Macro Wrap-Up

An Emojinal Oil Q&A

Topics - Macroeconomics

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An Emojinal Oil Q&A

Anything going on in geopolitics this week?

I think you’re talking about damage to the oil facilities in Saudi Arabia, is that right?

Can you please write in English, I have no idea what you’re talking about.
Look, I’m trying to make this current for young readers. I’ve been told this is how they communicate.

They also like to use Snaps that disappear, kind of like what I’d wish for your first two answers. Let’s get back on track. Why are people so concerned about oil fires?
Two installments were damaged, the Abqaiq oil stabilization facility and the Khurais oil field, both of which are material to world oil supply. Saudi Arabia was forced to suspend around 5.7 million barrels of production or around 5% of global daily production. 1 1 Close New York Times: “Attacks on Saudi Oil Facilities Knock Out Half the Kingdom’s Supply,” 9/14/19. It has not been coming back as quickly as authorities initially said it would, though also not as slowly as some of the more pessimistic forecasts.

Why does this matter? Aren’t oil inventories high?
Inventories are fairly high around the world, and the U.S. has abundant amounts of oil in storage. They should be adequate to prevent any immediate shortages. Oil prices in the U.S. did not rise as much as international benchmarks, because of high domestic inventories and because Saudi Arabia now sells most of its oil to non-U.S. customers. Saudi Arabian oil has some of the lowest production costs in the world, and that makes it difficult to replace at current price levels. In the unlikely event that production remains significantly impaired for months, there is some spare capacity that could be freed from the current OPEC+ production caps, but not enough.

U.S. shale production has made the U.S. the largest producer of oil in the world. Can’t shale just replace the lost Saudi output?
In the short term, no. Even though shale wells can be faster to stop and start than traditional projects, it takes more than just flipping a switch. In the medium term, producers have room to increase output, but they would have to believe that Saudi production is permanently impaired or at risk. Shale producers are already struggling to make their current projects profitable. Most of the projects have higher marginal costs than the Saudi wells. Sustained higher prices would be needed to entice them to restart projects or explore new ones. And even so, existing infrastructure (although getting better) makes transporting shale oil logistically challenging.

Okay – but it still seems like the reaction in markets was quite large, especially considering the high inventory levels.
You’re right. The move reflects deeper worries. Saudi Arabia and the U.S. have accused Iran of orchestrating the attack. Tensions could escalate and lead to a more permanent supply disruption in the form of an all-out war. Even if this specific incident blows over, it is making investors reevaluate risk in oil markets. The whole space may be more vulnerable than previously thought. Prices should reflect that. 2 2 Close The risk premium in oil markets should be higher.

How did the incident affect other markets?
Stocks were down and bonds were up because of the increasing geopolitical risk. The effect on currencies was muted. Some of the more energy-oriented currencies such as the Norwegian krone and Colombian peso outperformed their neighbors, but you would be hard pressed to find the move on a chart. Perhaps most surprising was the lack of a move in inflation breakevens. Markets are showing little if any worries about inflation even though gasoline, which has also rallied, is a meaningful part of consumer prices as measured in the headline CPI.

You mention that stocks were down. Aren’t there some big oil stocks in the S&P 500? Why would it be down?
The effect of higher oil prices on stocks is mixed. Prior to the shale boom, fear of inflation and the Fed’s reaction to it outweighed the benefits to oil companies. Now the correlation between stocks and oil futures is mildly positive. In this case, it was probably more about perception than the actual economics. Stock markets were more concerned with the geopolitical risks than the direct effects of higher oil prices. Stocks tend to dislike sharp moves in other markets, with the exception of unambiguously positive shocks. If geopolitical tensions ease, stocks probably won’t be averse to higher oil prices.

Markets aside, are higher oil prices bad for the U.S. economy?

The effects are also mixed. It hurts consumers who must pay more for gas. The U.S. is still a net importer of oil, but much less so than in the past. The potential for investment in new projects may outweigh the short-run pain to consumers. Shale projects have helped employment and represented a significant portion of marginal investment in the U.S. But again, the rise in prices has to last long enough to get that investment going.

Did anything else happen this week?

Are you trying to tell me the Fed cut rates? Forget it. I shouldn’t have asked.

What We Are Watching

Eurozone PMIs (Monday), German IFO (Tuesday)
Growth has slowed in many economies over the last couple of years, but the deceleration has been especially pronounced in Europe. High-profile business surveys, such as the Manufacturing and Services PMIs published by Markit and the German sentiment indexes published by the IFO, have fallen to multi-year lows, raising fears of outright recession. Over the last few weeks, the European Central Bank (ECB) has announced new stimulus measures, and risks around a No Deal Brexit and further escalation of the U.S.-China trade dispute have seemingly waned at the margin. If these developments provide a boost to confidence among eurozone firms, it could signal an inflection point in the European economy. Evidence of improvement would likely be supportive for the euro and put upward pressure on regional bond yields.

New Zealand Central Bank Meeting (Wednesday)

The RBNZ has lowered rates twice this year, a 0.25% cut in May and a more aggressive 0.5% move in August. While the central bank continues to express a positive view of the New Zealand labor market, policymakers “noted that inflation remains below 2 percent and the outlook for employment and inflation was softer. GDP growth had slowed and global conditions had weakened.” 3 3 Close RBNZ Monetary Policy Statement, 8/7/2019. The projections published alongside the rate decision showed some probability that the RBNZ would ease again in the next few quarters. While no move is expected at this month’s meeting, market participants will be watching the post-meeting statement for an indication of whether another cut is likely in the near term. Dovish signaling could lead to weakness in the New Zealand dollar and provide a boost to domestic equities and fixed income.

U.S. New Home Sales (Wednesday)
Housing is one of the main channels through which monetary policy impacts the economy. U.S. housing activity began to cool last year, when rate hikes from the Fed helped push 30-year mortgage rates to their highest level since 2011. 4 4 Close 2017’s Tax Cuts and Jobs Act also contained provisions which may have dampened house prices. As the Fed has shifted in a dovish direction this year, mortgage rates have declined meaningfully, and U.S. housing market data has shown tentative improvement. Although prices have remained soft, mortgage applications have picked up, and transaction volumes in the existing home market have improved. Housing starts and building permits have increased and new home sales have picked up. New home sales lead to increased investment spending and employment in the construction sector, so they are more important for the economy than existing home sales. An upside surprise in this week’s new home sales data could indicate that the economy is responding to the Fed’s recent rate cuts, helping to offset some of the concern around weakness in other sectors such as manufacturing.

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