Urals breaks $80; failed Price Cap funds surge in Russian war spending

As expected, Urals broke through the $80 barrier, closing on Friday at $80.21.  Brent ended the week at $92, with the US benchmark WTI at $91.  This is the closest WTI has been to Brent in some time and likely signals the end of the shale revolution.

Brent has risen by $22 / barrel in the last three months.  We last saw such surges in 2008 before the Great Recession and 2011, leading the EU into a brutal, near two-year recession.  A replay is likely this time as well, but oil prices need to move significantly higher before the economy craters.  The pace of the rise in Brent suggests further increases are likely. Pencil in another $10-20 / barrel in the next, say, 90 days.  This would put Brent in the $100-$110 per barrel around year-end.

Unsurprisingly, the Urals discount -- the difference between the Urals and Brent oil prices -- compressed last week to just under $14 / barrel, almost the smallest since the start of the war and consistent with the tendency of the spread to contract when Brent is strong.   The ESPO discount -- the difference between Russia's Pacific oil price and Brent -- similarly continues to compress, much as we have been forecasting.  ESPO is holding around $90 / barrel.  

The Urals oil price is near an eight year high and $17 higher than its level year ago, before the implementation of the Price Cap.  If we allow Brent at $100 - $110 at year end, that would peg Urals in the $86-$98 range heading into 2024.

Oil and the War

Russia is looking at a massive increase in defense spending.  The Moscow Times reports that Russia's Finance Ministry projects defense spending “to jump by over 68% year-on-year to almost 10.8 trillion rubles ($111.15 billion), totaling around 6% of GDP — more than spending allocated for social policy."  The Kremlin has limited resources to fund this increase.  Tax increases, spending cuts and international borrowing look dicey.  Therefore, Moscow is left with the alternatives of bluffing, printing money, or increasing oil revenues.  The Russian central bank does not typically bluff.  Therefore, Moscow is counting on increasing oil revenues to bankroll the war in Ukraine.  

This comes as no surprise for those who follow my macro oil forecasts and is the direct result of a poorly designed and failing Price Cap.  For example, in February, I noted in The Oil Supply Outlook (and why it matters for Ukraine) that

The conditions are present for a material tightening of the market in the medium to long term.  After 2023, oil price trends favor Russia, and perhaps substantially so.  For Ukraine, this could pose a serious threat, as the current European and US sanctions on Russian oil are unsuitable to deal with such an eventuality.

This is belatedly beginning to dawn on the Biden administration.  Even two weeks ago, various Biden administration proxies were defending the Price Cap in its current form (Benjamin Harris here and Eric Van Nostrand here).  This past week, however, the tone has turned more somber.  Bloomberg notes that "Treasury Secretary Janet Yellen said that recent market prices for Russian oil suggest that the Group of Seven’s price cap is no longer working as hoped, her first such public acknowledgment of challenges with the program."  Some analysts go farther.  Julian Lee, Bloomberg's oil markets analyst, in a Washington Post op-ed, It’s Time to Scrap the Russian Oil Price Cap, writes

It gives me no pleasure to say this, but it’s time to scrap the Russian oil price cap.

​Lee is a solid, level-headed analyst.  But in this case, his advice would be disastrous.  I would not be surprised to see Brent hovering around $110 /  barrel much of next year.  If we allow that every $25  barrel above $55 on a Urals basis allows Russia to double its military spending, then $110 Urals would allow Russia to triple its military budget compared to the pre-war era.  This is not only inadvisable, it's absolute insanity.  

The reality, unfortunately, is that the Biden administration has not a clue how to fix the Price Cap.  None of the administration, Treasury or Fed has the appropriate skill mix, which requires oil markets experience (supply and demand forecasting); oil price forecasting; an understanding of the linkage of oil prices to the economy, politics and society; crude and refined products shipping and pipelines expertise; a solid understanding of black market theory (my unique specialty); and familiarity with the eastern Europe mindset and culture.   None of this appears on, for example, the above-mentioned Benjamin Harris's otherwise impressive CV.

The rather unpleasant implication is that Julian Lee's vision, whether de facto or de jure, is likely to be realized: the Price Cap will be scrapped.  My Ukrainian readers should contemplate whether this is a desirable outcome, or whether Kyiv might finally wish to take a stand on the matter.

Ukraine's Emerging Funding Challenges

This is even more acute as Ukraine is running up against funding resistance.  This comes as no surprise once again, and for more than a year I have been warning about using the US Federal budget as a bottomless piggy bank.  To the average American, Ukraine is every bit as exotic and remote as Papua New Guinea, Yemen or Andorra.  Why are we spending so much money on that distant place?  Is it really our fight?  Many, many Americans are asking these questions.

The situation will deteriorate from here.  Part of it is simple war fatigue from the funders' side.  More importantly, we appear to be heading toward another oil shock, with JP Morgan forecasting a 7 mbpd shortfall in the oil supply by 2030, which is enormous. As oil prices break through $100, $110, or $120, the Russians will feel emboldened and Ukraine's western allies will find themselves enfeebled politically and economically, and they will progressively reduce their exposure to Ukraine. Recent Congressional theatrics and the Slovakian elections can probably be finessed.  But they are a clear warning shot and a harbinger of things to come.

The bottom line is this: The Price Cap can and should be appropriately restructured.  This would transform the war into a profit center for the US, with about $10 bn in US government annual support to Ukraine offset by about $25 bn in revenues to our defense industry.  That would silence Ukraine's critics and ensure Kyiv has plenty of money for both the conflict and reconstruction.

