Weekly Energy Update (October 27, 2022)

Posted on October 27, 2022December 13, 2022 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil prices appear to be building in a base in the mid-$80s.

(Source: Barchart.com)

Crude oil inventories rose 2.6 mb compared to a 1.5 mb build forecast. The SPR declined 3.4 mb, meaning the net draw was 0.8 mb.

In the details, U.S. crude oil production was steady at 12.0 mbpd. Exports rose 1.0 mbpd, while imports rose 0.3 mbpd. Refining activity fell 1.8% to 88.9% of capacity. We are approaching the end of refinery maintenance season, which means oil demand should begin to rise soon.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. As the chart shows, we are past the seasonal trough in inventories. The build seen from October into November is usually strong due to the end of refinery maintenance. With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2003. Using total stocks since 2015, fair value is $106.28.

The Emergence of Zero: Since the onset of the war in Ukraine, Europe has been dealing with a natural gas crisis. Between sanctions and Russia’s actions to reduce exports to the EU, natural gas prices have been on a tear.[1]

(Source: Bloomberg)

As the previous chart shows, natural gas prices from prompt delivery reached €300 per megawatt hour.[2] However, a truism of markets is that prices engender a reaction. Consumption has fallen and high prices have attracted LNG flows, leading to nearly full inventory levels. With commodities, in general, but natural gas, in particular, once storage is maximized, there is really no place for the gas to go. With liquid fuels, there is often some storage at the tertiary level. With gasoline, for example, some can be stored in cars and at service stations, and this isn’t counted in national data. With a gas, however, the ability to store is limited and because temperatures have been unusually mild in northern Europe, consumption for home heating has declined. This week, prices actually went negative.

(Source: Bloomberg)

This situation is unlikely to last. The current problem is that there is nowhere for the current flows of gas to go, but once temperatures fall, prompt supply plus inventory will be necessary. What must be remembered about natural gas inventory is that most facilities cannot store gas indefinitely as gas goes into the facility and out of the facility at roughly a steady rate. In the U.S., storage injections usually end in November and then the gas must be moved into the market whether it is needed or not. This is why the lowest natural gas futures prices have occurred in January. If temperatures are warm, prompt supplies are combined with inventory disgorgement, leading to a collapse in prices.[3]

The Passive Investment Problem: Academic finance has floated a theory called “common ownership.” It goes like this: an active investor will select stocks within an industry, but a passive investor buys an index that represents the entire industry. The active investor, as an owner, has different goals than the passive investor. The active investor may support an individual company’s investment, or pricing policy, which would be designed to improve the profitability or the market power of that individual company. However, if all the companies in that industry engage in similar behavior, the collective outcome may not be positive for the investors in the individual companies. On the other hand, the passive investor, because they own the entire industry, would tend not to support actions by companies, for example, to lower prices to gain market share or expand investment to do the same. Instead, the passive investor should support industry concentration and market power that enhance returns to shareholders. Simply put, the passive investor has no interest in companies actually competing. As passive investment begins to dominate, the cost to society may be less production and higher prices, and some have even argued that passive investment is “worse than Marxism.”

Obviously, this theory is highly controversial. Anti-trust authorities are examining it, the passive industry suggests it doesn’t exist, and the pushback against ESG raises concerns about investment concentration. What caught our attention is the notion that the common ownership problem may be contributing to the disconnect between commodity prices, in this case oil and gas, and the lack of a supply response. In other words, we haven’t seen oil investment and production rise despite elevated oil and gas prices. Although ESG has been blamed for this disconnect, the Dallas FRB survey suggests investor pressure was more important.

Recent data shows that oil production growth is overwhelmingly coming from private companies, since publicly traded companies are refraining from boosting output.

Currently, it is estimated that passive funds hold about 30% of the publicly traded universe of stocks. That’s up from 10% in 2010. In a sense, passive investment becomes a form of tacit collusion. In a classic prisoner’s dilemma, both parties defect, leading them to longer prison sentences than if they both stayed quiet. This outcome assumes a lack of coordination. In economic terms, the decision matrix could be invest/don’t invest. If both parties don’t invest, they receive higher profits, but if one company invests and the other doesn’t, the investing company is better off. However, if both invest, production expands and prices fall, leading to a worse outcome for the businesses but a better outcome for society (greater supply, lower prices). Last week, we reported on Harold Hamm’s quest to take Continental Resources (CLR, $73.67) private in order to free his company to boost production and release the firm from the clutches of the indexers.

President Biden is pressing the industry to boost output. Maybe the solution is to address passive investing instead.

Policy: Last week, we discussed the situation with SPR policy and what appears to be the evolution toward using the reserve as a buffer stock. Although the White House continues to argue that the releases are not politically motivated, it is hard not to observe that the releases are occurring before the midterm elections.

This chart overlays how many gallons of gasoline can be purchased at the current average U.S. gasoline price and the hourly wage for non-supervisory workers. The higher the number, the better off the gasoline purchaser’s position. Since 1996, when the gallon per hour measure is less than eight, the presidential approval rating averages 42.8%, while measures higher than eight average a 54.7% approval rating. Lower gasoline prices don’t always help approval ratings (they didn’t do much for President Trump), but it is pretty obvious that they are having an impact now.

The SPR has seen the steepest decline in its history. We note media sources are suggesting that there is still plenty within the reserve for emergencies. That is only partially true as these comments ignore the fact that we have seen a larger decline in sour crude, which is preferred by U.S. refineries. Although sweet crude is usable, it is more likely to be exported. Thus, if the goal is the optimization of protecting Americans from a supply outage, it would make more sense to export sweet crude to lower global prices. The fact that sour crude was drawn suggests that the primary goal is to lower gasoline prices.

As we have noted, the White House is promising to keep draining the reserve, but it is also promising to start buying crude oil in the $72 to $67 range. We harbor serious doubts this buying will ever occur, as does the industry, but that promise is in the public record and could affect prices.

Finally, one of the overlooked elements of the SPR’s release was that cars don’t use crude oil; rather, they use gasoline (and a few use diesel). Refining capacity has been constrained for some time, and industry officials told the energy secretary that recently shuttered refineries are unlikely to reopen.

