Due to experiences in the past, especially in the 1970s, many investors have been conditioned to expect the worst when oil supplies are threatened. While trends in oil demand tend to be far more persistent, and are largely affected by slower-moving events such as the demographics or recessions, oil supply can be disrupted instantaneously, so acts as a faster market price catalyst.
Over the prior weekend, it was confirmed that Yemini rebels (possibly backed or encouraged by Iran) used drones to attack two key Saudi oil extraction and refining facilities, which took nearly 6 million barrels offline—or about 5% of the world’s production volume. This is just one of several infrastructure attacks on Saudi soil this year, but by far the most damaging. The largest one-day oil price spike in 20 years ensued (over 15% at one point to back over $60/barrel). Later, prices tempered, following ramp-ups from other oil producers and the U.S. administration that crude could be released from the Strategic Petroleum Reserve as needed to shore up supply/demand in the interim. Again, as in decades prior, the U.S. government has been put in a tricky position regarding possible retaliations, and if so, towards whom and for how long.
The ultimate question always comes down to ensuring that there is enough oil getting to where it needs to go. There has always been a historical ‘risk premium’ baked into the price of crude oil, due to the geopolitical hotspots where it’s found—such as the Middle East, parts of Latin America, etc. The amount of this premium varies, but we were told years ago by an industry expert, and later government official, that it could be anywhere from $5-20/barrel at any given time. Of course, premiums only matter when they matter.
There are several differences here that separate this from reactions in prior eras. As a whole, despite the growth of emerging markets, populations use less oil per capita than they used to, due to modernized manufacturing and industrial efficiencies. The emergence of green technologies has also taken a further bite into petroleum consumption to some degree. As a result of the shale revolution, the U.S. has overtaken Saudi Arabia as the world’s ‘swing producer,’ meaning that disruptions in more volatile geographies should be less disruptive than they have been in the past. In fact, U.S. sanctions placed on Iran and Venezuela, as well as geopolitical unrest in areas such as Nigeria, have threatened far more in global inventories.
Financial markets also seem to have reflected the tempered concern. The risks, of course, are an escalation, and further attacks, which could begin to add up in terms of supply disruptions. The worst case would be a significant rise in petroleum prices, which has been a wildcard often associated with tipping economies into recession—if they’ve been on the precipice already. The positive side, of course, is higher revenues for energy-oriented assets, such as commodities and energy sector revenues, which have lagged the broader market due to oil prices being stuck in a lower trading range this year. Perhaps surprisingly, a small pickup in prices and drilling activity could also help U.S. GDP growth slightly.
What happened in short-term financing markets last week that caused rates to spike temporarily?
While falling under the radar for the most part, perhaps the most dynamic lubricants of the financial system are markets for short-term funding. These include the Fed-regulated market for ‘excess reserves,’ where banking institutions with excess cash held above their required reserve ratios can lend it to banks needing to fill their reserve bucket—governed by the FOMC-based fed funds rate used as a key tool in monetary policy. (Excess reserves are not a small part of the financial economy, totaling $1.4 trillion as of August.) Other short-term funding markets include the repurchase (or ‘repo’) market, in which firms can borrow cash for very short-term periods (a day in some cases, or longer), in return for posting a certain type of collateral (usually U.S. treasuries). Money market mutual funds are large participants in this market, which is the reason money market yields tend to be fairly close to the fed funds rate. This market is large and typically extremely liquid, considering the high quality of collateral and short maturities, but historically, the Fed has been close at hand to inject liquidity when needed to keep the ‘plumbing’ running smoothly.
Last week, however, those rates spiked when not enough funds were available to satisfy demand. In keeping with demand for an asset and limited supply, the cost (interest rate) of the good (money) rose sharply for a brief time until the Fed stepped into provide liquidity.
This has generally occurred during periods of extreme demand for cash, such as the financial crisis, which is why it was seen as a problem at first glance. However, it appears a confluence of factors created a perfect storm for such an event, which may have been brewing for some time. One of these is the Fed’s paying of interest on excess reserves (‘IOER,’ a new policy after the financial crisis) which kept more funds in the Federal Reserve system. It also adjusted the size of the repo market, depending on where lending banks can earn a slightly higher rate, even by a few basis points. Other factors may include the slow drain of liquidity by the Fed as quantitative easing was unwound, and a sharp increase in treasury issuance—which creates a mismatch between long-term maturities and short-term funding needs. More immediately, significant treasury bill settlements, adjustment of bank balance sheets for quarter-end, and quarterly corporate tax payments potentially added fuel to the fire, causing a cash crunch.
Many bond market professionals don’t see this is a watershed crisis event of any kind. The Fed didn’t address this in depth during last week’s press conference, but they may need to adjust the operations of this market a bit, such as providing more funding buffers to preserve repo market stability, in addition to lowering the IOER as they did last week from 2.1% to 1.8%, to incent banks to move more funds out into lending markets. Or, systematic changes may be required longer-term to prevent such ‘clogs,’ such as a standing overnight repo facility, like a credit line, which it has considered instigating in recent years.