The unprecedented attack on Saudi Arabia’s Abqaiq crude oil processing facility, the largest in the world, is getting a lot of attention and rightly so. As the single worst supply disruption in the oil markets in history, one would expect a bit of press. There are a few aspects of the enormous supply cut though that aren’t being covered very much. First, how much will this supply outage mask price inflation? And could it negatively affect the stratospheric bond markets?
The danger here besides oil prices themselves is that a higher oil price will obviously push up government price inflation indexes like the consumer price index (CPI) and personal consumption expenditures (PCE), but that won’t necessarily inspire the Federal Reserve to stop the current rate-cutting cycle. It will give the Federal Open Market Committee the cover to keep easing, even if inflation is considerably above its 2% symmetrical target. The reasoning will be that since the oil price spike is strictly a supply-side phenomenon, it does not reflect broader dollar weakness. Therefore, the Fed is more likely to tolerate higher price inflation numbers than it normally would, given they would assume the numbers would go back down once full oil production capacity at Abqaiq is restored.
There are serious problems with such a wait-and-see approach by the Fed. First of all, price inflation as measured by government indexes is already at multiyear highs and is in danger of breaking out strongly to the upside. We can see this mainly in the Core CPI, which strips out food and energy, so oil is not even directly involved in those numbers. The core inflation rate is now sitting at 2.4%, already 20% higher than the Fed’s target of 2%. This is the highest that core price inflation has been recorded at since September 2008.
Core CPI is not the only worrying number here that could portend an upside breakout in price inflation sooner rather than later. Another worrying indicator comes from the Atlanta Fed, which publishes an index known as the Sticky Price CPI. Sticky components of the CPI are (admittedly arbitrarily) defined as products that have a frequency of price adjustment of 5 months or longer. You can find them on page 2 here. Meaning, they change price at most every 5 months. The flexible CPI, on the other hand, is comprised of components that change price more frequently. The Sticky Price CPI, according to the Atlanta Fed, has now tied its highest level of 2.7% annual since February 2009.
You may counter that this is really an apples to oranges comparison, because Sticky CPI includes food and energy, so it is not core. But the Atlanta Fed has Core Sticky CPI too, and it also looks like it may be on the verge of a breakout. Core Sticky CPI is up a similar 2.6% annual. We have been at these levels recently, but with the possibility of oil moving back to $100 over the next few months, we could start to see the 3% level start being breached on the CPI by next year. Goldman Sachs, according to Reuters, believes that if the Saudis can’t restore capacity within 6 weeks, we could see $75 oil by then.
Keep in mind also that IMO 2020 regulations forcing the maritime shipping industry to switch to low sulfur fuel oil are going into effect in a little over three months’ time and could add substantial demand in the midst of a supply outage from the Saudis, if they can’t get fully back on-line by December.
That brings us to another problem, with the Fed being complacent on the inflation front. That is, the futures market looks like it is pricing in a year-long shortage in Saudi Arabia that could keep production suppressed all the way out until later in 2020. Nobody knows yet how much damage was done by the attack, but the futures market does give a general hint about what market makers are thinking. If we look at light sweet crude oil futures from the CME Group, we find that the oil market is now in backwardation until the December 2020 contract. Backwardation means futures are cheaper than spot prices. This indicates a shortage, which certainly makes sense in this context. What’s surprising is how far into the future contracts keep getting cheaper, or how far the backwardation extends.
These futures traders might be wrong, but since many futures traders are commercial hedgers rather than speculators, for example airlines or oil companies themselves hedging against future prices, they generally have a better understanding of oil markets because they are directly involved in them more than pure speculators. The next Commitments of Traders reports on oil will be especially interesting in this regard to tell us where commercials versus speculators are positioned after the attack.
If the oil market is in backwardation until December 2020, then while this market may not be precisely correct in terms of timing, it does mean that this shortage out of Saudi Arabia probably will not be resolved in just a few weeks. That brings us to $75 by November, according to Goldman at least. Even if the oil futures market is exaggerating and the shortage only lasts until March, that’s still 5 million barrels a day for 180 days, or an astronomical 900 million barrels. If we assume the Saudis can restore 50% of lost capacity in a matter of weeks, that’s still 450 million barrels of production lost in total. Throw IMO 2020 on top of that and a possible war with Iran after this attack, and we could realistically see $100 oil by the summer 2020 driving season.
Bond Market Infection
But the real problem of ignoring the rise in price inflation caused by this shortage may be for the bond markets. Whether or not prices are rising because of a temporary oil spike or general price inflation, the Treasury market and global bond markets are at such historically unprecedented nosebleed levels that 3% CPI inflation could spook bond markets and cause a selloff. Interest rates are well below inflation in the US, as it is without any of these disturbances, so real rates are already negative basically across the board. If inflation crosses the psychological threshold of 3% on the CPI, bond investors will have to seriously start asking themselves how much they are willing to lose on these “safe haven” investments.
Regarding the now-heightened possibility of a US war with Iran, tweets from President Trump are notoriously fickle. But for what it’s worth, he did say he was waiting for the Saudis to give him their opinion of who initiated the attack, basically giving Mohammad bin Salman the greenlight to blame Iran and invite the US to take on that country directly, as many in Trump’s inner circle have been wanting to do. An open war with Iran could also risk derailing any progress on trade talks with China and really push the CPI higher in the midst of the highest-priced global bond market in world history. Not to mention war itself is astronomically expensive, and would require even more Treasury supply being sold, in the midst of trillion-dollar deficits in peacetime very late into the longest business expansion in US history.
Just a few things to consider outside of a temporary oil shortage caused by a few drones.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long XOM.