The Breakdown - A Primer on How Oil Has Reflected Macro and Geopolitics

Episode Date: August 13, 2022

This episode is sponsored by Nexo.io, Chainalysis, FTX US and NEAR.   On today’s episode, NLW provides a primer on the recent history of oil markets. He looks at how oil went from trading in negative territory in April 2020 to being a massive contributor to 2022’s inflation. Finally, he explores how oil reflects political realignments that will shape the world in the years to come.  - Nexo is a security-first platform where you can buy, exchange and borrow against your crypto. The company safeguards your crypto by relying on five key fundamentals including real-time auditing and insurance on custodial assets. Learn more at nexo.io. - Chainalysis is the blockchain data platform. We provide data, software, services and research to government agencies, exchanges, financial institutions and insurance and cybersecurity companies. Our data powers investigation, compliance and market intelligence software that has been used to solve some of the world’s most high-profile criminal cases. For more information, visit www.chainalysis.com. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - NEAR is a simple, revolutionary Web3 platform for decentralized apps, created by developers for developers. More than 700 projects are now building on NEAR’s fast, secure and infinitely scalable protocol, from DeFi apps to play-and-earn games, NFT marketplaces and more. Start your developer journey now by visiting NEAR at near.org. - I.D.E.A.S. 2022 by CoinDesk facilitates capital flow and market growth by connecting the digital economy with traditional finance through the presenter’s mainstage, capital allocation meeting rooms and sponsor expo floor. Use code BREAKDOWN20 for 20% off the General Pass. Learn more and register: coindesk.com/ideas - “The Breakdown” is written, produced by and features Nathaniel Whittemore, aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsors is “The Now” by Aaron Sprinkle. Image credit: sesame/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.com, and ftx, and produced and distributed by CoinDesk. What's going on, guys? It is Friday, August 12th, and today we are talking about oil. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dig deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always. In addition to them being a sponsor of the show,

I also work with FTX. Lastly, this week I am thrilled to welcome NEAR as an additional sponsor. NIR is a revolutionary yet simple Web3 platform for building decentralized apps. Designed by developers for developers, over 700 projects are now building on NIR's fast, fast, secure, and scalable protocol. Whether you're a crypto-native launching defy apps, NFT marketplaces, and play and and earn games, or looking to migrate your project from Web 2, NIR makes it

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So, you are hearing this on Friday, but I am actually recording it a couple days in advance. We have a little bit of travel at the end of this week, and so I thought what might be fun is to do a short primer show on a macro topic that we often touch on, but which doesn't really have the chance to take center stage. Today, that topic is going to be oil. One of the ways that we can view the last few years is as a sequence of massive events with tremendous geopolitical and economic ramifications. COVID started a new structural period, and two years later, Russia's invasion of Ukraine accelerated shifts, both that were happening

already before COVID, but also those which were reinforced by COVID and the policies from governments that followed. I'm thinking specifically about the megatrend of de-globalization and a new way of looking at production in global markets. Throughout that, commodities in general, but oil in particular, have served as a uniquely interesting representation of what was happening in the broader world. To start, let's go back to early 2020. In January and February, we start getting hints of something really bad happening in China. Those of us who were in crypto or just in finance and business in general probably had a little bit more of a preview of COVID than others did,

given how much we interact with people who are already experiencing some of the problems of the COVID-19 pandemic. By the end of February and the beginning of March, however, it was clear that this was going to be a worldwide phenomenon. In early March, the World Health Organization declared COVID-19 a pandemic after a month of reported cases and deaths around the world. One by one, countries began to lock down, with the U.S. issuing national stay-at-home orders on March 15th. By the start of April, over half the world's population was under some form of lockdown across more than 90 countries. The price of oil had been tumbling for months at this point. Its starting point was a fairly stable price of around $60 per barrel throughout. 2019. In January, however, it was down over 15% as the first reports of the pandemic came out of

China. February was fairly stable for oil, but then it was down another 50% in March, as the rest of the world started to catch up with what was going on, and another 50% in April, as it became clear that pandemic measures weren't going to end quickly. This was never going to be, do this for two weeks and we'll all be done with it. Now, probably the most interesting part of this oil crash was the day that oil prices went negative. On Monday, April 20th, West Texas Intermediate, or WTI, which is the U.S. benchmark oil contract, dropped by almost 300% to below negative $37 in a single day. This was unprecedented in the history of the contract and seemed to defy basically all logic. It meant that holders of the contract were paying others to take it off their hands.