Market News:

The IEA is warning that the current situation is the first actual global energy crisis.
Germany is reluctant to support a price cap for natural gas, fearing that if the price is set too low, it could lead to shortages. EU industries are heavy users of natural gas, and if prices remain elevated, it is unclear if European industrial production can be maintained. For example, BASF (BASF, $11.38) announced it will “permanently downsize” its operations in Europe due to high energy prices. Petrochemicals are dependent on natural gas for feedstock, meaning that the loss of Russian gas makes operations in Europe tenuous.
Although EU gas inventories are near capacity, the interconnectedness of the system has never been tested with this degree of stress before. If all works perfectly, flows must cross national borders. If nations decide to hoard gas to protect their own markets, shortages may emerge even with ample inventories.
- Germany and Spain are at odds with France over a pipeline proposal that would expand capacity from the Iberian Peninsula to Germany. France opposes the pipeline for economic and environmental reasons.
- France’s nuclear power industry has suffered a spate of maintenance issues. Currently, 26 of its 56 reactors are offline due to problems ranging from basic maintenance to corrosion issues. If these issues are not resolved soon, it could mean higher demand for natural gas, fuel oil, and coal.
- In eastern Europe, households are scrambling to heat their homes by using lignite, wood, or even trash.
Although the U.S. is a net exporter of natural gas, the transportation system for gas (in the domestic U.S., most gas moves by pipeline) creates situations where some parts of the country require imports to meet demand. New England requires LNG imports to balance the market and is facing tight supplies as it competes with Europe for available supplies.
Turkey has been straddling the conflict in Ukraine since it began. For example, it provided drones to Ukraine early in the conflict. It has also engaged in talks with Russia about becoming a natural gas hub. Turkey is already a transit state for oil from Iraq and Azerbaijan. Iran is planning on expanding natural gas exports to Turkey, and we would expect these flows to be eventually destined for Europe.
A rise in COVID-19 cases in China’s coal-producing areas could lead to constrained supplies.
Slow Chinese growth is freeing up product supplies for export. China’s September diesel exports rose to their highest level since July 2021.
The U.S. will hold an auction for offshore oil development in March. This auction was part of the Inflation Reduction Act.
China has made a large shale gas find in the Sichuan Basin.
Shell (SHEL, $53.32) has announced its participation in a Qatar natural gas development.

Geopolitical News:

The EU has announced sanctions on Iran due to Tehran’s decision to provide drones to Russia. Protests continue in Iran, and this article provides an anecdotal “feel” for how the protests appear on the ground. One of the more interesting quotes discusses the worries of the government: “They are really worried that Iran will become like Syria.” We suspect the market’s take on the protests is that if the government falls, it will be bullish for oil. However, if the end of the regime results in chaos, we could have a situation similar to Libya, where oil flows, even if permitted, become intermittent due to internal power struggles.
- Protest participants are moving beyond students and women to the labor movement. The security forces are cracking down with increasing ferocity, leveling charges against hundreds.
- Two Iranian Revolutionary Guard Corps members, including one colonel, were assassinated in the Baluchestan province. This area has always been difficult for Iran to control, but unrest has been rising along with tensions elsewhere.
- Tehran is moving more deeply into Russia’s camp.
One of the reasons OPEC+ announced target cuts was to counteract the U.S.-sponsored price cap. The White House has countered that the cartel wasn’t the target of the measure; perhaps that is true, but the cap does create a mechanism that could be used against oil producers.
- Sources claim that Russia can probably evade the price cap and sanctions, although it would require ports and canals to accept Russian insurance. India and China continue to flout Western sanctions.
According to reports, the Kingdom of Saudi Arabia (KSA) pressured other members of OPEC+ to publicly support the recent target cuts so that the U.S. couldn’t isolate the KSA for criticism.
The Biden administration has not decided how to “recalibrate” its relations with the KSA. Clearly relations have deteriorated, but the White House seems to want to move slowly on a complete break. Conditions are so bad that the KSA had to issue a statement saying that the crown prince didn’t privately disparage President Biden. The NYT has reporting that suggests the administration thought it had a “secret deal” to raise production and thus was caught by surprise over the OPEC+ decision to reduce output. It appears to us that relations between the two countries have sunk to a new low, in part because Crown Prince Salman is charting a new foreign policy path that won’t be as dependent on the U.S. That decision will further disrupt trading patterns that have been in place for decades.
- We have observed that there is often a divergence between the business community and national security policy. For example, tech firms are often at odds with Washington over China policy. As the U.S. begins to distance itself from the KSA, we note that financial firms are apparently still on board with Riyadh.
Although the U.S. has accused the KSA of siding with Russia, perhaps a more important trend is the Saudis’ engagement with China. The KSA has a long history of building relations with oil importers, so when the U.S. was a major oil importer, the KSA aggressively defended its market share to the U.S. Now that the U.S. is a less important importer, it would be consistent policy for Riyadh to improve relations with Beijing. However, this policy direction could put Saudi Arabia in direct conflict with the U.S. as relations with Washington and Beijing continue to sour.
Norway is worried that Russia will sabotage its energy infrastructure. According to reports, unidentified drones, presumably Russian, have been buzzing Norwegian offshore oil and gas platforms. Norway has become a critical natural gas supply source for Europe, so any disruptions could be a major problem for natural gas supplies.
- Despite numerous investigations, there has been no official announcement on who sabotaged the Nord Stream pipelines.
The Venezuelan opposition is contemplating ending its “interim government” claim, which would be a step toward allowing the U.S. to normalize relations with Caracas.
The new left-wing government in Colombia is at odds with its energy industry. The Petro administration is raising taxes on the coal and oil sector and looking to curtail investment to back climate change reform.

Alternative Energy/Policy News:

The SEC appears to be rethinking its proposal to make firms disclose carbon emissions. It is unclear what is causing this reversal, although we suspect some of it is due to the costs of compiling the data.
Hyundai (HYMTF, $27.10) has started construction on an EV plant in Georgia.
Climate issues continue to affect a wider circle of issues. The latest labor demand is for formalized time off to address local destruction caused by weather events.
Although China continues to dominate battery production, the U.S. is seeing a surge in investment and a buildout of a “battery belt” across the lower 48. Meanwhile, U.S. battery infrastructure is at risk for siting constraints.
Carbon capture is one way fossil fuel companies can address climate change issues. As CO₂ is generated by burning fossil fuels, capturing that gas and storing it would allow for continued consumption. As investment grows, we should see in the next few years if such projects actually work.
Climate change remains controversial, and last week we noted that the insurance industry is moving to factor this concern into policies. The survey from the insurer AXA (AXA_SA, $24.61) indicates that climate change is the primary concern of insurers.

[1] So much so that U.S. exports of fertilizer to the EU have soared, taking advantage of lower relative natural gas prices.

[2] That’s over $1,000 per MMBtu.

[3] There are some natural gas prices in the Permian that are approaching zero due to the lack of takeaway capacity.

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Daily Comment (October 26, 2022)

Posted on October 26, 2022October 26, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including the latest on Moscow’s misinformation campaign claiming that the Ukrainians are planning to detonate a radioactive “dirty bomb.” We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the U.K.’s transition to a new prime minister.

Russia-Ukraine: Ukrainian forces continue to recapture modest amounts of territory in the country’s northeastern Donbas region and in the southern region around Kherson, while the Russians continue launching missile, air, and kamikaze drone strikes against civilian energy infrastructure throughout the country. The continued Russian attacks prompted the Ukrainian government to request additional air-defense weapons systems in calls with U.S., U.K., and France. Meanwhile, the Russian government continues its misinformation campaign claiming that Ukraine plans to detonate a “dirty bomb” consisting of conventional explosives laced with radioactive materials. This time, the accusation was made in a letter to the UN Security Council. Western officials remain concerned that the misinformation campaign is aimed at justifying a further Russian escalation of the war.