Rigs and Spreads Sept. 29: More of the same

• More of the same.  Rigs and spreads continue to fall, high oil prices notwithstanding.

• Rig counts

• Total oil rig counts: -5 to 502

• Horizontal oil rig counts: -4 to 447

• The Permian horizontal oil rig count: -4, again

• The Canadian horizontal oil rig count remains essentially unchanged over the last four months, this week down 23 from last year

• The US horizontal oil rig count is falling at a pace of -4.0 / week on a 4 wma basis.

• This number has been negative for 43 of the last 44 weeks

• Frac spreads fell, -4 to 255  

• This is still too high for the current rig count, as DUCs continue to fall.  

• To hold DUCs steady, the spread count must fall by 20

• It looks like the industry has settled on 16 weeks of DUC inventory, where it stood on Friday, as the new normal.

• As a result, expect spreads to roll off pro rata with rigs from here on out -- beyond the 20-spread readjustment necessary to hold DUCs steady -- at a ratio of one spread for every two rigs.

• The Brent Spread – the difference between WTI and Brent – is also signaling the end of the shale revolution

• Historically, WTI sold at a premium to Brent

• Since the shale revolution, WTI has typically sold at a discount to Brent, generally in the range of $4 / barrel in recent times.  

• This discount was necessary to place incremental US shale oil barrels in the market.

• In the last two weeks, the Brent spread has collapsed to around $1.50 / barrel, suggesting a tightening US market, which could be explained by low or no growth in US shale oil production.

• Once again, nothing cheery in the data

Rigs and Spreads Sept. 29.pdf

Rigs and Spreads Sept. 22: Peak Shale?

• This week’s numbers were all but disastrous.  Both rig counts and shale oil output continue to fall

• Rig counts

• Total oil rig counts:-8 to 507

• Horizontal oil rig counts: -8 to 451

• The Permian horizontal oil rig count: -4

• The Canadian horizontal oil rig count continues to lag, down 28 from last year.  

• The US horizontal oil rig count is falling at a pace of -3.0 / week on a 4 wma basis.

• This number has been negative for 42 of the last 43 weeks

• Frac spreads fell, -5 to 259  This is still too high for the current rig count, as DUCs continue to fall.

• DUC inventory has fallen back to 15.7 weeks of turnover

• The EIA’s latest DPR, published this past week, also shows shale oil output from the key plays declining, down 17 kbpd from July.  In addition, the EIA is forecasting further declines, with October shale oil output down 82 kbpd from the July peak.  That is, given the continued decline in rig counts, the EIA appears to be calling peak shale oil production for July 2023.  

• It is important to note that the EIA routinely revises previous output figures and that EIA projections should be considered provisional, not definitive. Nevertheless, the EIA production decline forecast is consistent with the chronic erosion of rig counts we have seen since last December.  

• Last week, I wrote this:

Lagged oil prices for the next eight weeks are consistently above $80 WTI, and at times well into the mid-$80s. As a result, we should in theory see at least modest life in the horizontal oil rig count. If we do not, it will be further evidence that the underlying problem is a lack of drilling opportunities, not unfavorable economics

• Instead of modest rig additions, we see a stiff decline of 8 horizontal oil rigs this week, half of them from the Permian.

• The continued decline of rig counts, particularly with lagged WTI above $80, is bad.  The decline in shale oil output from key plays is bad. And the continued erosion in the DUC inventory is also bad.  

• There is nothing redeeming in the data this week.  Perhaps the numbers turn around at some point, but right now, the picture is ugly.

Rigs and Spreads Sept. 22.pdf

Urals heads toward $80

WTI and Brent have been rocketing up, respectively at $93 and $96 at writing.  (For those interested in the oil market dynamics, see my presentation from Italy last month.  I'll have a separate post on this).  

Urals continues to track Brent, with Urals at writing posted at $78.12.  Given the surge in Brent, we might expect to see Urals at $80 / barrel in the next week or so, $20 higher than the $60 Price Cap.  

The Urals discount is largely holding steady, about $17 at writing.  I expect the discount to narrow over time.  The ESPO discount continues to shrink, again per expectations.

Urals is now $22 / barrel above the average for the 2015-2021 period and near a peak for the week in the last nine years.  With ESPO at $89, Russia's blended crude oil export price is just about $80, sufficient to double Russia's military budget compared to the pre-war period (assuming Russia can repatriate those earnings).

The ruble continues to hold up, near 97 rubles / USD.  There has been no collapse.  Russia's central bank is doing its share, raising benchmark interest rates to 13%.  I would note that there is no such thing as 13% interest rates in the 5-7% inflation environment Russia's central bank projects for 2023.  Inflation is likely substantially higher, as I have argued, because the Kremlin is funding the war in part by printing money.  With the increase in oil prices, this pressure may ease, and it is not inconceivable that the ruble will stabilize near its current range.  Much depends on the evolving nature of Russian federal outlays, including for the war, as well as the portion of oil export earnings Moscow is able to repatriate.   

​The Biden administration's proxy at Brookings has defended the Oil Price Cap.  The author, Benjamin Harris, was one of the program's architects.  I am not certain his analysis is intended as a defense of the Price Cap; perhaps it is better read as a eulogy.  Defending the Cap is exactly the wrong response, because surging Brent and WTI will make a mockery of the supporting arguments.  Americans are not going to care a whit about rationalizations.  They are going to care about pump prices, with Republican candidates pillorying the Biden administration for its incompetence in constructing the program, and justifiably so.  The Price Cap needs to be fixed, not defended in its current form.

