of always assuming that Q4 demand goes to the moon.

Every year, you see their models and these massive Q4 deficits that are implied are always because of this massive Q4 demand number. I think that you can just start to see these patterns repeat themselves in the data, and you just start to adjust for that. You’re like, “Okay, probably not.”

[00:30:39] Hari

Doesn’t that point to seasonality, at least? Don’t these agencies factor seasonality into their estimates?

[00:30:48] Rory

They do, I would say, to varying degrees. I also think each of the models that underpins IEA, EIA, and OPEC are all different as well. I think some of them are much more complex than others. Some of them are much more like headline, regional GDP equals this many barrels, some are trying to build it up from a jet fuel diesel, like an actual end-use model. So they all have different approaches. I have the ones that I prefer. But I also think that, as an example, IEA is great, but it’s paid. I think it’s a reasonably steep paywall for people that are just casually interested in the sector.

I really like the EIA’s steel report of the short-term energy outlook because it’s free. It’s easily accessible. They’ve got a great data explorer on their website and they have a fantastic API that allows you to pull all this data in, a tremendous amount of data, and each month, you can pull from, so you can also see the changes in those forecasts. I think the other thing that’s really interesting, I track the changes of all these major agency forecasts month to month, so you can see the tenor of supply growth assumptions, or whatever, change over time. I think that is also really interesting.

[00:32:03] Hari

There’s an analogy in the equities world where analysts make earnings forecasts and they usually undershoot because it’s not in their best interest to make a bold bet, but the adjustments they make have potentially some content. Is that what you’re saying?

[00:32:19] Rory

I think that’s exactly it. I think that’s a great parallel.

[00:32:20] Hari

Good stuff. Now, jumping a little bit, I’ve watched a few of your podcasts and in one of them, you said that technicals do matter in energy markets. But eventually, there’s a tethering of price to fundamentals ultimately and so prices will never stray that far away from fundamental value. Is there any way to quantify that or to at least expand upon that idea?

[00:32:54] Rory

Yeah. When people are thinking about oil or the price of oil, they’re typically just thinking about Brent and WTI, almost always. Me in Canada, I have an overt fixation on Western Canadian Select, which is our main export grade. But what you can see is that there are hundreds of different kinds of blends and export grades of crude globally, and all of them have what you call physical differentials to these major benchmarks. So I think one of the things that is often levied against the financial…

[00:33:29] Hari

By differentials, you mean sweetness, lightness?

[00:33:32] Rory

Yeah. Differential would be mostly referring to the price and then the grades. You have different reasons for the differential. So it’s a great example just to provide a little bit more content or context on this point. Western Canadian Select is a heavy sour blend of crude. It’s diluted bitumen shipped from Canada’s oil sands. It has a high sulfur content, it has a high passive or natural cut of high sulfur fuel oil, but it’s also trapped in Canada behind (very frequently) insufficient pipeline infrastructure.

So when you see differentials blow out on Western Canadian Select crude, it can blow up for one of two major reasons. By blow out, I mean, normally, the differential is like $13, $15 a barrel under WTI at Cushing. In 2018, that blew to $50 a barrel under WTI, so massive value loss for Canadian producers and that was due to insufficient pipeline and egress, your inability to get it. So there were literally stranded barrels in Alberta that had to be discounted to such a huge extent to basically cover, almost literally putting it on our truck and driving it. That was how bad the differentials were.

This year, however, we also saw a differential blow to more than $30, $35 a barrel, but there was very little to do with pipelines. It was mostly due to these global quality issues. You had hugely discounted value for high sulfur fuel oil. I believe the crack spread or the refining margin on high sulfur fuel levels was like negative $40 a barrel, and basically, crudes that have a high natural cut of that need to reflect that value erosion in an end product.

[00:35:17] Hari

I’m showing my ignorance here. I thought there was just basically one widely quoted crack spread. You’re saying there are multiple crack spreads for multiple different oils.

[00:35:26] Rory

The most widely quoted crack spread is known as the 3:2:1 crack. It’s essentially the residual value of two barrels of gasoline and one barrel of diesel compared to three barrels of crude, and that is because, for particularly North American and US refiners, that’s a lot of what you get. You have a crack spread effectively for each individual end-use product. I think each crude grade or stream has natural yields of these different products given, let’s say, a really simple refinery, and I think that gets worked back into the value of these crudes. So this year, in particular, it’s been very bad for WCS because it’s been really bad for high sulfur fuel oil and naphtha and a couple of these other end-use products.

