As oil prices make new highs, everyone is talking about how the Russian invasion of Ukraine has caused the stagflation we are seeing around in the world. But the invasion just exacerbated a trend that was already in place, and the U.S. Fed and government know that very well.
Let's review the laws of supply and demand -- and timing.
First, a review of how we got here: As the Covid crisis had begun to wane in the U.S. following the vaccine rollout, President Joe Biden announced a massive fiscal boost to help consumers. But this came at a time when the Fed had already announced a $5 trillion in monetary stimulus boost to help support financial assets. Basically, the U.S. had a massive jumpstart both monetarily and fiscally in a matter of months, which saw a huge jump in aggregate demand. Of course it would lead to surge in prices as demand bounced back, so strongly that the supply side did not have time to "anticipate" or plan for this increase. Supply is usually not something that can just be started overnight, it takes time to increase capacity after careful planning from all sorts of companies across all sorts of industries. This demand increase, however, was like jumpstarting a car: It picks up with a boost and then starts driving a lot more smoothly once moving. The inflation we are seeing over the past year is a consequence of this demand surge, and this has hit every U.S. consumer. The cost of goods, services, groceries have moved up dramatically and quickly, but disposable income and wages, have not managed to keep up.
It is no doubt that Russia's invasion came at a time when the world was already in too much debt, too much inflation, and perhaps Putin knew all this too well. Given global economies reopening post-Covid lockdowns, oil too saw a massive boost in demand. As this happened, OPEC+ has been highly diligent in bringing back oil production loss slowly to the market and the beaten up U.S. shale industry has refused to leverage on rising prices. All this has added up to make the oil market tighter than it would have been.
At the end of the day, if demand grew more gradually, that would have given the producers a lot more time to mange and grow. But this demand growth rate is not sustainable. The world is going through a massive slowdown as prices have seemed to hurt all industries, manufacturers, and consumers. The recent economic numbers are showing this deceleration in a host of macro economic data. It is only a matter of time when this starts showing up in the oil data, too.
The oil market is driven by products, mostly gasoline, distillate and jet fuel. The demand for these products is what drives the demand for oil. It is true that we have a shortage of distillate and diesel inventories, but the attack on Ukraine made this balance even worse, especially at a time when refineries are going through maintenance and China through lockdowns, which means less products on the market. Today an average refiner is making about $50 per barrel in margins to refine gasoline. In the United States, refiners currently receive roughly an average of more than $150 per barrel from the sale of gasoline and diesel at wholesale prices, while paying only around $100 to purchase. Refiners should be maximizing production to take advantage of these profits and surely they are. But it is all about timing.
For now, the oil market tightness is all in products. U.S. distillate fuel oil stocks are 31 million barrels (23%) below the pre-pandemic five-year average compared with a deficit of only 6 million barrels (3%) in gasoline. This is why prices are holding up as Commodities are all about inventories needed today. China reported horrific macro economic numbers on Monday. China's Industrial output fell 2.9% year-over-year in April vs. previous 5% growth, expected 1.1%. Growth in retail sales fell 11.1% year-over-year in April vs. a previous 3.5% drop and expected 5.9% drop. It is easy to blame the extreme lockdowns in China for this collapse in demand. True as that may be, perhaps it was their intention to begin with, how else to get prices down and fast without using such draconian measures. China has been slowing down since the fourth quarter 2021 post the technology, education, and housing crackdown. The lockdowns just exacerbated the problems. This coupled with higher rates and inflation, means China does not have the flexibility to cut rates and boost productivity as it did before.
This is the same dilemma that the Fed faces. Central banks now only know one way to boost demand, and that is by printing more money. Today inflation is close to 8.5% y/y, so their hands are tied. If the central banks did print more debt, it would put the economy into stagflation or depression permanently. Asset prices are a consequence of demand and supply. It just to happened that a strong demand surge came at a time when the supply side was caught off sides. Econ 101 suggests that at some point, either the supply side catches up, or demand falls to get prices back in equilibrium. Timing is everything.