Rigs and Spreads Sept. 15: Stabilization

• Horizontal oil rigs stabilized this week

• Rig counts

• Total oil rig counts were +2 to 515

• Horizontal oil rig counts were +0 to 459

• The Permian horizontal oil rig count was up 1

• The Canadian horizontal oil rig count continues to lag, down 24 from last year.  

• The US horizontal oil rig count is falling at a pace of  -2.0 / week on a 4 wma basis.

• This number has been negative for 41 of the last 42 weeks

• Frac spreads rose, +12 to 264.  Again, this is not sustainable without rigs additions.

• DUC inventory fell back to 16.4 weeks

• We are approaching the moment of truth for the shale industry

• For the last several months, the breakeven to add rigs has averaged around $77 WTI

• At writing, WTI was $91

• Lagged oil prices for the next eight weeks are consistently above $80 WTI, and at times well into the mid-$80s

• As a result, we should in theory see at least modest life in the horizontal oil rig count

• If we do not, it will be further evidence that the underlying problem is a lack of drilling opportunities, not unfavorable economics

Rigs and Spreads Sept. 15.pdf

The Price Cap is keeping oil prices high

I have written several times that the adverse effects of prohibitions and related enforcement are as much as 20 times worse than the problem itself.  Today, we'll examine one of those adverse effects, the impact of the Price Cap on oil prices.

The bottom line for my busy readers is this: The Urals and ESPO discounts have motivated non-OECD buyers, notably the Chinese and Indians, to hoard as much Russian oil as possible.  As a result, excess inventories -- those above routine daily needs -- are about 1 billion barrels in the non-OECD.  As long as a discount remains, Asian buyers will continue to hoard cheap Russian oil.  If the discount disappears, that oil will return to the market, likely capping Brent around $85 through 2024, and potentially driving it down as low as $65 / barrel at times.

One might be tempted to conclude that the Price Cap should be abandoned.  This is the wrong read.  The Price Cap needs to be restructured to fix the hoarding problem, while at the same time ensuring funds for Ukraine's war effort and reconstruction. 

*****

Excess crude oil and refined product inventories are those above the quantity needed by the industry to ensure uninterrupted, regular business.  The OECD countries ordinarily carry about 60 days of crude and refined product inventory as a share of consumption.  For example, US oil consumption is about 20 mbpd (million barrels per day), and normal inventory is about 60 days of consumption, or 1.2 billion barrels.  If we had 66 days of inventory, then we could say that 6 days, or 120 mb (million barrels) of that inventory is excess.  If refiners and distributors are holding excess inventory, they will be motivated to liquidate such excess, typically by lowering prices -- the same as any other industry.

In the OECD, we know both the actual level of inventories and the volume to be expected based on normal turnover of 60 days.  Excess inventory (or the deficit of inventory) is the difference between the reported inventories and the expected level assuming 60 days.  Therefore, if the EIA reports 1.3 billion barrels of US inventory and we would anticipate 1.2 billion barrels based on 60 days of turnover, then we can say that the US has 100 mb of excess crude and product inventories.

The matter in the non-OECD is not quite as straight-forward, as non-OECD countries often report their inventory levels late, unreliably, or not at all.  Therefore, we have to impute non-OECD inventory levels.  During 2018-2019, oil markets were largely in balance and inventories were at historical averages in the OECD.  We can assume that inventories were similarly balanced during this stretch in the non-OECD and use this as a baseline for subsequent changes.  We can then adjust for subsequent builds or draws using EIA supply and demand data, deducting reported OECD inventories.  The result can be seen on the graph below.

As the graph above shows, excess inventories soared with the start of the pandemic.  Readers will recall that the world closed down and oil started piling up around the globe, with fears that available storage capacity would be swamped.  As it turned out, oil companies rapidly began to reduce their production, but excess inventories still crested over 2 billion barrels in the spring of 2020.  Thereafter, excess inventories were slowly worked off as operators withheld production and the global economy gradually recovered.  By late 2021, excess OECD inventories had all but disappeared and excess non-OECD inventories were gradually declining.  Had the war not occurred, excess non-OECD inventories would likely have dissipated by now.

However, with the start of the war, a huge discount opened up between Brent and the various Russian oil prices, incentivizing countries like India and China to load up on Russian oil.  As a result, excess inventories started to balloon again, visible in the darker red color on the graph above.  This was not the result of a mismatch between supply and demand fundamentals, but rather due to hoarding by purchasers of Russian crude.  As long as the discount persists, purchasers of Russian crude will have an incentive to load up as much inventory as they can handle.  In other words, the Price Cap is preventing excess inventories from returning to the market on a net basis.  Previously purchased cheap Russian crude is processed to make gasoline and diesel, but inventories are immediately replenished with new, discounted Russian crude.  The result is about 1 billion barrels of excess crude and refined products stored in non-OECD countries.

If the Urals and ESPO discount disappeared, holders of cheap Russian crude would have an incentive to run their inventories back to normal levels.  That is, about 1 billion barrels of excess inventory would find its way back to the market over a period of 2-3 years.  This implies a draw of 1-1.5 mbpd of crude and products from inventory, which is a lot.  This would depress oil prices.  

Moreover, excess inventories exert strict discipline on the market.  Such inventories will be stored, ready for use, in tanks conveniently located near ports and rail terminals.  They can be dumped quickly on markets in almost unlimited quantities if the price is right.  Therefore, as long as such inventories last, they would cap oil prices, likely limiting Brent to around $85 / barrel through 2024, with the potential to push it all the way down to $65 at times.  