[00:36:17] Hari

Which is a bit worrisome, though, because if I’m a refiner in Alberta and I hedge my risk by trading the crack spread on WTI, there is a huge mismatch there. There’s a massive amount of basis risk.

[00:36:32] Rory

Absolutely, absolutely. It’s been a huge challenge. A lot of the Canadian majors are vertically integrated to a large extent so they try and capture that by essentially refining or upgrading the crude themselves. Canada exports WCS’s diluted bitumen, but it also exports, I should say, we also export synthetic crude. That’s essentially upgraded crude that brings it up to a higher level and essentially changes that chemical component.

[00:37:03] Hari

Which brings me to the point, if price discrepancies are large for similar assets, similar commodities globally, should oil companies in theory be more profitable because they have the infrastructure to arbitrage some of these differences in a way that the average punter doesn’t? In other words, they can move commodities around, they can sell them into different markets, they have the transportation capacity, they have the refining capacity, all of these things.

Would that be something that an equity investor would consider. If there are large, potentially arbitrage opportunities in, let’s say, oil, then whoever trades in those or deals in that business on a large scale should have an edge. Is that a reasonable rule of thumb?

[00:37:53] Rory

I think that’s very true. Through weird markets like this, you’ve seen the large integrators perform very well. Now, each company has a different exposure to different elements of that crack spread or differential blows. The other ones that benefit hugely in moments like this are the large commodity trading firms, Glencore, Trafigura, etc. They have a tremendous amount of information about this market from very granular. They own pipelines and they own refineries, so they’ll know far more clearly, far earlier than virtually anyone else in the market as to what’s really going on. They’ll have a better view on that granular level over time.

[00:38:35] Hari

Why is it that we never see interviews of traders from Glencore or various companies? What’s the reason for that?

[00:38:42] Rory

I was literally just on another podcast and I suggested there’s a really great book, two really great books. The more recent one is The World for Sale by Javier Blas and Jack Farchy. They’re both Bloomberg reporters, and it essentially covers the wild world of commodity trading. That covers oil predominantly, but all the other commodities as well, grains and metals, etc. The other one, my first introduction to this, there’s a book called The God of Oil or The King of Oil, I can’t remember exactly which one it was. That is essentially a book about Marc Rich, the legend of Marc Rich. For those that aren’t aware, both Glencore and Trafigura are the essential children.

[00:39:30] Hari

He founded them, didn’t he? Yeah.

[00:39:31] Rory

Yeah. Mark Rich & Co basically became Glencore and Trafigura was a split off of that. Some of the traders left and created their own firm. Fascinating, fascinating history. What you can see in The King of Oil and the Marc Rich story, in many ways, these traders and Marc Rich himself really created the spot market for crude oil, that historically, crude oil and the prices you saw weren’t real things. They were essentially accounting metrics that Exxon or Chevron or whoever would produce oil and then trade it within their own company and the prices were essentially for tax purposes. It was all very cozy, you had the Seven Sisters, etc.

It wasn’t until you had these residual leftover barrels that were outside of that system, that traders could eventually create liquidity in the spot markets. That’s what created and facilitated the growth of a much more vibrant ecosystem of price discovery for oil. And that’s eventually when the major integrators lost control of that. What you’re seeing now with other commodities like let’s say LNG, we’re starting to see a gradual move toward something similar.

Historically there wasn’t much spot price discovery in LNG because there was so little liquidity. Basically, all the cargoes were long-term committed. But now that you’ve had just massive build-out in infrastructure globally, you just naturally have residual cargoes that can begin to trade and create this better, more informed view on what current spot dynamics are telling you.

[00:41:09] Hari

Very interesting. Well, I think the original question was about fundamental tethering of oil prices to fundamental value.

[00:41:19] Rory

Yes. I got away from that and I apologize.

[00:41:21] Hari

No, no, it’s fine. I’m guessing that simply because they’re real money or they’re real users of oil. It’s not like various other markets where it’s not a consumable good, it’s just a security or something. Maybe that’s the reason for the fundamental dependence over the long term.

[00:41:39] Rory

I’ll stress two things here. The first thing to support this point is that people often talk, in a lot of securities and oil in particular, like the market will look through this. This is a known factor, the market will look through it and address it. But that’s, I think, a misnomer that, at the end of the day, physical spot markets need to clear.

