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October 6, 2023
The Days Ahead:
Every now and then Cushing, Oklahoma gets in the news. Not in a good way. If you stick your finger in the middle of a map of the U.S., you’d probably hit Cushing nine times out of ten. It’s 1,409 miles from Los Angeles, 1,394 miles to New York, 670 miles from Corpus Christi, the country’s largest port, and 738 miles from Chicago.
That’s by design. Cushing is an oil storage town. It can hold 100 million barrels of oil which is about 112 days of national gasoline consumption and about 15% of total U.S. storage. That may not sound very much but it’s about one-third of the Petroleum Strategic Reserve.
Much of U.S. oil storage is underground. Not underground tanks or anything fancy but in depleted reservoirs. The EPA doesn’t much like underground oil and petroleum tanks, and with good reason, given their history of leaks, flooding and cold. The choices to store oil are thus at the wellhead (not much room if it’s offshore), at refineries (expensive), in ships (very expensive), pipelines (ok, unless you need them to transport oil), caverns, salt domes and underground reservoirs (great but remote).
The trouble with any of those is that they’re a long way from where they’re needed for transport and refining and so only work for long-term storage. The oil industry needed was an entrepot where oil could be stored and moved easily.
Enter Cushing. If an oil company doesn’t have a ready buyer for crude, it ships or pipes it to Cushing. It’s then sold and moved again to whatever port, refiner or other storage facility the buyer decides . Cushing operates 30 inbound and outbound pipelines so it can move oil quickly and cheaply. Its importance is such that if you buy a futures contract of the West Texas Intermediate (WTI) oil on the Chicago Mercantile Exchange, the contract stipulates that if you’re a seller you must deliver the oil to Cushing, and if you’re a buyer, pick it up at Cushing.
This is what’s going on at Cushing right now.
Oil storage is at about 20% of capacity and one of the lowest levels in years. It’s also fallen very quickly, having halved in less than three months. It’s getting to the point where the oil is difficult to remove.
Oil storage tanks in Cushing come in two types, those with outlets and those without. If there’s an outlet, water and sediment sink to the bottom and what’s left becomes sludge and can’t be removed. If there’s no outlet, the storage tank roof floats on the crude, preventing evaporation (a good thing) but it compresses the oil all the way to the bottom creating a pool of less oil but a heck of a lot of combustible vapors. In both cases, it’s expensive and dangerous to remove. Many of the Cushing storage tanks are now at levels that are impractical to remove. Cushing needs more oil.
The reason Cushing storage has run down is down to three reasons.
The first reason is that Russia and Saudi Arabia agreed to price cuts which sent oil prices from around $80 to $94 in the six weeks from mid-August to end of September. That created demand for already-purchased oil which was stored in Cushing.
The second and more important reason is that refining and export demand spiked in September and the quickest way to get more oil was to buy it from Cushing. The reason refinery demand spiked was that many refiners delayed maintenance in the summer after running full tilt for over a year. They needed time to fix them. There have been 124 mechanical outages at U.S. refineries this year up from 81 in 2022. Remember that the last major refinery of over 200,000 barrels capacity a day was built in 1977 and only eight refineries, with total capacity of 298,000 barrels, have been built in the last 22 years. That compares to daily refined oil needs of 18 million barrels. The U.S. has a chronic capacity problem with refineries. Any minor glitch and prices start to move quickly.
The final reason is that the above two issues coincide with the time of the year when refineries move from summer to winter blend. Summer blend evaporates at lower temperatures so there’s less pollution. Summer blend is more expensive to refine and many oil companies want to make the switch as soon after the legal date switch as possible, which was September 15.
California only allows winter blend from October 31st, which is one reason California gas prices are the highest in the country at 14% above the second highest and 68% above the national average. But whether for national or California deadlines, refineries must shutdown to make the switch. Peak maintenance is expected around mid-October, after which capacity should be back to normal.
So, a combination of the three means Cushing is running out of oil and needs to refill at current spot oil prices. But the future price of oil is much lower than the current price, which is called backwardation in the futures world.