Today, oil demand is running well ahead of supply, pushing oil prices up and putting sufficient pressure on the Biden administration to prompt the U.S. Department of Energy, as Reuters notes, to approach oil producers and refiners to ensure stable fuel supplies at a time of rising gasoline prices.  Notwithstanding, the non-OECD has an absolute ocean of excess inventory, available if the Urals and ESPO discounts dissipate, or more precisely, are properly restructured.

As I have noted before, we need to reform the Price Cap to bring it into conformity with both theory and historically successful practice.  One benefit will be lower pump prices to US and European consumers.

Urals breaks through $75

Ten days ago, I suggested we might see Urals at $75 in short order, and here it is today, $75.59 at writing.  ESPO, Russia's eastern oil export price, is trading above $85, with WTI at $88 and Brent at $92.  

The Urals discount, the difference between Urals and Brent, has once again shrunk, to $16.40 / barrel, about $2 / barrel less than ten days ago.  

The Urals price is now above its level from a year ago and near the high for the 2015-2021 period.  

It is hard to avoid the impression that the Saudis and Russians, among others in OPEC+, are working to jack prices up, in part an attempt to undermine the Biden administration heading towards the election.  The Price Cap itself is largely to blame for the situation.   As I have noted earlier, the side effects of prohibitions and related enforcement are up to 20 times worse than the underlying problem.  A cartel antagonistic to the sponsors of the Cap is but one adverse effect of a prohibition-based approach.

Oil and a Malthusian Transition

Oil and a Malthusian Transition.pdf

Rigs and Spreads Sept. 8: Continued Unwind

• Horizontal oil rigs rolled off again this week

• Rig counts

• Total oil rig counts were +1 to 513

• Horizontal oil rig counts were -4 to 459

• The Permian horizontal oil rig count was down 2.

• The Canadian horizontal oil rig count continues to look frail, down 23 from last year.  

• The US horizontal oil rig count is falling at a pace of  -2.75 / week on a 4 wma basis.

• This number has been negative for 40 of the last 41 weeks

• Frac spreads rose, +8 to 252.  Not sustainable without rigs additions.

• DUC inventory fell back to 17.3 weeks

• Overall, we continue to see more of the same:

• Roll-offs of horizontal oil rigs not justified by oil prices; frac spread counts at unsustainable levels; and a continued unwind in the Permian

Rigs and Spreads Sept. 8.pdf

US Concedes Price Cap Defeat

Despite Brent near $91 and Urals above $74 -- $14+ / barrel above the Price Cap limit -- Reuters reports that 

The G7 and allies have shelved regular reviews of the Russian oil price cap scheme...even though most Russian crude is trading above the limit because of a rally in global crude prices.

Initially, EU countries agreed to review the price cap every two months and to adjust it if necessary while the G7 would review "as appropriate" including "implementation and adherence."  The G7 has not reviewed the cap since March, however, and four people familiar with G7 policies said the group had no immediate plans to look into adjusting the scheme.

The sources said that while some EU countries were keen for a review they said that there was little appetite from the United States and G7 members to make changes.

To recap: Despite the fact that Urals has exceeded the Price Cap for nearly two months, the G7 has no plans to either review or adjust the scheme. To put it another way, the G7, and in particular the Biden administration, is substantively conceding the defeat of the Price Cap.

And why is that?  Reuters explains, from July 27th

The [Biden] administration...is set to move slowly, wary of creating ripples in a market that could send rising global oil prices higher.  The administration is in a "policy pickle" because it does not want to come down too hard with enforcement threats and risk boosting global petroleum prices by interfering with the movement of oil, the source with knowledge of administration thinking said.  "They'll spook the service providers facilitating exports, they certainly don't want to do that."  High consumer energy prices are a political risk for President Joe Biden, who is seeking reelection in 2024.

The failure of the Price Cap is not unexpected.  Indeed, I have criticized the Price Cap and the EU embargo as the wrong policy from the start -- more than a year ago now.  Prohibitions, including embargoes and price caps, virtually never work and almost always have severe side effects, by my research, up to 20 times worse than the problem itself.  This was fully evident by July 28th, when I noted that "the Price Cap can now formally be considered a failure."

Policy responses, I argued, would prove misguided, which again, a review of the historical record of prohibitions clearly indicates.  In my August 4th analysis, The Price Cap is Dead, I wrote

[Don't] expect the Biden administration, the US Treasury or the Federal Reserve to make the necessary adjustments.  When faced with a violation of prohibitions, governments' responses historically have been misguided and counterproductive.  

I elaborated on August 29th

The Biden administration is more likely to paper over the failings of the current regime or admit defeat than to make necessary and constructive modifications to the Price Cap.

This largely brings us up to date.  Eric Van Nostrand, acting Assistant Secretary for Economic Policy, continues to gamely defend the Price Cap.  The matter is rapidly descending into farce, however, and the Biden administration had better come up with something more convincing, and soon.  A likely scenario heading into the election is both sky-high oil prices -- Goldman Sachs is forecasting $107 Brent for 2024 if Russia and Saudi Arabia hold their nerve (a fair bet) -- and a blow out of the Urals price.  Given that the G7 seems in no mood to enforce the Price Cap, we can expect the Urals discount to shrink, and a worse case scenario could put Urals as high as $100 / barrel for 2024.  This is almost twice Russia's average crude oil export price for the 2015-2021 period and sufficient to triple Russia's military budget compared to the pre-war period.  This will also add drag to the western economies and depress public support for Ukraine as unaffordable.  Both the Biden administration and Kyiv will find themselves cornered.