Separately, the Joint Coordination Center managing the Russia-Ukraine deal allowing Kyiv to ship grain out of its southern ports is investigating reports of a possible sea mine in the authorized Black Sea shipping corridor.
- Russia has recently expressed its dissatisfaction with the way the deal is being implemented, which raises the prospect that it is trying to sabotage the deal.
- If Russia does scuttle the deal and Ukrainian grain is once again bottled up, one likely result would be renewed upward pressure on global grain prices.
As we have reported previously, financier and mercenary leader Yevgeny Prigozhin continues to build a power base that could potentially allow him to challenge President Putin in the future.
- In addition to criticizing and demeaning the Russian Ministry of Defense, Prigozhin is also building a large following on his various social media platforms.
- That following is beginning to challenge the Kremlin’s previous near monopolization of information in the country.

EU Energy Crisis: Reflecting our concern that high energy prices will help prompt a process of deindustrialization in Europe, German chemicals giant BASF (BASFY, $11.43) has warned that it will have to downsize permanently in the region because of unstable natural gas supplies and soaring prices.

The statement came less than a month after BASF opened a new €10 billion plastics engineering facility in China, but we don’t think Asia will necessarily be the prime beneficiary of Europe’s deindustrialization.
Rather, we think much of the investment pulled out of Europe in the coming years will be channeled toward the energy-rich U.S., boosting the U.S. economy and prompting positive spillover effects into a range of U.S. companies.

Germany-China: Chancellor Scholz has approved a Chinese company’s acquisition of a large stake in Germany’s largest seaport, drawing criticism from the country’s lawmakers and officials in Brussels.

Scholz’s approval for the acquisition came despite opposition over national security concerns from his own foreign affairs, defense, economy, and interior ministries.
Scholz’s decision is being seen in the same light as Germany’s prior decision to build the Nord Stream natural gas pipelines that made Germany overly dependent on Russian energy. The port decision has increased concern that Scholz and his Social Democratic Party are failing to appreciate the national security implications of increased dependency on autocratic states like China and Russia.

Norway-Russia: Norwegian authorities have arrested a Brazilian university researcher at the Arctic University of Norway in Tromsø on suspicion that he is, in fact, a Russian spy. The researcher had been working in a group studying irregular warfare methods such as cyberattacks and disinformation campaigns.

United Kingdom: Yesterday, newly-named Prime Minister Sunak began building his cabinet, keeping a striking number of officials in their previous positions and working hard to build unity by offering positions to all the major Conservative Party factions.

Importantly, Chancellor of the Exchequer Hunt will remain in his job, lending some continuity to fiscal policy in the face of concerns over Britain’s debt levels.
In one of his first acts under Prime Minister Sunak, Hunt announced he will delay the date for his long-awaited medium-term fiscal plan from October 31 to November 17, ostensibly to fine-tune the economic forecasts and projections.
The plan will now take the form of a full Autumn Statement, accompanied by forecasts from the Office for Budget Responsibility.
The fiscal plan will aim to close the U.K.’s fiscal hole, estimated at between £30 billion and £40 billion, with a series of tax raises and spending cuts.

U.S. Energy Market: Spot prices for natural gas in west Texas fell below zero yesterday, as surging production in the Permian Basin region butts up against pipeline constraints and outages at liquefied natural gas terminals used to export the U.S. gas overseas. However, the situation is expected to rectify itself in the coming days after the end of a scheduled maintenance outage on a key pipeline.

U.S. Financial Regulation: The SEC has proposed a crackdown on the misleading marketing of investment funds by tightening the rules on fund names. Under the proposal, funds would have to be able to prove that at least 80% of their holdings match their names. The proposal would apply to everything from “core” and “growth” funds to those that invest in “sin stocks” or claim to rely on environmental, social, and governance investing factors.

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Daily Comment (October 25, 2022)

Posted on October 25, 2022October 25, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where Russia appears to have ratcheted down its recent missile, air, and drone attacks as it runs low on its inventory of weapons. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further fallout from China’s recent Communist Party conference and the installation of a new prime minister in the U.K.

Russia-Ukraine: As Ukrainian forces continue to slowly press the Russians back in the northeastern Donbas region and the southern Kherson region, Russian forces continue to attack Ukrainian civilian infrastructure targets with missile, air, and kamikaze drone attacks. However, Ukrainian officials report that the scale of the Russian strikes on Monday was markedly smaller than in previous days, probably because the Russians have now depleted much of their stockpiles of missiles and drones and because the attacks have proven largely inconsequential.

Meanwhile, Russian military officials continue to push their misinformation campaign claiming that Ukraine plans to detonate a “dirty bomb” consisting of a conventional explosive laced with radioactive material.
- The Russian misinformation campaign is being taken mostly as a threat that Russia plans to use such a weapon itself.
- All the same, U.S. officials said they had detected no signs that Russia is planning to use nuclear arms, and therefore had no reason to raise the alert level of U.S. nuclear forces.
Meanwhile, financier Yevgeny Prigozhin continues to build a power base that could put him in position to challenge President Putin’s authority. Besides lambasting Russia’s uniformed military, Prigozhin’s Wagner Company mercenaries continue to threaten Ukraine’s hold on the Donbas city of Bakhmut, even as Prigozhin begins to build his own volunteer battalion.

EU Energy Crisis: European natural gas prices have dropped below €100 per megawatt hour this week for the first time since Russia slashed supplies earlier this summer. The drop reflects the unexpectedly warm weather and the fact that the EU’s gas storage facilities are now close to full, easing concerns about winter shortages.

The drop in energy prices is a welcome development that has the potential to pull down inflation and minimize the impending recession in Europe.
All the same, the EU still faces much worse conditions than it did in recent years, especially if weather patterns turn negative again.
More broadly, EU energy ministers are meeting in Luxembourg today to continue hashing out a potential price cap on natural gas, and to consider a longer-term change in the EU’s energy-pricing mechanism.

China: Chinese stocks stabilized today following foreign investors’ scrambling for the exits on Monday after President Xi’s election to a norm-breaking third term in office and his tightened political grip on the country. However, the renminbi has lost another 0.6% against the greenback to trade at 7.3084 per dollar. At that rate, the Chinese currency has now lost a whopping 12.8% year-to-date.

Turkey: In recent years, in a move largely unnoticed by investors around the world, Turkey has become a key supplier of advanced military goods, particularly drones and other autonomous weapons. In the latest development, a Turkish defense firm has been awarded government subsidies to produce one of the world’s first viable long-range, unmanned helicopters known as the Alpin. Once the drone chopper is field tested and combat proven, the government plans to export the Alpin worldwide.

South Korea-North Korea: South Korean President Yoon Suk-yeol warned that North Korea has now completed preparations for its seventh nuclear test. If North Korea goes ahead with the test, it would be the first such provocation since 2017 and would likely touch off a new geopolitical crisis and further sanction efforts against Pyongyang.