No matter what your view, if supply is 10 million barrels a day over demand, let’s say, in April of 2020, yeah, the price is going to go toward zero. It has to. I think the important thing here isn’t that it’s not necessarily the flat price that needs to go to zero or to go to negative, but what you need to do is you need to dramatically widen the contango in the market in order to facilitate and finance (pay for) increasingly scarce inventory space. In distressed markets like you saw in 2020 and 2016 before that, in February 2016, you essentially saw the emergence of super contango, which essentially is the structure where you have the spot price is at a $20 discount to let’s say crude for delivery a year from now.

In my mind, in moments of extreme crisis like that, that reflects to a degree the cost curve of inventory storage costs, that essentially has more and more of the easy cheap inventory. Normally, we’re talking like 20, 30 cents a month for inventory leasing. It’s usually pretty cheap. So contango doesn’t need to be that wide for someone to have a very attractive arbitrage where they can say, “I’m going to store this, I’m going to insure it, I’m going to finance it and as long as those costs are less than the contango, I’m literally printing money.” That’s how the commodity market clears in moments of oversupply.

But in super contango, you’ve run out of all those easy opportunities for storage. So that’s when you get these supertanker trades where a commodity trader or a major oil company will literally lease supertankers and store one or two million barrels of crude in a tanker and just float it off the coast for like 6 months and that’s floating storage. So that’s definitely true. The other side of this, however, is with physical traders. Often what you’ll see, if a market is just trending sideways, let’s say for two months, three months, the price hasn’t really moved at all but you’ll see widening differentials one way or the other at the physical level.

Let’s say Saudi crude keeps becoming more and more expensive relative to that benchmark, those benchmarks that you see trading sideways. That is a sign, I believe, that the market, the physical market is telling you that the financial market is underpricing these commodities relative to end users. But in moments like last year where you saw a very rapid rise and a lot of physical traders were saying, “Look, these differentials are not screaming crisis levels. This price is running away. This is all speculation.”

But even if you were at a weak kind of differential or let’s say a weak discount for these crudes but that discount was staying relatively flat at that weakish level but oil gained $40 a barrel, that doesn’t mean that the market is weak. It just means that the financial market was a couple of weeks ahead of the physical market. I think that’s actually exactly the point of what financial markets are for. It’s for allowing a huge amount of information to be transmitted into price discovery very quickly, often faster than the physical realities manifest, because this is all about forward-looking anticipation, etc.

So I think both of those things can be true, that you can have real physical signals and value. It’s always important to look at both sides of this, but I think that both can tug and pull at different moments in different ways.

[00:45:27] Hari

Yeah. I’ve always sort of thought of things from the leverage standpoint, in the sense that, say, a trend follower. Why do markets trend? They trend because if you have a position on, and it’s on side, the market is moving in your direction, you have more margin to play with so you can build your position even more. So markets overshoot as a function of the growth in speculative profits in the direction of the move. I didn’t phrase it that well. What you’re saying is that there is an underpinning here that eventually will overwhelm the speculative stuff that’s going on.

[00:46:09] Rory

Exactly. Yeah.

[00:46:10] Hari

Is the upshot that if I do look at Commitments of Traders reports and things, and if I do figure out how to understand them and figure out who’s a spec and who’s a hedger and so on, it might help me but only over a shorter term horizon? Is that what you’re saying?

[00:46:24] Rory

Yes. I believe that’s true. In my weekly, Oil Context Weekly, I cover five main things every single week, one of which is the Commitment of Traders report. The reason I see it is valuable, and to your point about hedgers and spec and non-spec, I typically just use the disaggregated numbers and use the managed money component, which I find to be the most volatile, and I think, the most capricious in this way. To your point, I see it as useful. I don’t think it’s necessarily useful for forecasting, but I think it’s useful for tactical risk management.

[00:47:02] Hari

Positioning. Over positioning.

[00:47:03] Rory

Yeah. Exactly. I look at it both in terms of nominal barrels and in terms of as a share of total open interest in the contracts. So as an example, back in November or even very recently, you saw spec interest in these contracts reach very high levels of total open interest relative to its recent history. I always kind of normalize it to, let’s say, the last year of whatever the norm is, and I think you see deviations but it tends to mean revert. I always think about spec in this capacity as the most flighty, the most capricious holders of this crude that are holding it for entirely non-commercial reasons.

So if they’re really, really bullish, they could get slightly more bullish. It’s not likely to get materially more bullish from there. The next most likely outcome is that they mean revert, they take profits, they sell back down, someone gets spooked, and they start establishing new shorts or whatever. I think that’s actually what we’ve seen.

[00:48:04] Hari

I hate to speak like an academic here, but you’re saying when the final marginal buyer has been tapped out?