So what are the Ukrainians doing?  The Ukrainian embassy in Washington reads all my reports.  The ambassador has had these analyses on her desk for seventeen months.  And what have they done with it?  Absolutely nothing.   No qualification, no presentation, no advocacy.  Absolutely nothing.  I am as pro-Ukrainian as they come, but it would be helpful if the Ukrainians could take just a little, baby step towards defending their own financial interests.  The difference between the abandonment of the Price Cap and restructuring it to capture the value of the Urals discount (and then some) is absolutely huge, as much as $100 bn / year if Goldman's oil price forecast holds up.  If the Cap is abandoned, those sums will go to Russia and will be used to grind down Ukraine for years to come.  Alternatively, those funds can be redirected to Ukraine and the western alliance partners, materially funding the war, eliminating the financial considerations to Ukraine's entry into the EU and ensuring that Poland and the Baltics are kitted with all the weapons they need.  And a few Republican Congressmen will be able to breathe easier.

The Ukrainians need to step up and fight for constructive financial policy as hard as they are fighting the Russians in the field.

Urals to $75?; more on Russian inflation

Urals, Russia’s crude oil export price to the west, rebounded this week on a surging Brent oil price. As of Monday, Brent was trading at $89 / barrel and Urals was once again peaking over the $70 threshold, $10 /barrel above the Price Cap.

The Urals discount, the difference between the Urals and Brent oil prices, has widened to more than $18 / barrel. Whether this is as a result of a lag in reporting Urals compared to Brent, or whether it reflects greater difficulty in the Russians placing their exports remains to be seen. At a guess, the Urals discount should trend back into the $15-16 range.

None of this bodes well for either Ukraine or the Price Cap. Barclays Bank sees Brent averaging $92 / barrel in Q4 and $97 / barrel in 2024. Assuming a $15 Urals discount, Urals could average $77 in Q4 and $82 in 2024. As a rule of thumb, each $10 / barrel translates into $25 bn in revenue for the Russian government. Put another way, every $25 / barrel allows the Russian government to double its defense spending compared to pre-war days. Barclays forecast puts Russia's oil price at $21-26 / barrel above its pre-war level.

Russia’s Inflation and Exchange Rate

Russia's inflation rate has been much debated.  The Russian Central Bank is predicting 6.5% inflation for the year, which is inconsistent with interest rates at 12.5%.  At the same time, Steve Hanke of Johns Hopkins has posited an inflation rate of 60%, which is a modeled number and not derived from observed price changes.  Inflation is also attributed to devaluation, which vastly overstates the case.  The Washington Post notes that "imports still [make] up to 40 percent of the average Russian consumer basket", which creates the impression of some sort of free-wheeling, Hong Kong style economy.  In fact, pre-war and pre-covid, imports constituted about 20% of Russia's GDP and are probably substantially less now.  

The average Russian mostly consumes Russian goods like meat, dairy, cheese, bread, butter, milk, toilet paper, laundry detergent, and, naturally, vodka, among others.  These are almost all produced locally, even if they carry global brands.  Imports will be found on store shelves, of course, but in most cases, the Russian consumer can substitute local products for these.  Further, Russians spend a large portion of their budgets on items like housing, transportation, and local services like plumbers or haircuts which are non-traded goods.  For the average Russian household -- which by definition is not located in Moscow or St. Petersburg -- the day-to-day impact of devaluation is probably on the order of 10-15% of Russians' routine consumption basket.  That is, a 20% devaluation translates into perhaps 2-3 percentage points of inflation.  This is not enough to move the needle.

Instead, posted increases in the money supply are consistent with observed devaluation and should be driving inflation of similar value.  This should manifest as Russians complaining  about prices and observed reductions in purchases of routine, Russian-made goods.  And it appears to.  The above-noted Washington Post articles reports that

One study published Aug. 16 by Russia’s largest market research agency, Romir, found that 19 percent of respondents had begun cutting back on purchases of basic goods such as toothpaste, washing powder and food in July, compared to 16 percent the month before.

These are mostly locally-produced goods, which implies material inflationary pressures domestically, and not only through imports.  And this is what we would expect.  

Similarly, Russia is seeing spot shortages of gasoline and diesel at filling stations in the country.   This results from both devaluation and inflation.  Wholesale fuel prices are determined by their value on global markets (in dollars), even as retail gasoline and diesel prices are set administratively and capped.  As a result, Russia, one of the world's leading producers of refined products, is seeing a local shortages as refiners find it more profitable to export fuel than sell it on the home markets.  Of course, the government is well aware of this.  The failure to raise domestic prices is an attempt to suppress underlying inflation and retain public popularity.  These initiatives almost always fail, and the government is sooner or later compelled to raise fuel prices.  

As I have written before, all this suggests the government is funding the war in part by printing money.  The fact that fuel prices have not been raised implies the Kremlin feels constrained in passing through all costs to consumers.  In other words, the Kremlin is boxed in politically, allowing ample room for the western powers to revise the Price Cap and Embargo programs.  Putin cannot afford to stop exporting oil.

Rigs and Spreads Sept. 1: An inflection point?

• Rigs took a pause this week within the wider context of nine months of nearly continuous roll-offs.  In my last report from August 11, I noted that spreads at the time were too high at 262.  This number has plummeted to 244 in the intervening three weeks, with horizontal oil rigs easing back by just 7 over the same period.  As a result, rigs and spreads are now largely in balance, suggesting that the chronic erosion of DUC inventories may be ending.  With the breakeven to add rigs running around $76 WTI and the WTI currently holding a pricey $86, the prospects for a rebound in rig counts are improving.  We may be approaching the end of the mini-cycle begun last December.  Maybe.  We don't yet have enough data to call a trend, but it feels like we may be at an inflection point, or at least a mini-inflection point.
  