Now, there are a few factors that combine to enable this strange market action. The worsening pandemic had already reduced oil demand by a third, as air travel was halted and economies were shut down. However, oil production can't simply shut down within a few weeks. Major Western producers had cut forward production, but this takes time to carry out. In early March, OPEC, which is the coalition of non-Western oil-producing states, led by Saudi Arabia, had failed to reach an agreement on production cuts with Russia, leading to a price war in ongoing negotiations. Refineries were overstocked and long-term storage facilities

were filling up. We'd gotten to the point where oil tankers were being used to hold excess barrels rather than to transport them. In other words, production had been cut somewhat but nowhere near enough to meet suppressed demand. The physical market for oil was overflowing. Now let's talk about the actual contract for a moment. The WTI oil contract is the standardized monthly futures contract for oil supply in the U.S. There is one contract per month which expires in the third week of every month. It's closely tied to the physical oil market as well. While some futures contracts are cash settled, meaning that on the expiry of the contract,

the holder receives cash equivalent to the goods in the contract, WTI is a physical settlement contract, meaning that if you're holding a contract on expiry, you have to have somewhere to take physical delivery of the thousand barrels of oil that each contract represents. April 20th of 2020 was the day before, the expiry of the May 2020 contract. Given that it was the penultimate day of trading, liquidity was thin. At market open on Sunday night, the contract was trading at $17,

but it had experienced six straight days of losses and seven negative weeks over the past two months. A few days earlier, OPEC had finally agreed to a production cut representing around 10% of global supply, which was historically large, but nowhere near enough to calm fear in the market. By the time morning trading commenced on that Monday, the price had dropped to $11 and showed no signs of stopping its slide. The afternoon session saw prices slide into the single digits, but they just kept falling. The contract crossed over into the negative territory by 2 p.m. and ultimately closed the day at negative $37.63. The previous low for the contract had been during the 1986 crash, which dropped the price below $10. The key takeaway here is that this was a real-world

issue exacerbated by a financial issue. The expiry of the contract was the big. challenge. Market participants who ended the following day owning the contract would have to scramble to find a way to take delivery and find storage. There was very little liquidity for a contract that was dropping like a rock and represented the liability of having to find storage over the next week, rather than the asset of having oil that could be used. The June contract, which had begun trading by then, represented a more reasonable liquid valuation of oil at the time, which was around $20. The May contract ended up trading back up the next day into expiry in the afternoon at $10.

It really was a fascinating confluence of events. You had this crazy, unexpected demand destruction based on lockdowns. You had really severe issues with storage, in particular in the U.S., and you also had just the unique dynamics of this financial instrument. Still, if only for a few hours for that one day in April 2020, traders were being paid to own oil. In times like these, security of your assets should be your number one priority. If you want to offset risk as much as possible and still stay in crypto, you need a trusted partner by your side.

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by visiting us now at Chainalysis.com slash coin desk. The breakdown is sponsored by FTX US. FtXUS is the safe, regulated way to buy and sell Bitcoin and other digital assets with up to 85% lower fees than competitors. There are no fixed minimum fees, no ACH transaction fees, and no withdrawal fees. One of the largest exchanges in the U.S. FTXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. Now to the middle part of our story. By the beginning of 2021, the world is coming out of lockdowns and we have a very different dynamic. As activity resumes, it doesn't just resume, it plays catch up. But then, of course,

2022's big fun geopolitical event begins to heat up. This time it's not a virus, but a belligerent autocrat from a faded power. Throughout January 2022, The oil price began to rise. This was on fears of increasingly hostile rhetoric coming out of Russia. In late February, that rhetoric became real. Ukraine was invaded and sweeping sanctions were imposed. In the weeks following the sanctions, oil markets dislocated violently to the upside. They surged by 25% in a week to hit a peak above $125 per barrel. Those were price levels we hadn't seen since 2014. Physical markets were also badly dislocated.

supply chains experienced huge problems with Russian oil being sort of soft sanctioned and needing to be redirected away from Western countries who discouraged or outright banned Russian imports. The issues were numerous, not just strict sanctions per se, but also shipping companies and insurers not being sure where the U.S. and its allies would end sanctions and not wanting to jump in bed with the Russians at that time. The Dallas Fed released modeling in March of this year that suggested the world would lose around 3 million barrels per day in oil supply from an already tight market with increasing demand. Zooming out, in the U.S., the fallout of this has been one thing, and we'll address the

Strategic Petroleum Reserve in just a moment. But in Europe, in particular, the fallout has been even more severe. Even as the world started sanctioning Russia, one of the exceptions was energy. Russia supplied a huge part of Europe's energy needs, especially in natural gas. And so there has been a real rock and a hard place sort of situation. The U.S. and its European allies want to punish Putin, and Russia for its invasion, but can't really afford to forego Russian energy entirely. In that landscape, Germany is weighing whether to extend the life of their three remaining nuclear reactors and in general rethinking their strategy of shutting them down. In places like Spain, the country is proposing strict controls on the temperature

its citizens and businesses can set air conditioners and heaters to in an attempt to conserve energy. In short, it's an absolute mess. In the U.S., we're more immune to the immediate fallout in the context of our energy needs, but we're not immune to the overall price shocks. One of the big drivers of inflation over the last six months has been increases in the global cost of oil. It's a cost for essentially all meaningful production, agriculture, logistics, manufacturing of plastics. Crude oil pricing affects the cost of essentially everything in modern economies. This year, the Biden administration claimed that more than half of the inflation was due to the rising oil price. Remember the rhetoric of Putin's price hike.

