An Energy Crisis, Wrapped In A Banking Crisis, Engulfed In Monetary Crisis

Submitted by QTR's Fringe Finance

One of my favorite investors that I love reading and following, Harris Kupperman, has offered up his thoughts on the market for Q1 2023 - with a focus on commodities like oil and his largest positions - which I think are a great read.

Harris is the founder of Praetorian Capital, a hedge fund focused on using macro trends to guide stock selection. Mr. Kupperman is also the chief adventurer at Adventures in Capitalism, a website that details his investments and travels.

Harris is one of my favorite Twitter follows and I find his opinions - especially on macro and commodities - to be extremely resourceful. I’m certain my readers will find the same. I was excited when he offered up his latest thoughts to Fringe Finance, published below (bold emphasis is QTR’s).

Market Views

Many market pundits are currently fixated on interest rates and their expectation that the fastest rate cycle in recent memory will succeed in creating a recession. While I’m receptive to such a view, I don’t think that rates will be the kill-shot. Rather, I believe that the imminent arrival of an energy crisis, precipitated by dramatic increases in the price of oil, will supersede whatever impact rates may have on the economy.

Taking a step back, I’ve been speaking about oil for a while now. At first, the recovery from negative prices in 2020, made me look astute as a prognosticator. However, since peaking out following the Russian invasion of Ukraine, oil prices have drifted lower, losing almost half of their peak price. As a result, it would be disingenuous for me to tell you how oil is about to rapidly increase in price, if I didn’t first explain why oil prices took a breather, especially over the past 9 months.

In the end, it all comes down to math. Unfortunately, given the nature of oil, precise data is impossible to come by. Instead, I’m forced to use some back-of-the-envelope internal estimates that are likely to be directionally correct, if empirically incorrect. With that in mind, I believe that oil investors have now suffered through the following since the late summer of 2022:

• China locking down over COVID for approximately 200 days with a demand loss of 2.5 million barrels per day (bbl/d) or 500 million barrels (bbl) throughout Asia

• Global Strategic Petroleum Reserve releases in excess of 300 million bbl

• Russia dumping approximately 150 million bbl of crude and refined products before sanctions took hold

• A warm winter in Europe and North America which reduced heating oil and propane demand by approximately 100 million bbl

In total, we’re looking at a swing of approximately 1.05 billion barrels over a period of roughly 200 days, or 5.25 million bbl/d. With that in mind, the surprise shouldn’t be that oil prices declined under the weight of this massive swing. Rather, the surprise should be that global commercial inventories barely increased. Where did those barrels go? They got consumed. What’s more, they got consumed during a period where increasing interest rates incentivized many consumers to run down their existing inventory, inventory that is not tracked by the various acronym agencies tasked with tracking inventory, adding a further headwind to global imbalances.

Now, we find ourselves at a moment in time when the first three of the headwinds noted above are reversing, and no one can predict the weather. Meanwhile, global demand grows every year. If global commercial inventories could barely increase with these extreme factors in play, what happens now that they’ve reversed? What happens if there’s an accident on the supply side for a change?

In my year-end letter to you, I estimated that the year-end 2023 deficit would be between 4 and 6.5 million bbl/d. I remain convinced that this is a great baseline to use (adjusted for a smaller decline in Russian production offset by an increase in global consumption as the “Work from Home” trends reverse) and recent OPEC moves to reduce production by 1.15 million bbl/d will only accentuate the deficits.

Now, think about how ludicrous it sounds to say that we’ll draw inventory at 5.15 and 7.65 million bbl/d to account for the recent OPEC cuts? Of course, we will not draw at anything approaching that rate, but that’s only because oil prices will have to rise to a level that destroys roughly that much demand, balancing the market. Hence why I’m not worried about interest rates. Instead, I’m trying to envision the magnitude of the energy crisis necessary to destroy somewhere between 5% and 7% of global demand. For a point of reference, the GFC, which was the largest economic crisis since the Great Depression, destroyed less than 2% of global energy demand. Could a crisis, a few times worse be necessary and imminent?

Of course, in a highly dynamic market like oil, there are often countervailing forces at play—some positive and some negative for balances. Who could have predicted that a warm winter would save Europe from having to burn copious quantities of oil for power generation? Or that Libya would enter a rare period of relative political stability? These were both impossible to predict, yet positive for overall balances. Where were the inevitable and offsetting negative events?

In summary, it’s odd for a period of time to witness so many events that swing balances in one direction, without other offsetting adjustments in the other direction. I think the past 200 or so days were an unusual outlier, that is unlikely to repeat, and without the events noted above, the energy crisis would have already arrived. At the same time, I’m finely attuned to the fact that many of these events are out of my control, and I have positioned the portfolio so that if the thesis again gets postponed or adjusted in magnitude, we should not suffer too gravely. Ideally, we can profit handsomely, even if the events play out differently than I anticipate.

The fact that some prominent and successful energy investors use...(READ THIS FULL LETTER HERE).