[00:48:10] Rory

Absolutely. That’s the way I view them. I view them as marginal buyers. I think that’s the exact perfect word for this, that you have the normal structural price formation that’s going on in the market and then these players get on and they can either just take flat price exposure or they can take steepener or flattening trades in the curve, etc., etc. But I think to your point, if your marginal buyers are really overextended, it’s not likely that you’re going to have much incremental marginal buying. But if your marginal buyers are really, really short, you have a lot of dry powder on the side of the market that is typically associated with oil investments.

You see that typically come back and I think that’s a fairly reliable kind of metric. Again, it’s not causal, but I think if you have a really high net spec as a percentage of OI, you have a higher risk of these major downside moves. I think when you’re really, really short, you have a risk of these major upside moves. I think that’s how I approach the COT report.

[00:49:15] Hari

That makes a lot of sense. Next question is, oil is priced in dollars, generally, in global markets, so isn’t the oil price really just to play on the dollar?

[00:49:28] Rory

It definitely can be. One of the charts I have on the Bloomberg terminal up to the side of me here is basically just Brent and then an inverted DXY. I think it provides you a good sniff test of, if crude spiked one direction and the dollar spiked in the other direction, you could say okay, that might be because of a risk trade, that people are flooding to the dollar. I think that’s the important thing. You have both denomination effects and you have inverted risk-off risk-on trajectories as well, that when people flood into the dollar, it’s often because they’re worried about growth or whatever. And then at the same time, people will de-risk oil. So I think that’s a good way of just sanity-checking yourself.

[00:50:14] Hari

So if I go to march 2020, let’s say, the dollar rallied hard, oil dropped hard, even harder. How do I know what percentage of that or what the loading was on the dollar vis-à-vis just a collapse in demand?

[00:50:30] Rory

Yeah. I wrote a piece on this, actually. I called it Dollar Wrecking Barrel. It was essentially about this. So this whole thing that we’ve been talking about, typically, they move inversely, inverted to one another. But for the majority of 2020, sorry, 2022, the dollar rallied at the same time the oil was rallying. What you saw in that moment was this concern and flight to quality, flight to dollars, because of a ground war in Europe that also had a major oil element. So I think at certain moments, they can trend together, positively correlated, when the risk is something specifically related to the oil market.

But to your question about can you extract the specific domination effects, I’ve tried in a couple different ways. I think the most effective way of doing it or the most (I was going to say theoretically but I almost said theologically) theoretically sound, is essentially the way this is really going to manifest at the end of the day is the affordability of oil and oil products. The majority of the world that consumes oil does not earn money in dollars, but the commodity is priced in dollars. So when you see, let’s say, a major devaluation relative to the renminbi, or the euro, or whatever, it’s proportionately more expensive for those consumers to consume oil.

So you would assume that all else equal, oil would adjust gradually around that and essentially create a consumption-weighted currency index, and you can kind of extract how much of that was based on denomination effects alone versus flows effects. I think both of those can play in. That said, very frankly, I think the denomination effect on a month-long timeframe is a useful framing. But day to day, it’s probably not that useful. It’s probably an over-complication of a relationship where the dollar goes up, oil goes down.

[00:52:27] Hari

Yeah, I was going to come to that. So if I picked a horizon, let’s say, a month, and I break the scenarios up into four: oil up, dollar up; oil up, dollar down; oil down, dollar up; and both down, where you are, which quadrant you’re in should tell you something about the state of the world. Is it fair, at least on a retrospective basis?

[00:52:48] Rory

Yeah, I definitely think that’s fair. Let’s say in a month or even in a given week that oil prices rose by 10 bucks and DXY was up 5%, then yeah, it’s actually an even better week for crude because on a dollar-adjusted basis, crude has done even better. I’m going to keep coming back to context. It’s important to ground yourself in why you think these things are happening together, because I think that informs a bit of your view of like, well, is that going to persist, is something that’s going to unwind, which side is going to unwind. It just gives you a bit of tactical awareness of the space. I think a lot of people just passively consume this data. I think it’s always important to critically assess why those things are happening together.

[00:53:37] Hari

Now, let me throw another monkey wrench in the works here, which is that if I understand correctly, the Fed model for inflation uses oil as a major input. It assumes that perhaps oil prices are transitory or highly mean reverting, but if they become sticky, suddenly all bets are off (sticky and high) and you can expect, at least if they follow the model, tightening. So is there this complex interaction between short rates, oil price levels and stickiness and the dollar? Is this some kind of strange brew that one has to consider? Do you consider that stuff or is it slightly outside of your boundary?