At the FOMC meeting in June, Chairman Powell explicitly pointed out that the Federal Reserve can't print oil. So this is the landscape in which the U.S. made its own response. In the middle of these markets spikes, the Biden administration announced that they would begin releasing barrels of oil from the Strategic Petroleum Reserve or SPR to ease markets. The U.S. has maintained the SPR since 1975 to allow it to better cope with oil shocks. The SPR holds physical barrels of oil in dozens of heavily guarded caverns on the Louisiana and Texas coasts. Going into the first price shock in late 2021, the SPR held over 600 million barrels of oil, enough to satisfy U.S. demand for around a month.

29 other countries also hold strategic reserves as part of the International Energy Agency, altogether holding around 1.5 billion barrels in September 2021 before any supply releases had taken place. The U.S. has subsequently conducted two release programs. The first came in November, which released 50 million barrels over the next five months, and the second came in April after the conclusion of the first release, which consists of 180 million barrels over the next six months. This is the largest ever release from the SPR. Now, these programs have garnered some significant criticism. The SPR has been used from time to time to ease domestic supply in the event of natural disasters

and infrastructure failure, but this was the first time the SPR was viewed as being used in reaction to high fuel prices. Some argued then that the release was being used purely as a political maneuver in reaction to declining poll numbers for the Democrats as prices at the pump skyrocketed. The key criticism was that there was no real shortage in the U.S. just that prices were high. Whatever the motivations, the U.S. is now in the position where 25% of the SPR inventory held in mid-201 has been released. Current release schedules end in November just after the midterm elections. Meaningful additional supplies have not been forthcoming. So what about the state of oil in the economy

now in the U.S.? On Wednesday, we got our first inflation print reading in the context of a number of weeks of decreasing oil and gasoline prices. It was the first inflation surprise to the downside in more than a year. Headline inflation was at 8.5% year over year and 0% month-to-month. Core CPI was at 5.9% yearly and a less than expected 0.3% month over month. A big driver of this was gasoline falling 7.7% in July. Now, as the Fed continues to raise rates while the U.S. economy rolls over, with consecutive quarters of negative growth, the large question mark hanging over economic policy at the moment is whether monetary policy crimping demand will be enough to bring down inflation.

or whether these structural supply issues of key commodities like oil are much bigger when it comes to inflation than the demand side. For now, oil prices have come down significantly. They've dropped by more than 25% since the start of June, falling below $90 a barrel for the first time since the Ukraine invasion. However, this is all happening with the U.S. still releasing oil from the SPR at a record rate. However, even when we're discussing oil in terms of its relationship with recent inflation prints or, as an indicator of economic slowdown, it's still a fairly limited view. The geopolitics of the situation remained to me the most interesting and important piece of this. On August 10th, Bloomberg columnist Javier Blas wrote, in the energy markets Putin is winning the war. He points out that

as bad as things are now, they're likely to get worse. Quote, electricity costs for homes and businesses are set to soar from October, as the surge in oil income allows Putin to sacrifice gas revenue and squeeze supplies to Europe. UK prices are likely to jump by 75%, while in Germany, some municipal utilities have already warned prices will increase in excess of 100%. Russia has successfully weaponized energy supplies. Western governments will come under increasing pressure to spend billions, either subsidizing household bills, or, as is already the case in France, by taking control of power companies. Blas goes on to point out that there is some fairly significant realignment happening. Initially, after sanctions, Russian oil output fell dramatically,

and they were forced to price the oil that they did have at a steep discount, but now production is back to nearly where it was before the invasion, and the price is basically at parity with other sources of oil. What's more, the U.S. has not had much success in trying to open up new supplies outside of Russia. So this is kind of the state of play right now. And in terms of the political dimension, in the wake of the Russian war with Ukraine, there were two diametrically opposed positions that started to emerge in American politics. On the right, it was all about drilling and why we shouldn't restrict ourselves on energy, which is obviously so fundamental to our national security. On the left, it was a newish narrative that continuing to use fossil fuels is tantamount to funding

dictators and human rights abusers. So far in the U.S., looking at midterms, neither of these points of view has gotten a lot of traction. People are simply too concerned about the actual cost of living and inflation to care. However, I think it seems likely that this debate will accelerate in the lead-up to the 2024 presidential race as candidates lay out their vision for the future. So anyways, guys, there is a quick primer on oil. Hope this was interesting. Hope you learn something. useful. For now, I want to say thanks again to my sponsors, nexo.io, chain aliasis, FtX, and NIR, and thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.