United Kingdom: Many British pension funds and the companies that manage their “liquidity driven investment” programs are reportedly amending their contracts to allow the funds to post liquid assets other than cash, such as government bonds, when they have to provide collateral to hedge their positions in the market.

The need to sell Gilts was a key reason for the spike in British interest rates and the fall of former Prime Minister Truss after she released a budget-busting series of tax cuts and spending hikes last month. If enough pension funds amend their credit support documentation, it could make the British financial system less susceptible to a future run on Gilts.
Separately, Rishi Sunak today formally became Britain’s new prime minister, succeeding Truss. Next week, Sunak’s government intends to release a new fiscal plan aiming to reassure investors that Britain’s debt is under control. In his speech today, Sunak said he would act with “compassion” but that he would not let future generations pay for debt that “we are too weak to pay ourselves.”

U.S. Semiconductor Industry: Pat Gelsinger, the CEO of Intel (INTC, $27.18), said at a conference that recently imposed U.S. restrictions on semiconductor-industry exports to China were a necessary shift in supply chains as the U.S. seeks to maintain technological leadership in its competition with China.

U.S. Fiscal Policy: Data late last week showed that the federal budget deficit for the fiscal year ending September 30 came in at $1.375 trillion, down from the deficit of $2.772 trillion in the previous fiscal year. The report showed that the improvement in the deficit mostly stemmed from a 21.0% surge in revenues as the recovering economy boosted tax receipts. In contrast, federal outlays declined 8.0% as many pandemic relief programs got scaled back.

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Bi-Weekly Geopolitical Report – Defining Deglobalization (October 24, 2022)

Posted on October 24, 2022October 23, 2022 by Amanda Ahne

by Bill O’Grady | PDF

Words are important. They are a key tool to how we communicate, but they also can narrow meanings and lead to misunderstandings. Often, the term “deglobalization” has led pundits to suggest that this isn’t really happening by deploying something of a “straw man” argument. The writer will suggest that trade is still happening, therefore deglobalization isn’t really occurring.

Since we have argued that deglobalization is upon us, in light of various reports, it makes sense to provide our definition of terms. In reading these reports, we have some sympathy for their positions. We are seeing a change in how trade is conducted, but we don’t think that international trade will end. However, as we discuss below, in our analysis, the core concepts that have driven globalization are now at risk and will have lasting ramifications. The miscommunication risk of our position is that it is interpreted as global autarky. The risk of others suggesting deglobalization isn’t happening is that they fail to comprehend that the changes underway are so fundamental thereby the assumptions that have underpinned globalization no longer hold.

In this report, we begin with a framing of the reason globalization took on special characteristics after the Cold War ended. Next, we discuss the “end of history” argument and how it created the Washington Consensus. The next section examines how the “end of history” was not the end of geopolitics. We note the key geopolitical imperatives of China and Russia and examine how investing patterns in the Cold War era led to risky investment decisions. We also discuss the impact of the Washington Consensus on the U.S. economy. We close, as always, with market ramifications.

View the full report

Don’t miss the accompanying Geopolitical Podcast, available on our website and most podcast platforms: Apple | Spotify | Google

Daily Comment (October 24, 2022)

Posted on October 24, 2022October 24, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including a new Russian misinformation campaign alleging that the Ukrainians are preparing to detonate a radioactive bomb. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, with a particular focus on the Chinese Communist Party’s big national congress, which wrapped up over the weekend by electing Xi Jinping to a precedent-breaking third term in power.

Russia-Ukraine: As Ukrainian forces slowly push the Russians back in the northeastern region of the Donbas and in the southern region around Kherson, Russian forces continue to stage missile, air, and kamikaze drone attacks against Ukraine’s civilian energy infrastructure. Reports indicate that the Russians are also preparing to destroy a major dam on the Dnipro River upstream from Kherson to flood the region around the city and complicate Ukraine’s effort to recapture it. Beyond that, the Russians are reportedly planning to retreat from Kherson in the coming days. Separately, Russian Defense Minister Shoigu held telephone calls yesterday with his counterparts in the U.S., U.K., France, and Turkey to warn them that the Ukrainian military was preparing to detonate a “dirty bomb” (a conventional bomb laced with radioactive material) in order to accuse Russia of using weapons of mass destruction. The calls were probably aimed at intimidating the U.S. and its NATO allies in order to undermine their support for Ukraine.

Following the recent sabotage of the Nord Stream natural gas pipelines from Russia to Western Europe, along with other apparent sabotage of European communications and transportation infrastructure, governments around the world are placing more focus on the security of those facilities.
One country to watch in that regard is France, which earlier this year released a new “Seabed Warfare Strategy.” Putting that strategy to work, France has recently signed a contract with a Norwegian firm for trial tests of a Hugin Superior Autonomous Unmanned Vehicle (AUV) which can operate in depths of down to 6,000 meters. Deep-sea robotics could well be an important growth area as countries work to rebuild their military forces in response to Russia’s war in Ukraine.

China: As the Communist Party wrapped up its 20^th National Congress over the weekend, Xi Jinping secured a norm-breaking third term as the party’s general secretary and replaced four of the seven members of the ruling politburo standing committee with his hand-picked allies. Among those replaced was Premier Li Keqiang, a former rival of Xi’s. It appears he is being replaced by Shanghai party boss Li Qiang, whose loyalty to Xi evidently was enough to offset his bungled COVID lockdown in Shanghai earlier this year. It also appears that Xi orchestrated a brutal kneecapping of his predecessor, Hu Jintao, who was hustled off the leadership rostrum on Saturday, ostensibly for “health” reasons. Separately, the delegates also approved a new party constitution that enshrined “opposing and containing Taiwan’s independence” as a key task. The new constitution also beefed up the party’s commitment to “common prosperity” and using state-owned enterprises to drive the economy.

Three People’s Liberation Army generals on the Central Military Commission were retired from the party’s Central Committee after reaching age 68, but an exception was made for General Zhang Youxia, aged 72. Zhang, a close ally of President Xi, reportedly will become first vice-chairman of the Commission under Xi’s chairmanship.
- Zhang is one of the few remaining Chinese military leaders with combat experience, having served as a company commander in China’s 1979 war with Vietnam.
- Allowing Zhang to remain on the CMC could indicate that Xi is desperate to have a top military decisionmaker with the experience of combat. Of course, having that kind of experience would be especially useful if Xi is contemplating some kind of military action around Taiwan.
If you think these Chinese political moves would have no immediate impact on the financial markets, think again. Investors in mainland China and Hong Kong reacted to Xi’s tightening grip on the country and his failure to announce eased Zero-COVID restrictions by selling off stocks. Hong Kong’s Hang Seng Index ended down 6.4%, marking its biggest decline since the Great Financial Crisis and ending at its lowest level since 2009.
Adding to the downward pressure on Chinese stocks, the government finally released its delayed data on economic growth. Third-quarter gross domestic product was up 3.9% from the same period one year earlier, modestly beating expectations but still far below the government’s target of about 5.5% for 2022.