• Rig counts

• Total oil rig counts were flat at 512

• Horizontal oil rig counts were flat at 463

• The Permian horizontal oil rig count was down 2.

• The Canadian horizontal oil rig count was again looking frail, down 25 from last year.  Whatever is going on in the US oil patch has now officially spread to Canada

• The US horizontal oil rig count rose to -2.0 / week on a 4 wma basis.

• This number has been negative for 39 of the last 40 weeks

• Frac spreads fell, -2 to 244.  Spread numbers are back to the level of January 2022.  Not great.

• DUC inventory came in at 17.9 weeks, the highest in more than a year

• This recovery suggests a change of sentiment in the oil patch, that operators may decide to no longer pursue a policy of DUC inventory liquidations

• On the other hand, this recovery has been driven by a collapse in the spread count, not as a result of a surfeit of rigs over spreads.  In any event, it feels like a change in the weather.  The coming weeks will tell us more.

• In the August DPR (admittedly published two weeks ago), the EIA sees July crude and condensate production from key shale plays rising to 9.25 mbpd, up 6 kbpd from June

• Permian production actually fell in July, down a marginal 1 kbpd over June, and in July was 11 kbpd lower than its March peak.  

• The minor plays are up marginally over the period, supporting modest shale oil production growth in aggregate.  

• The ‘peak shale’ thesis appears to be holding up.

Rigs and Spreads Sept. 1.pdf

Urals softer; ruble stabilizes; looking dicey for Kyiv

Urals, Russia's crude oil export price to the west, closed last week at $67.54, easing back on softer Brent pricing.  Urals remain more than $7 / barrel above the Price Cap limit.

The Urals discount, the difference between the Urals and Brent oil prices, widened a bit to $15 / barrel for the week, but remains almost the smallest since the start of the war.  The ESPO discount -- the difference between Russia’s Eastern Siberia - Pacific Ocean pipeline price and Brent -- continues to close and is on pace to disappear entirely by year end.  

The takeaway remains as it was.  The Price Cap is materially irrelevant.  Urals is tracking Brent and the discount widens or narrows as Brent varies.  When Brent is stronger, the discount shrinks.  When Brent is softer, as it was this week, the discount widens.

As last week, the Urals price is close to its high since 2015 and is running at nearly $12 / barrel higher than its average for the 2015-2021 period.  The Russians have reason to be pleased.  

Indeed, Russia appears to be extending its production cuts and looks to cut exports by 300,000 bpd in September.  The EIA estimated Russian oil production largely unchanged at 10.5 mbpd in July, which looks a pretty fair estimate given that the Russians have stopped reporting production levels in recent times.

Hysteria two weeks ago about a collapsing ruble has dissipated, and the ruble has stabilized under 95 / USD.  This is not a surprise.  Reported increases in the Russian money supply did not warrant an exchange rate beyond Rbl 100 / USD.  Moreover, high oil prices and a collapsing Price Cap dictate improving Russian terms of trade, and that should underpin ruble strength.  If one were to guess, go long the ruble here.   

Overall, oil markets developments are favoring Russia at present.  The Price Cap has visibly failed, OPEC+ production cuts are supporting oil prices, and the resulting terms of trade favor the ruble.  As we are now in the last week of summer, on one cares in Washington DC, or to appearances, in Kyiv.  Let's see if the mood changes after Labor Day.  For Kyiv, the situation looks increasingly dicey.  The Biden administration is more likely to paper over the failings of the current regime or admit defeat than to make necessary and constructive modifications to the Price Cap.

The Price Cap requires prompt attention

Last week, I wrote that the Price Cap is dead.  This week, we begin to contemplate its reincarnation.

As expected, Urals broke through the $70 barrier this week, briefly touching $72 intraday before closing at $71.64 on Friday.  This is a hefty $11.64 / barrel above the $60 cap.

The Urals discount -- the difference between Urals and Brent -- has continued to narrow, closing the week at $15.59 ($16.11 on a weekly basis), the lowest since the start of the war, that is, even before the implementation of the Embargo and Price Cap.  We might expect the Urals discount to continue to shrink to the $8-12 / barrel range, but probably not much less, as that would make Russian oil uncompetitive in India, an indispensable customer for Russian crude.  This provides little comfort, alas, because Urals will simply follow Brent up, as it has since May.

The situation is even more unfavorable to the east.  Russia's ESPO (Eastern Siberia - Pacific Ocean pipeline) oil price closed the week above $81, just $2 / barrel below the US benchmark WTI oil price.  We can expect Russia's eastern oil prices to all but close the gap on Brent in the coming weeks to months.

If we look at the Urals oil price in the longer context, the situation is even more disturbing.  The Urals oil price today is actually higher than it was one year ago -- by $6 / barrel -- and, again, that was before the Price Cap was implemented.  In fact, the Urals price today is about the highest it has been for the week since 2015.  

I had said that the Price Cap would prove a liability for the Biden administration come Labor Day, but we may not have to wait that long.  Here's Friday's headline from the Kyiv Independent:

Bloomberg: Russian oil breaks price cap, revenue soars in July

The article notes that Russia's July oil revenues were up 20% from the prior month.  August will be even more dramatic.

How will the Biden administration respond?  With Brent heading towards $90, western leaders may prove reluctant to crack down on shippers violating the Price Cap.  The alternative is an insistence from the administration that, despite its flaws, the Price Cap still holds the Urals price below Brent by $10-15 / barrel.  This will likely remain true, but my Ukrainian readers may nevertheless despair, and with good cause.  Every incremental $10 / barrel equates to $25 bn in annual revenue to the Russian government.  If Urals marches up to $80, Putin may have little difficulty doubling Russia's defense spending.