[00:54:28] Rory

Particularly in moments like this, no one could ignore monetary policy. I would not consider myself a well-vetted fed watcher. I think what we interestingly saw last year, and historically, you’ve seen the Fed really focus on these core inflation drivers, structural moves in prices and would in some ways actually fade to just temporary energy or food effects. But what you saw a lot of commentary around last year was this overwhelming concern with headline inflation and this idea and this risk of an unmooring of consumer inflation expectations.

For that reason, you saw Fed officials continually cite not just oil, but specifically, pump prices. The other thing that was going on last year and why everyone was particularly losing their mind over gas prices was not only did you have oil at 120, you had gasoline crack spreads, which normally are at about 15 bucks a barrel, gasoline crack spreads were at 60 plus dollars a barrel. So you weren’t paying $120 at the pump, you were paying 180. I think it’s that double whammy. So the Fed became overly fascinated, overly fixated on oil price.

I do think for a little while there, at least, when prices were that high, they were going to keep hiking until prices came down. Thankfully, they did come down so that wasn’t the driving thrust anymore. I say this often, now you hear there’s an egg crisis stateside, all of these prices and whatever skyrocketing, but I still guarantee you that people are not as aware of the price of eggs as they are the price of gas, because it’s literally the only thing and it’s literally everywhere. You see the price everywhere. I think there are legitimate debates over the usefulness of inflation expectations in inflation modeling, but we know that the Fed takes that very, very seriously.

If your concern is more of inflation expectations and you’re worried about what consumers are seeing and feeling, then yeah, gas prices are going to be literally top of that list. So for them, both oil prices came down by 40% or so from that level. But thankfully, gasoline crack spreads went from $60 a barrel to almost flat, almost zero in the US, and I think negative in some areas of the world later that year. So I think that helped take a huge amount of pressure off of monetary policy authorities and this concern of inflation expectations.

[00:57:06] Hari

Now, speaking of spreads, I would have thought, naively, that oil and natural gas should have some relationship because drillers have a choice, at least to some extent, what they’re going to drill for. Why has nat gas gotten hit so hard relative to oil? Other than the oil sands argument, the structural argument, is there anything else behind all of this?

[00:57:29] Rory

My one caveat here is I do not cover nat gas nearly as closely as I do crude markets and refined product markets. But as an overarching thesis here, there’s two things that you should consider at once. One, the North American gas market is very, very structurally different from the rest of the world’s gas market, natural gas market, I should say. In a lot of areas of the world, and this is true for a lot of LNG shippers and even piped gas from Russia, a lot of that was actually explicitly indexed to oil prices, because in many cases, producers were actually typically not targeting gas specifically, they were actually targeting oil, at least historically.

What you see in North America is much more of a decoupling of those markets and a lot more gas on gas competition in terms of pricing. In North America, you’ve seen that they have fallen similarly, let’s say, over the past six months. It’s been a bad six-month period for both crude and natural gas. The way I think about it is not so much in terms of demand competition, because there isn’t much. There aren’t many moments where you actually have a lot of substitutability between oil and natural gas. But at the producer level, people always talk about breakevens, or the cost of production for a US producer, they talk about it in oil terms, so like it’s a $60 breakeven or $70 breakeven or whatever.

But the important thing to remember is that many of these producers produce like a 50/50 gas oil split. So the higher the price of gas steady-state assumption, the lower your effective breakeven for oil is. What we’ve seen now when the price went from nearly $10 a million BTU for Henry Hub down to, we are currently at $2.63 as I’m looking on the screen right now, which is not a great price for gas, let me tell you. But that kind of 75% reduction in the value of gas inflates, all else equal, the breakeven price of oil these producers need in order to actually have profitable oil production. So that’s the main way I look at it. I look at gas and how it affects the oil market.

The other thing that you see is that natural gas is a very material input both for heat, power and for the production of hydrogen in refineries. So what you see as well and one of the reasons that you saw quality differentials, I was talking about this earlier with heavy blends of crude etc., when the quality differentials blew out, they often require hydrogen to continually break down into more and more valuable products. And if your cost of hydrogen, because of the cost of natural gas, is skyrocketing, either it goes to like $10 Henry Hub or truly astronomical levels in Europe, well, that’s completely eroding your refining margins.