Here’s what it looks like:
This says that if you need oil for October 19, it will cost you $89 to deliver. But if you need it in January, it will cost only $84. If you don’t need it for a year, it will cost $77.
The spike in oil and gas prices should ease in the next few months, especially as Cushing stocks slowly refill. We don’t think it will have a lasting effect on inflation but it does show how delicate is the balance between supply and demand. A Saudi/Russian production cut, a few out-of-commission refineries and a change to winter fuel blends can send things into turmoil. But it shouldn’t last. Oil this week dropped from $94 to $82. We expect those Cushing stores to increase in coming weeks.
We’ve mentioned a few times in these notes that Japan is an unusual case. For most of the last 30 years it’s population was shrinking and ageing and inflation was negative in 25 out of 28 years. Between 1996 and 2021 total inflation was 1.7% or 0.06% a year.
The Bank of Japan (BOJ) famously initiated a near-zero interest policy rate of 0.5% in 1995 and 0.3% in 1998 where it’s been ever since. The 10-Year Government Bond Yield sunk below 2% in 1998 and 0% in 2016. Meanwhile, the BOJ started a government bond buying program back in 1998 which today stands at $5.2 trillion. In 2023 it’s risen by over $200 billion at a time when every other major central bank has started to run down balance sheet holdings.
But things are changing.
Japanese inflation is slowly moving and briefly hit over 4.0%, although it has since eased to 2.8%. Wages are growing. They remain 4% below what they were in 1994 but in the last year rose 2.7%. And the 10-Year Bond yield rose to 0.78% from 0% a year ago to reach the same level it was in 2013. Finally, a new Governor was appointed to head up the BOJ in April.
There have been many false dawns in Japan and many a wise hedge manager has lost a lot of money shorting government bonds in the last 30 years, such that it was often called the “widow-maker” trade. It was a bet that looked great on paper and had history and rigor on its side. It’s just that no one expected the Japanese malaise to last so long.
Slowly, however, Japanese inflation seems to be staying above the 2% target. Meanwhile, a number of stock market reforms are in place to help retail participation, the most notable being the Tokyo Stock Exchange’s 2025 deadline for companies to raise their stock prices above a price to book value of one, or risk being delisted. This has helped the stock market rise some 20% this year, one of the best performing of the major markets.
We’d also take some comfort that there is a new generation of leaders who believe this time is different. They’re not of the post-war “Showa”, where corporate leaders were told they could do nothing wrong. And they’re not the “post-bubble trauma” managers from 1991 on who were told they could do nothing right. There seems to be a new group who want their own positive legacy.
That’s fine. But this is a problem.
This is the yen against the U.S. dollar in an inverted scale. This year it’s fallen 14% and by 23% in the last year. Against the Euro it’s fallen 12% and 14% and against the renminbi it’s fallen 6% and 11% (and that’s with a managed, not floating, exchange rate regime). It’s no real mystery why. The Fed, European Central Bank (ECB) and PBOC have all raised rates while the BOJ has stood still. The rate differential for overnight deposits ranges from 2.5% for the renminbi to 5.5% for the dollar. The interest rate differential makes keeping cash in yen very unattractive.
But ¥150 to the U.S. dollar is somewhat of a pressure point for the BOJ and Treasury. It’s not only the same level as it was in 1986 but it’s also at the same level as it was a year ago. At that time, the Ministry of Finance instructed the BOJ to buy yen with dollars. They have plenty of firepower with over $1,253 billion in reserves and only needed around $42 billion to drive the yen up by 17% in six weeks. We feel they may have intervened this week when the yen strengthened from ¥150 to ¥148 in the space of a few hours on Tuesday but promptly weakened again the next day.
Markets may try and push the Yen lower to test the resolve of the BOJ. The Japanese 10-Year Bond has already risen from 0.4% in July to nearly 0.8% this week but the volumes are very thin as the BOJ holds most of the outstanding 10-Year Government bond issues.