European Union-China: As Xi was preparing to win a third term in power, EU leaders reportedly held a secret discussion on China at their summit last Friday. Reports indicate that the three-hour discussion resulted in a broad agreement that Europe has become too dependent on the powerful autocracy in manufacturing supply chains and raw materials.

Nevertheless, some leaders, apparently including German Chancellor Scholz, continued to argue that Europe needs to keep engaging with China to tackle common problems.
Driving home the point, next week Scholz will travel to China with a business delegation, raising fears that Germany is making the same mistake it did by getting too close to Putin’s Russia.

France: New regulatory filings indicate that many of France’s nuclear generating plants that were idled because of corroded piping are taking longer than expected to repair. As a result, 26 of the 56 nuclear plants in France are now offline for maintenance or repairs. In addition, strikes at 18 reactors owned by EDF SA (EDF.PA, €11.94), France’s state-controlled power giant, have delayed their restart by several weeks. The outages threaten to make it even more difficult for Europe to make up for the energy supply disruptions caused by Russia’s invasion of Ukraine.

Italy: Conservative Brothers of Italy Party leader Giorgia Meloni finished putting together her governing coalition and was sworn in as prime minister over the weekend. While Meloni’s support for the U.S., NATO, and Ukraine is clear, all eyes will likely now be focused on how her government will work with the EU bureaucrats in Brussels. A key challenge will be to balance Italy’s economic dependence on EU support with the Eurosceptic tendencies of Meloni’s right-wing coalition partners.

United Kingdom: In the race to succeed Liz Truss as Conservative Party leader and prime minister, Former Chancellor Rishi Sunak has won a poll of support among the party’s members of parliament today after former Prime Minister Johnson pulled out of the race and challenger Penny Mordaunt struggled to win supporters. That means Sunak will now become the U.K’s next prime minister.

Sunak, a wealthy Brit of Indian heritage, is widely seen as committed to sound economic management and orthodox economic policy.
As Sunak’s prospects for the prime minister’s job have improved, the pound, so far this morning, has risen approximately 0.3% to $1.1336. Benchmark 10-year Gilts traded up, pushing the yield down to 3.81%.

U.S. Military: In its annual report on U.S. military power, the conservative Heritage Foundation assessed that the U.S. has only a “weak” ability to fight and win in a hypothetical crisis involving two simultaneous major regional wars. The report assesses that the Marine Corps has retained “strong” capabilities for such a scenario, but it scores the Army as “marginal,” the Navy as “weak,” and the Air Force as “very weak.”

The weak scores stem in large part from what the Foundation sees as under-investment in modern equipment. For example, it argues that the U.S. Navy needs a combat fleet of at least 400 manned ships, compared with the 298 currently available.
The report supports our view that China’s geopolitical aggressiveness and Russia’s invasion of Ukraine will likely spur the U.S. and its allies to reinvest enormous sums into their military forces in the coming years, eventually giving a big boost to defense industry firms.
Notably, the call for a stronger defensive effort from the Foundation is a reminder that the right wing of the political spectrum is still pro-defense, even if many right-wing politicians are isolationist and want to ratchet back U.S. support for Ukraine and other allies. As the isolationists realize that such support often means higher orders for U.S. defense firms, they may become more supportive of Ukraine and Europe as time goes on.

U.S. Education System: New data from the Education Department shows fourth- and eighth-grade students’ math scores dropped by the largest amount ever this year. The data also showed a nationwide plunge in reading scores that wiped out three decades of gains. The declines are ascribed largely to the lingering effects of the COVID-19 pandemic.

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Daily Comment (October 21, 2022)

Posted on October 21, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment discusses how Brexit may have paved the way for Liz Truss’s brief stint at Downing Street. Next, we explain how the Fed’s monetary policy has forced central banks to accumulate greenbacks. Lastly, we conclude with an overview of countries adapting to the security threats posed by Russia and China.

Now What? Liz Truss’s quick rise and fall in the U.K. may serve as a cautionary tale for other countries looking to exit from the European Union.

The race to succeed Liz Truss as prime minister of the United Kingdom has commenced. The front-runners include previously ousted Prime Minister Boris Johnson, ex-Chancellor of the Exchequer Rishi Sunak, and Leader of the House of Commons Penny Mordaunt. Given the previous prime minister’s reckless fiscal policy, the markets will be hesitant to trust any new leader. So far, British bond yields have surged from Thursday’s low, while the British pound has dipped to $1.11. The new leader is expected to be picked by next week.
The new prime minister will be the country’s fifth since the 2016 Brexit vote. After leaving the EU, the U.K. has not been able to establish its post-EU identity. The Theresa May government sought to blend pro-remain and pro-Brexit ideals, while Boris Johnson ran promoting a nationalistic agenda, and the short-lived Liz Truss wanted to bring back Thatcherism. The frequent shifts in identity show that the country is still unsure of how it will fit into the world separate from Europe. As a result, investing in the U.K. may be difficult as it isn’t clear what direction the country will go in the next five years.
The swift market backlash that the U.K. faced following its decision to abandon economic fundamentals could lend to more support against an EU breakup. Consistently, Eurosceptics have argued that leaving the EU will prevent the need for draconian policies in favor of pro-growth policies. The recent selloffs in the British pound and bonds contradict these claims. Although this may not be enough to prevent Eurosceptics from complaining about the EU, it should be easier for the EU to push through free-market reforms in countries like Italy.

Central Bank: U.S. monetary policy has pressured central banks to hoard USD.

The Federal Reserve’s hawkishness continues to grow as the central bank is determined to prove its inflation-fighting credentials. New Fed Governor Lisa Cook and Philadelphia Fed President Patrick Harker warned markets that the central bank is prepared to lift rates above restrictive territory and keep it there for some time. Investors responded to the remarks by placing bets that the Fed will raise its benchmark rate to 5% next year, which is 50 bps higher than median fed funds in the latest dot plots. That said, we think the talk is cheap. The Fed has not demonstrated that it can withstand the public scrutiny of raising rates during a recession. Thus, the Fed may pause sooner than the market realizes.
The Bank of Japan is determined to squash speculators betting against its currency. The central bank signaled that it would intervene in FX markets for the first time since 1990 to prevent the yen from weakening further against the dollar. Currency chief Masato Kanda warned that the bank has limitless resources to protect the yen. As the largest holder of U.S. Treasuries, we suspect the bank could liquidate its holding to prop up the currency. Although this would be a temporary fix, the move would be another example of how reluctant the BOJ is to remove monetary accommodation to combat inflation.
- The sale of U.S. Treasuries can lead to complications in the international banking system. For example, central banks’ usage of the Overnight Reverse Repo Facility retreated to $330 billion in the period ending October 19, down from an all-time high of $333 billion. The drop suggests that foreign central banks are withdrawing some of their cash holdings at the New York Fed. The lack of cash could make it harder for repo transactions to take place for financial firms facing a liquidity crunch.
To accommodate the need for greenbacks, the Federal Reserve set up a series of USD swaps with its prominent central bank counterparts. The Fed will give the swap lines to the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. The measure should help alleviate liquidity problems abroad as banks cope with tighter financial conditions. Although this is a positive step forward, we still believe that the international banking system may be susceptible to runs in the event of a financial crisis.