Such an outcome is, of course, entirely avoidable.  The Price Cap and Embargo were poorly designed.  They can be modified to fit Ukraine's needs.  But don't expect the Biden administration, the US Treasury or the Federal Reserve to make the necessary adjustments.  When faced with a violation of prohibitions, governments' responses historically have been misguided and counterproductive.

Rigs and Spreads Aug. 11: Rig additions in September?

• Rig counts

• Total oil rig counts were flat at 525

• Horizontal oil rig counts fell, -1 to 470

• The Permian horizontal oil rig count was flat.

• The Canadian horizontal oil rig count is looking a bit fragile, 19 below last year for the week

• The US horizontal oil rig count fell at a pace of -4.25 / week on a 4 wma basis.

• This number has been negative for 35 of the last 36 weeks

• Frac spreads rose, +5 to 262.  Spread numbers are still too high.

• DUC inventory came in at 15.1 weeks, in this range since last November

• In order to hold DUC counts constant, horizontal rigs would have to rise by 57 or frac spreads would have to fall 28.  As such, DUCs appear to be rolling off at an accelerating pace.

• The breakeven to add rigs has remained in the $75 WTI range for the last several weeks.  Given the recent strength in Brent -- $83 at writing – our model is, for the first time this year, forecasting material rig additions, from mid-September.

• Weekly US crude and condensate production came in at 12.6 mbpd this week, up 0.4 mbpd over last week

• Readers will recall that I wrote the following last time:

• There is a continued disconnect among the crude supply numbers respectively from the weekly PSR, the monthly STEO and the monthly DPR (all EIA reports)…either supply trends are worse than they appear, or the weekly reporting framework needs a bit of revision.  

• Of course, my friends at the EIA read this report. (What numbers junkie doesn’t?)  And like most analysts, they try their best with the data available, which can be challenging with high frequency numbers

• The revision is likely to be a ‘true up’, a plug, to bring the weekly numbers into line with the monthly numbers (more on that in the next PSR report).  That is, it does not represent production growth, but rather acknowledges production growth that was not captured earlier in the high frequency (weekly) data

• This is the role of management, sometimes to sacrifice precision for accuracy.  The right call, in my view.

Rigs and Spreads Aug 11.pdf

Understanding Ruble Devaluation and its Implications for the War

Much has been written in the press recently about the collapse of the ruble and inflation soaring to 60% in Russia.  Such claims appear exaggerated and, more importantly, neglect associated implications.  For policy purposes, we are interested in devaluation and inflation as they affect the Kremlin's ability to finance its war and contain public discontent at home.  

Analysts tend to focus on year-ago data, but Russia's pre-war position is the appropriate baseline.  Before the war, the ruble was trading at 74 / USD.  With the start of hostilities, oil prices soared and Russian consumer goods imports collapsed, leading to a 40% revaluation of the ruble.  Over time, oil prices declined and Russia re-oriented its imports, leading the ruble to fall back to its pre-war level.  That trend has continued, with the ruble today at 98 / USD, representing a devaluation of 25% since the start of the war.  This is certainly significant, but not catastrophic under the circumstances.

Currencies can devalue for a number of reasons, for example, underlying terms of trade, comparative interest rates, or sanctions.  Large devaluations, however, are often linked to loose monetary policy, that is, the government printing money to cover expenses.  We can analyze this using the Quantity Theory of Money (QTM).  Basically, QTM holds that, if a country doubles the currency in circulation, the price of goods will accordingly double (twice the money chasing an unchanged amount of goods), and the currency will devalue by half to hold the real exchange rate constant.  (More here.)  QTM has not been fashionable with economists recently but, nevertheless, remains a useful tool.  For example, a QTM analysis of the Federal Reserve's pandemic monetary policy largely predicts the US inflation of the last three years.

The Russian Central Bank reports that Russian money in circulation rose from 15.2 trillion rubles in September 2022 to 17.9 trn rubles in June 2023, representing a money supply increase of 21% on an annualized basis.  This is consistent with the 21% pace of devaluation in the same period.  These in turn suggest Russian domestic inflation around 20%, rather than the Bank of Russia’s forecast of 5.0–6.5% for 2023.  The Bank's surprise interest rate hike to 8.5% also suggests inflation at least in the high single digits.   Thus, QTM analysis suggests fairly stiff, but not catastrophic, inflation in Russia for 2023.

We can also assess an increase in the money supply from the fiscal perspective.  Based on the Sept.-June period, money in circulation in Russia has been rising at the pace of 3.6 trn rubles (cc $45 bn) per year.  This is the equivalent of 2.4% of Russia's GDP.  Put another way, the Russian government appears to be covering a budget deficit of 2.4% not through borrowing or fiscal adjustments, but rather by printing money.  This implies Russia's net budget deficit is larger than reported.  Again, the magnitude is not disastrous, but it does underscore the Russian government's cash hunger, about which I have written on several occasions.

Russian defense spending is running at twice budget levels, implying an additional 6 trn rubles in military spending anticipated for the second half of 2023.  If this is covered by printing money, it would imply inflation moving towards 30% and an exchange rate of 110 rubles / USD by year-end, with devaluation continuing in 2024.

For Putin, money is tight, but the situation is not yet critical.  Still, our analysis suggests that the Kremlin has precious little wiggle room, something which can be exploited by Ukraine and its allies.

The Price Cap is Dead

The Urals oil price -- the price Russia receives for its western crude exports -- continues to rise, reaching $69.22 / barrel on Friday.  This is the highest since November and well above the $60 Price Cap.  