We’d guess that the BOJ will wait until the yen reaches some number over ¥150, see how many traders are over their skis, step in with some buys and then watch the yen strengthen. But the decision comes from the Ministry of Finance, not the BOJ. It’s a bit of a waiting game right now, but it’s coming.
Bond markets use a lot of technical terms but a common one is the “yield curve”. Right now, it looks like this:
The top (blue) line shows the yield on Treasuries ranging from 5.3% for two-month bills, all the way to 4.8% for the 10-year Treasury and 4.9% for the 30-year Treasury. The other lines are from a week ago (green) and the beginning of August (black line). You’ll notice short-term rates have barely moved while the long-term rates have climbed from 4.0% to 4.8% for the 10-Year and 4.2% to 4.9% for the 30-Year Treasury. The gap between the 2-year Treasury and the 10-year Treasury was about 0.72% in August and it’s now 0.34%. That means it’s inverted. Short-term rates earn more than long-term rates.
What’s happened is that the curve has become less inverted by way of a “bear steepener.” What’s that? Well, here’s a picture.
In each case the curve moves from the solid line to the dotted line.
What’s happened in the last month is a version of the left-hand side, a bear steepener. Long-term rates have climbed while short-term rates have pretty much stood still. That suggests the market thinks that rates will stay higher for longer. The Fed more or less controls short-term rates and those haven’t moved much. But the long-term rates moved up on the expectation that we’re some quarters away from a Fed cut. A “bull steepener” is when the market expects a lower rate from the Fed and short-term rates fall in anticipation of easing. In both cases the curve ends up “steeper” than when it started.
Sharp eyes may see that the “bear steepener” chart looks nothing like the curves of the last few months and that’s true because it’s more or less copied (with bad PowerPoint skills) from a standard text book that deals with theory.
But the world is messier than text books. Here’s the real-world version of the “bear steepener” case.
We left “bull steepener” out because that’s not the world we’re in.
You can see that the curve looks something like the chart two above. It moved upward with the short-term rates mostly unchanged and the long-term rates yielding more. Even though the curve is upside down, or inverted, it is steepening (even though it looks flatter!) in bond world jargon. Confusing, I know. The short-term rates remain unchanged and long-term rates yield more and so fits our definition of a “bear steepener.”
So that’s what’s happening right now. What’s next?
Well, the curve may stay this way until the Fed cuts rates. But that, barring some major economic trauma, won’t be until mid-2024. Meanwhile, the 10-year Treasury is yielding more than at any time since 2007 and looks increasingly attractive to bond buyers. Thanks to the “bear steepener.”
Much of the week was focused on a “will it, won’t it” on the 10-year Treasury. Would it break through to 5% or sell off before the nice round number? It rallied. By Thursday it was back at 4.75%. We had a strong Job Openings and Quits number (JOLTS) and poor ADP report. We don’t usually talk about the ADP report but it’s a job survey from the payroll company of the same name. It’s a terrible report, opaque, littered with mistakes and prone to missing the real jobs report by 80% in either direction. But hey, the markets watch it.
We wrote some months ago about “R*” or the natural rate of interest. That rate, which is a sort of equilibrium rate where the economy is neither expanding or contacting, has gone up since Covid-19. There are two camps.
One is that the Covid-19 and its aftermath haven’t really changed the tradeoff between growth, employment and inflation.
The other is that it has.
If you’re in the first camp, the recent rate rise is worrying. If you’re in the second camp, then the low Nominal GDP growth of the 2009 to 2021 period is over, the economy less lethargic and a higher rate environment is both apt and welcome. But this takes some adjustment and we’re in the midst of that adjustment. Meanwhile equities are softer, down around 5% in the last three months. But we’re entering a new round of earnings reports. We think they’ll be better than the market thinks.
Art: Jylian Gustlin (b. 1960)
Please read important disclosures here.
Christian is a Partner in the North Bay office. Prior to joining Cerity Partners, Christian was Chief Investment Officer for Brouwer & Janachowski. He oversaw...
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