The Geo-Poly Shuffle: Threats from Russia and China have forced Western countries to rethink their alliances.

The U.S. is one step closer to removing sanctions on Venezuelan oil. The political opposition in Venezuela has discussed plans to wind down its support of Juan Guaidó’s claim of being the country’s legitimate leader. The move could pave the way for Maduro’s government to sell its crude overseas again. Venezuela has an oil production capacity of 1 mbpd. The U.S.’s decision to work with an authoritarian government suggests it feels pressure to fill the supply gap left by Russia.
Japan and Australia will discuss improving defensive ties as they look to counter China’s influence throughout the Indo-Pacific. Beijing’s increased assertiveness over the South China Sea and Taiwan has made the partnership vital. The countries plan on sharing military intelligence and working on joint projects to build wartime technology. Tensions in the Pacific have been overshadowed by the war in Ukraine, but we believe that a conflict could break out within this region in the next five to ten years. Fighting in the area can potentially disrupt over $5.3 trillion of annual global trade. Hence, investors should be sensitive to any hostilities within the region.
The Ukraine war continues to cause divisions within the European Union. Although the countries could agree to gas-price caps, it will not come easy. Germany, probably the most dependent on Russian energy, has decided to drop their opposition to the cap, albeit while kicking and screaming. However, the lack of unity around this issue shows that the members may not be fully cohesive in their efforts to cut themselves off entirely from Russia.

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Daily Comment (October 20, 2022)

Posted on October 20, 2022October 20, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our explanation as to why unorthodox policies can lead to currency weakness. Next, we discuss how the possibility of a withdrawal of Western support could help end the war in Ukraine. We end the report with our thoughts on rising inflation’s impact on earnings and its implications for economic growth.

It’s the Economy: Japan and the U.K. are facing backlash as the countries’ unorthodox policies continue to stir controversy.

U.K. Prime Minister Liz Truss was forced to resign from her position on Thursday. Truss’s failed attempt to push through a controversial set of tax cuts designed to stimulate the economy has led her party members to question her leadership. Her removal from office led to a rally in the pound, but we suspect that uncertainty over her possible replacement could lead to a reversal. Additionally, another reshuffling of the party’s leader may erode Tory support among the general populace. The resulting chaos has led rival parties to call for new elections. The latest polls show that the Labour party would be heavily favored if there were another election.
The 10-year yield on Japanese Government Bonds exceeded the Bank of Japan’s target on Thursday, forcing the bank to intervene. The BOJ offered to buy an unlimited amount of 10-year notes at 0.25%. The surprise action helped push the yen to 150 per dollar, a multi-decade low. It is unclear whether the Bank of Japan will end its ultra-low policy accommodation; however, it is becoming clear that the market believes it has no other choice.
- In the meantime, the bank may be forced to offload some of its U.S. Treasury holdings as it looks to recoup dollars to meet its cash needs. Thus, this situation could further worsen the U.S. government’s securities liquidity problem within the banking system.
Market pushback against Japan and the U.K. may explain why central banks may be hesitant to end policy tightening prematurely. As the impossible trinity shows, a central bank has three policy options: fixed exchange rate, sovereign monetary policy, and free capital flow, but it can only choose two. Because Japan and the U.K. have decided to maintain the latter two, they are forced to grapple with sudden changes in their exchange rates when they go against the market. This problem is particularly an issue as the Fed raises rates because it gives investors a higher-yielding and safer alternative. As a result, we suspect global tightening will likely continue as long as the Fed feels it is appropriate to continue raising rates.

Higher Prices, Higher Profits: Rising inflation has helped boost earnings; however, this trend is unlikely to last forever.

High inflation figures in the U.K., Canada, and the Eurozone suggest more global monetary tightening is on the way. The September Consumer Price Index rose 10.1% from the prior year in the U.K. and 6.5% for the same period in Canada. Meanwhile, the revised CPI report for the Eurozone showed prices rising 9.9% since September 2021, down 0.1% from the previous report. The persistent inflationary pressures will force central banks to raise rates to restore price stability. These three countries control half of the world’s six most traded currencies. As a result, foreign countries that repay debt using these currencies could see their interest payments increase due to the fluctuation in exchange rates.
U.S. firms still have significant pricing power. On Wednesday, consumer goods companies Procter & Gamble (PG, $130.14) and Nestle (NSRGY, $105.70) posted better-than-expected earnings thanks to price increases. These companies’ ability to push costs onto consumers suggests that inflation may be stickier than initially thought. This relationship is exemplified when comparing the prices paid by retail producers for food and alcohol and the prices paid by consumers for the same goods. We expect that the economic slowdown and margin contraction will not sustain the current price trend. Thus, we do believe that inflation could be heading down faster than most investors realize.

As inflation becomes more of a problem, central banks will respond by raising rates. The Federal Reserve has already increased its benchmark rate by 300 bps this year and could hike it by at least another 100 bps by December. Although the Bank of England and the European Central Bank have not tightened as aggressively as the Fed, both banks are expected to have similar hikes. Moreover, tightening financial conditions will worsen the economic slowdown and hurt company profits. We believe that as global growth slows and inflation remains high, it will be favorable for commodities.

Under Pressure: Despite Ukraine’s recent successes on the battlefield, it is now facing political headwinds from the West.

As the U.S. prepares for midterm elections, Kyiv frets over whether it can rely on American aid to sustain its war efforts. On Wednesday, House Minority Leader Kevin McCarthy warned that if Republicans take over the House, Congress will not write Ukraine a blank check to help fight its war. This message caught many Ukrainian officials off-guard as it had received previous assurances from the lawmaker that nothing would change if Republicans won. The lack of U.S. support will make it difficult for Ukraine to maintain its current momentum. As a result, Ukraine forces may look to consolidate their territorial gains now.
Meanwhile, energy supply constraints could weaken the European Union’s support for Ukraine. In Italy, the likely new Prime Minister Giorgia Meloni is expected to navigate the EU’s third-largest economy away from the economic abyss. Although she favors aiding Ukraine in its war efforts, her likely coalition partners, Silvio Berlusconi and Matteo Salvini, do not, especially if it means no Russian gas for Italy. The lack of unity around this issue suggests that Italy may not be much help to Ukraine.
- The German Chancellor Olaf Scholz expressed concern over implementing an EU-wide cap on gas prices. He warned that the plan could backfire. Although not a surprise, given Deutschland’s dependence on Russian energy, his comments reflect a growing hesitancy among EU members to support Ukraine.