The Urals discount -- the difference between the Urals and Brent oil prices -- continues to erode.  At week end, the discount stood at $16.67 / barrel, narrowing by $3 / barrel compared to a month ago.  On a weekly basis, the current discount is the smallest since the start of the war.  

Both the Urals price and the Urals discount signal that the Price Cap is dead.  This is all the more so as Saudi oil production cuts will likely hold Brent at elevated levels, implying that Urals will also remain above the Cap limit.  Indeed, strength in Brent suggests that Urals will break through the $70 threshold this coming week.  The political optics will be poor.

Governments inevitably attempt to counter the evasion of prohibitions, including on the sale of Russian oil above the Cap, with one of two counterproductive policies.  The first of these is denial or complacency, which was this week's primary menu offering.  Reuters reports that Acting Assistant Secretary for Economic Policy Eric Van Nostrand, at a London conference, hailed the Price Cap as a successful part of the multilateral sanctions regime imposed on Russia over its invasion of Ukraine.  Clearly, Urals at nearly $70 / barrel cannot be considered even remotely a policy success.

Governments also turn to enhanced enforcement, and Van Nostrand duly noted that Washington and its partners were working to thwart any evasion. This is proving progressively more challenging as Russia's shadow fleet of crude oil tankers expands.  

The standard responses to prohibitions evasion almost inevitably prove failures. They will this time as well.

No one will care much about the issue in the dog days of summer, but come Labor Day, a mortally wounded Price Cap will become a political liability for the Biden administration.  The topic will be back on the political agenda, as I noted last week. We may see a 12th sanctions package on Russia to remedy the shortcomings of the first eleven.   

EIA PSR Week of July 28th: More of the same; the Price Cap has collapsed.

• More of the same this week.

• Excess crude inventories, as measured by seasonally-adjusted days of turnover, fell 8 mb to 25 mb, a notable fall but to a level in the range seen in the last few weeks

• Excess crude and key product inventories (collectively CDG, that is, crude, gasoline and distillate) were largely unchanged at 22 mb, mostly due to soft demand for products this week.  

• There’s nothing special about these numbers which should move oil prices one way or the other.

• Incentive-to-store analysis suggests the market continues to anticipate normal supply/demand conditions for the next year, just as it has since at least December.

• US oil production remains flat at 12.2 mbpd.  Production is up only 0.1 mbpd compared to a year ago

• Oil prices firmed Thursday after a slightly softer patch on Wednesday, with WTI $80.33 at writing.

• The Russian Oil Price Cap is facing total collapse, with the Russian Urals price standing at $68.38 on Thursday, well clear of the $60 / barrel cap.

EIA PSR Week of July 28.pdf

Urals has broken containment; to the political agenda soon

The Urals oil price -- the price Russia receives for its western crude oil exports -- ended the week at $67.42, well clear of the $60 / barrel price cap.  Urals has exceeded the cap limit for the last seventeen days.  

The Urals discount -- the difference between the Urals and European benchmark Brent oil price -- is holding steady at just under $18 / barrel, as it has for the last week or so.  The discount has narrowed by $2 / barrel compared to the May-June average.

As I have written on several occasions, the Price Cap lost its effectiveness in April. Since that time, Urals has tracked Brent with a discount of about $20 / barrel.   When Brent exceeds $80, Urals by extension exceeds $60.  

Given that oil market fundamentals appear set to prop Brent above $80 going forward, the Price Cap can now formally be considered a failure.  Policy-makers will face some difficult choices in their attempts to respond.  Be that as it may, I think we can assume the Price Cap will return to the political agenda in the coming weeks, certainly after Labor Day.

How long will the war last?

Many in the media and politics anticipated dramatic and rapid Ukrainian victories during the summer of 2023. Nevertheless, progress on the ground has been slow, raising the prospects of a protracted war.

This begs the question: Just how much longer could the war last?

The precedent of prior wars is one way of looking at the issue.  On the graph below, we consider the three wars perhaps most similar to the current war, each involving Russia.

The Russo-Japanese war of 1904-1905 lasted one year and three months. The current war has already run longer, and therefore we can safely dismiss this example as relevant.

The next longest war of interest is the Crimean War of 1853-1856, which lasted two and one-half years.  If this were the template, the current war might be expected to end in August 2024.  

The longest arguably comparable war was World War I, which ran three years and seven months, implying an end date of September 2025.

If one were to guess, the Crimean War would seem the likely precedent.  By August 2024, the Ukrainians will have eliminated 430,000 Russian soldiers (if we accept the Ukrainian body count and 500 incremental eliminations per day).  Russia lost 450,000 soldiers in the Crimean War, so the scale would appear similar, granting that imperial Russia’s population was approximately half the current level of the Russian Federation.

Russia has had longer conflicts, including the Second Chechen War, which lasted ten years, or for that matter, the first phase of the Ukrainian War, which ran from 2014-2022. Nevertheless, both these wars were low level affairs from the Russia perspective.  For example, total Russian losses in the Second Chechen War are estimated at no more than 14,000, fewer than the Russians are losing every month in Ukraine.  Large countries like the US and Russia can maintain low level conflicts almost indefinitely.

Major wars, however, are another matter, and the current conflict in Ukraine constitutes a major war from both the Russian and Ukrainian perspective. The dynamics are therefore likely to follow those of other major wars. This suggests slightly better than even odds that the war ends within a year and near certainty that it ends by September 2025.

I would note that in the three comparable wars — the Russo-Japanese, the Crimean and the first World War  — the Russians lost.