So when you look at the crack spread, crack spreads are a screen, a simple product on product, but they’re not taking into account the underlying refining costs which has also exploded. That’s why that challenge also comes in, particularly for an area like Europe that had astronomical gas prices and astronomical power prices. Refineries are both gas and power, highly intensive. So that also erodes those crack spreads, those effective refining margins.

So that’s a challenge that sometimes the crack spread on the screen will tell you one thing, but the reality on the ground is very different, because maybe there’s a reason that those crack spreads have blown up to that degree.

[01:00:58] Hari

Fertilizer, isn’t nat gas relevant for fertilizer production?

[01:01:03] Rory

Yeah, absolutely.

[01:01:04] Hari

Is there a disconnect between farming pressures structurally and nat gas prices in your view or is it something where there are so many different factors, one can hardly isolate one?

[01:01:18] Rory

I’m not an agriculture market expert by any means. I do think that it obviously hurts profits. I think you saw a lot of that both in 2021 and 2020. (What year are we in?) So, I think that was a topic of discussion. But the other thing, in many ways, that’s hurt farmers as much, if not more, in some cases, is, while I mentioned like gasoline crack spreads were at $60 and came back down to basically zero, diesel crack spreads, which is the main fuel that underpins farm equipment, industrial machinery at large, those crack spreads, they’re actually down material and right now in New York Harbor, they’re sitting at about $45 a barrel.

That hit almost $70 a barrel, which again, normal is 15 bucks. So these are huge cost burdens for producers that consume diesel in large quantities. I said earlier that I think one of the best personal trades I’ve ever made was in 2021. We switched a diesel car for a gasoline car, not based on any personal or professional view, just because that was what was available with what we were looking at. But it ended up being one of the best trades I have ever made because oh my gosh, the diesel prices have been painful.

[01:02:42] Hari

Very interesting. Now, I’m worried because we’ve gone over an hour. I don’t know what Niels is going to say but I’m going to say we should do a round-two one of these days as well if you’re available.

[01:02:52] Rory

Always happy to join.

[01:02:54] Hari

Is there anything you’d like to say in conclusion? I know we’ve covered a bunch of topics. I didn’t make as many contentious statements as I’d hoped but we can always do that next time.

[01:03:03] Rory

Sorry. My apologies as always.

[01:03:05] Hari

No, it’s not you. It’s more me. But is there anything you want to tell the audience about what they can look for from you going forward or what you’re focused on now on the research side?

[01:03:17] Rory

Yeah. On the research side right now, I was mentioning, obviously, a lot of my focus has been on the supply-demand, its lagged model. Well, the big thing I’m working on right now is essentially now casting that model, so bringing that from two months lag to as close to present as I possibly can get. And then from there, I’m looking to actually begin forecasting. I don’t actually have official forecasts right now because I think my value add is more on this decomposition of historical work.

[01:03:44] Hari

Is the nowcasting statistical work?

[01:03:47] Rory

It’s partially statistical, partially alternative data. So right now, I’m working on jet fuel and using a variety of the different data providers out there that provide real-time flight activity and trying to relate that to jet fuel demand. From there, it goes on to fuel oil and shipping demand, and then you go into gasoline and diesel work, etc. That’s going to be my way of beginning to work that through.

[01:04:16] Hari

Excellent. Well, I look forward to that bit. That’s long overdue. I’ve seen inflation and GDP nowcasts, but I haven’t seen an energy one. So with that, I will hand it back to Niels.

[01:04:31] Niels

Thank you so much Hari and Rory for a conversation full of energy and some really good insights. There were quite a few things that really stood out to me in this conversation and I just want to mention a few and probably do it in reverse order. I think the impact of nat gas on the refining industry was quite fascinating, as well as Rory’s comments to the relationship between oil and the US dollar and how changes in correlation can tell us something about how the world is doing.

Also, I really appreciated Rory reminding us of the price discovery process within commodities and how that can lead to some unimaginable price moves like what we saw in oil in May of 2020. Of course, Rory’s book recommendations were great and I think both books are in my ultimate guide to the best investment books that you can grab a free copy of on the TTU website. I’m sure you can tell that we believe that energy and commodities in general are super important and critical to understand and we will do our very best to bring you more great content in this area of finance.

Make sure you go and follow Rory’s and Hari’s work because as you can tell from today’s conversation, there are many exciting facets to learn from those who have been in the trenches for many years, and we really look forward to exploring many more of them as our series continues. From Hari and me, thanks so much for listening and we look forward to being back with you on the next episode. In the meantime, take care of yourself and take care of each other.

[01:06:09] Ending

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