In short, an indefinite war for Ukraine may be out of the question. If it wants to continue fighting, it needs to tighten its fiscal belt now because it cannot rely on the West’s support in the future, especially as these countries head toward recession. That said, there is a silver lining. Ukraine could be forced to the negotiating table next year, in which it may have to accept some territorial losses in order to maintain its sovereignty. If we are right, the situation could pave the way for Russian commodities to enter the market, thus providing much relief for struggling countries. At the same time, EU energy consumers can never look at Russian supplies the same way again. Even if Russian oil and gas returns to Europe, there will still be an incentive for redundant supply sources. It would not be inconceivable to see quotas on Russian oil and gas flows. Thus, even if the hostilities end, the reverberations will continue.

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Weekly Energy Update (October 20, 2022)

Posted on October 20, 2022December 13, 2022 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil prices remain in a downtrend as concerns about global growth, especially with China, are weighing on prices.

(Source: Barchart.com)

Crude oil inventories fell 1.7 mb compared to a 2.0 mb build forecast. The SPR declined 3.6 mb, meaning the net draw was 5.3 mb.

In the details, U.S. crude oil production rose 0.1 mbpd to 12.0 mbpd. Exports rose 1.3 mbpd, while imports fell 0.2 mbpd. Refining activity fell 0.4% to 89.5% of capacity. We are approaching the end of refinery maintenance season, which means oil demand should begin to rise soon.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. As the chart shows, we are past the seasonal trough in inventories. The build seen from October into November is usually strong due to refinery maintenance. With the SPR withdrawals continuing, the seasonal build has been exaggerated this year.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2003. Using total stocks since 2015, fair value is $105.59.

Market News:

In a widely anticipated move, Germany has extended its use of nuclear power plants into next April.
Although the actual cuts in production from OPEC+, as we noted last week, won’t be as dire as the headlines suggest, it will still remove some barrels from the world’s oil supply. Unfortunately, the U.S. won’t be able to fill the gap, despite rising production in the Permian.
As world trade flows for energy adjust, Europe is moving away from Russia as an energy supplier and working to establish new flows with other nations. The U.S. has become an important supplier and so has Qatar.
- Currently, Russia is supplying the EU with about 0.6 mbpd of crude oil. Those flows will be cut off on December 5. Not only will the EU stop importing Russian oil, but European insurance firms will no longer be able to underwrite cargo insurance for oil tankers. Without this insurance, the costs of Russia shipments will soar because some of the key chokepoints won’t allow vessels to pass without this insurance. It is not obvious, as we note in the above bullet point, where this crude will come from. This is where the price cap idea comes into play. If a buyer were willing to pay less than the cap, insurance would be provided. Of course, the opposition of OPEC+ to the price cap was likely part of the reason to cut production targets.
  - Interestingly enough, Indian refiners, who have been large buyers of Russian crude oil, have suspended purchases until clarity is provided on how the EU sanctions will work.
- One potential place for the EU to purchase oil would be from the U.S. SPR. However, some members of Congress are pushing for a bill that would ban the export of SPR crude oil. However, this action would contradict the original SPR measures created by the IEA. Under IEA rules, in a global emergency, national SPRs could be under the IEA’s jurisdiction. The goal of the SPR is to discourage hoarding. If we were to see national governments prevent the export of SPR oil, it is quite likely that global oil prices would soar. If this bill gains traction, it could cause further disruption to global oil markets. However, we could also see a situation where SPR oil would simply displace the domestic oil that would have been exported instead.
- On the topic of the SPR, the Biden administration has announced additional sales, although the announcement did cause some confusion. There is about 15 mb of sales left in the original announcement and 26 mb scheduled for release next year (as part of a budgetary agreement), but the administration is worried about high gasoline prices and has suggested even more could be sold from the reserve.
  - As we noted in earlier reports, the administration seems to be moving the SPR from a strategic reserve to a buffer stock. Buffer stocks have been used in commodity markets before, with the goal being to stabilize prices. The trick to managing the stock is getting the price right (which begs the question: why bother?). Set it too low, and the stock becomes exhausted. Set it too high, and it becomes too large. When first floated, the administration suggested $80 as a baseline to begin buying oil. That has now fallen to a range of $67 to $72. We don’t expect that ANY oil will be bought by this administration as there does not seem to be a price that is politically low enough.
- The EU has been able to build natural gas inventories, in part, because weak Chinese demand for LNG has allowed for shipments to be diverted. China is signaling this diversion will end, although Chinese demand is expected to remain sluggish. China is also indicating that it will increase its energy reserves as winter approaches.
- As the EU attempts to shift its natural gas supply away from Russia and to LNG, it is finding that bottlenecks at terminals are becoming a problem.
- The EU has generally been unable to craft a functioning price cap for natural gas, so the group is trying to create other measures to bolster available supply.
- To a great extent, the world’s energy situation is dependent upon the weather.
The DOE has issued estimates for this winter’s heating costs, and although natural gas remains the cheapest source of heating, it is poised to have the fastest price increases.
Although crude oil inventories appear adequate, the situation in diesel fuels is a growing concern.

(Sources: DOE, CIM)

Diesel fuel is often used for emergency electricity generation, and so, if there are disruptions in electricity this winter, demand could rise into a tight market which will then lift crude oil prices as well.
One of the factors that has reduced U.S. crude oil production has been the demand from investors that companies focus on profits and returns to shareholders. This desire is partly driven by the ESG movement and the fears that peak oil demand is near. If oil and gas are going to be industries in decline, then shareholders will tend to focus on near-term returns. In terms of net-zero promises, there is evidence to suggest that publicly traded firms are more sensitive to such goals than are private firms. It appears that such pressures are leading Harold Hamm to take Continental Resources (CLR, $73.68) private.
Prime Minister Truss of the U.K. has essentially lost control of her government after proposing a radical economic program that the financial markets fundamentally rejected. The new Chancellor, Jeremy Hunt, has reversed nearly her entire fiscal package. Part of the original package was massive support measures to protect businesses and consumers from higher energy prices. The original bill was expected to cost £60 billion and its generosity was part of the reason that the financial markets panicked. However, in walking back the package, Hunt didn’t offer a replacement to protect less affluent households that may be at risk due to higher prices.

Geopolitical News:

Mohammed al-Sudani has been appointed to be the new prime minister of Iraq. It is unclear how long he will be in office because he is not popular with the al-Sadr faction.
Last week, Saudi Arabia argued that its decision to support a cut in oil production targets was based on market concerns and was not done to support Russia. The U.S. has dismissed the explanation as “spin.”
Russia is proposing to make Turkey a hub for natural gas transfers. Although clearly attractive for Turkey, we doubt the EU would see this as a viable alternative. It might not help Russia either, because if Iran ever normalizes relations, Turkey could be a conduit for Iranian gas as well.
Exxon (XOM, $101.23) announced that it has fully withdrawn from Russia after accusing Moscow of “expropriation.” The charge could signal that the company is planning to sue Russia over its exit.
Unrest and atrocities continue in Iran. Recently, there was a fire at the infamous Evin prison which houses dissidents and political prisoners. It appears that the fire was related to recent national protests. There is a general question about the stability of the regime, and one of the keys to watch for is if the security services turn on the government. There is little evidence that that most potent Iranian forces have joined the protesters.
Iran’s support for Russia’s war effort has triggered a response from the U.S. Washington is planning various penalties against Iran that could target third parties.
- As an aside, the sale of drones to Russia by Iran would seem to make it nearly impossible for the U.S. to return to the JCPOA. Even the Europeans are now acknowledging this outcome.
In France, protests against high fuel prices have evolved into complaints about inflation in general.
- In light of the Inflation Reduction Act’s measures to encourage battery makers to build facilities in the U.S., French President Macron is calling for a similar industrial policy for the EU.

Alternative Energy/Policy News:

One of the more controversial issues in environmentalism is geoengineering. As defined, these are various technologies designed to offset some environmental ill. Trees, for example, can be used to reduce CO₂. However, some measures that would reflect sunlight out into space in order to keep the planet cool could raise fears concerning unexpected side effects such as changing rainfall patterns that could then create distributional or geopolitical concerns. And so, these worries have tended to dampen investment in such technologies. However, the White House has announced a five-year research study on geoengineering to investigate its various technologies.
CO₂ emissions growth looks set to unexpectedly slow this year after declining global growth.
Financial analysts argue that there is ample liquidity available for the private sector to fund alternative energy. However, the bulk of this investing power is in the energy and mining sector, which may not be keen on investments that will harm its basic industry.
At the CPC conference, General Secretary Xi said China would not “rush” its clean energy transformation, likely meaning that fossil-fuels consumption will remain elevated.
Although there is a wide debate over climate change and its effects, one area where the impact is quantified is in insurance. The insurance industry and the Treasury are analyzing climate risk, which may result in some areas paying much more for coverage. Insurers are pushing back against the government’s investigation.
The SEC is pressing publicly traded firms for information on climate issues. Lobbying efforts to shape regulation are increasing.
Russian drones have attacked an important sunflower oil terminal in Ukraine. Although this attack will obviously affect the world supply of edible oils, it may also have an impact on biofuels.
Although starting from a low base, carbon capture project activity is increasing rapidly.
We are also starting to see increased investment in green hydrogen projects.

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Daily Comment (October 19, 2022)

Posted on October 19, 2022October 19, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including reports that Iranian military personnel have been deployed to Russian-occupied Crimea to help Russian forces operate their Iranian-supplied drones. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news that the Biden administration is planning further sales of crude oil from the country’s Strategic Petroleum Reserve in a bid to hold down energy prices.

Russia-Ukraine: As Russian forces remain under pressure in both the northeastern Ukrainian region of the Donbas and the southern region around Kherson, they continue to strike back with waves of missile, air, and kamikaze drone attacks on Ukraine’s civilian infrastructure. New reports indicate that members of Iran’s Islamic Republican Guards Corps have deployed to Russian-occupied Crimea to either advise the Russians on how to make better use of their Iran-supplied drones or to operate those drones themselves. The presence of the Iranians illustrates how the war could potentially widen over time. Indeed, some European officials have already called for tougher sanctions on Iran because of its support for Russia (the situation is also rapidly pushing European officials toward giving up on re-instituting the 2015 deal limiting Iran’s nuclear program). A Ukrainian strike on Crimea that killed IRGC members could be especially dangerous since it could encourage even greater Iranian involvement in the conflict.

General Sergei Surovikin, the newly appointed commander of Russia’s invasion force, warned yesterday that the situation was “not at all easy” for his troops trying to hold Kherson, and that “difficult decisions cannot be ruled out.” The statements probably aim to prepare the Russian people in case the military is forced to abandon the city in the coming days, as appears increasingly likely.
Russian authorities in occupied Kherson are reportedly moving thousands of Ukrainian citizens out of the city and deeper into Russian-held territory, ostensibly to protect them from the Ukrainian military’s upcoming assault, but also likely as bargaining chips or to keep them from helping the Ukrainian military once it regains the city.

Global Energy Market: Spot rates for liquified natural gas tankers have risen to yet another record this week of approximately $450,000 per day, compared with a range of just $30,000 to $300,000 in 2021. The jump in rates illustrates how the energy-supply disruptions from the war in Ukraine have increased demand for LNG. Spot rates for LNG tankers are expected to keep rising during the winter.

United Kingdom: As shown in the data tables below, the U.K.’s September consumer price index was up 10.1% year-over-year, accelerating from the 9.9% increase in the year-to-August and matching the highest rate in four decades. After stripping out the volatile food and energy components, the September Core CPI was up 6.5%, accelerating from a 6.3% rise in the year-to-August. The re-acceleration in inflation ensures that the Bank of England will implement another big interest-rate hike at its next policy meeting in November.

China-United Kingdom-Australia: The British and Australian militaries are both investigating reports that some of their former air force pilots were offered lucrative financial deals to teach Chinese pilots how to fly western attack aircraft. The approaches were made through a flight school based in South Africa. According to a British official, some serving pilots were also solicited. The incident suggests China is looking for ways to better understand and learn Western war-fighting skills as it ramps up its own military forces.

China-Taiwan-Japan: The world’s most important manufacturer of advanced computer chips, Taiwan Semiconductor Manufacturing (TSM, $63.71) is reportedly considering expanding its fabrication capacity in Japan to reduce its geopolitical risk. As we have long highlighted, the company is at risk as China puts increasing political, economic, and military pressure on Taiwan to reunify with the mainland.

The company has already begun building new capacity out of harm’s way, including in the U.S.
The latest reporting suggests that the company will continue to diversify its production capacity in the future.

Turkey: To bolster his chances for re-election in an upcoming poll, President Erdoğan has launched a $50-billion, state-subsidized housing construction program for lower income citizens. More than seven million have already signed up for the new housing units. Of course, the increased spending will likely exacerbate Turkey’s sky-high inflation and put further downward pressure on the lira.

U.S. Energy Market: Today, President Biden plans to announce that the Energy Department will sell the last 15 million barrels of crude oil out of the 180 million barrels he authorized for sale from the Strategic Petroleum Reserve in March. He will also direct the Energy Department to prepare for more sales from the approximately 400 million barrels left in the reserve if Russia or other petroleum-producing nations continue to disrupt world markets. The sales to date have helped push down prices for gasoline, diesel, jet fuel, and other petroleum products that had been driven up by supply shortages related to the war in Ukraine.

U.S. Labor Market: Workers for Amazon (AMZN, $116.36) in upstate New York voted against unionizing, despite a successful unionization vote at an Amazon facility on Staten Island earlier this year. Even though the tight U.S. labor market has generated successful unionization drives at a range of service companies recently, the Amazon vote shows that the trend isn’t universal or set in stone.

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