Energy, a Jack-in-the-Box

Oil is objectively cheap, even after its 50% increase following the resumption of the Iran–U.S. tit-for-tat attacks. It remains objectively cheap.

If we look at the relative-value metrics:

On every one of these measures, relative valuations appear stretched. Relative value metrics do not stay stretched for very long. The only relative-valuation metric that is not stretched is oil relative to housing, which I discussed in a recent letter this month.

What we have seen in oil is both demand and supply destruction:

Additionally, and quite thankfully, we have seen a huge reduction in energy demand, which is one of the factors suppressing oil prices. That reduction is coming from China, alongside the release of strategic petroleum reserves by Japan, the IEA, South Korea, and the United States.

The stabilizers that can potentially lower the burden of high oil prices in the future are almost fully drained. OPEC's spare capacity is gone.

The strategic petroleum reserves have been sold. The issue with the strategic petroleum reserves being sold is the mechanism that makes it put downward pressure on prices when they are sold. IE, the state is not a for-profit entity, meaning that when they are selling, they sell below market prices. It's also true that when they aim to replenish their reserves, they buy above market prices.

China is pulling back almost 5 million barrels of oil per day, roughly one-third of its daily energy consumption, at least on a pre-war basis. This is a significant change, not only in the energy market but also in the potential future supply of goods.

I refer to China’s scale back in energy requirements as a jack-in-the-box. These 5 million barrels of energy that are not being consumed will eventually manifest in one of two ways. Either we will see an enormous wave of demand return at some point, placing relentless upward pressure on energy prices, or the effect will appear in the form of higher consumer-goods prices.

This matters because, when we look at something like the S&P-to-oil ratio, a ratio stretched to this degree suggests that either the S&P needs to fall, oil needs to rise, or both. The same for copper, and for gold.

If the supply of goods from China declines, prices for those goods will rise. The result will be a higher cost of living for much of the world, given that China is the largest exporter. The standard of living in many countries depends heavily on Chinese production.

If that production changes, and if supply is cut—as the decline in energy demand may be signalling—then higher prices are the likely result. If consumers face a higher cost of living, or if Chinese goods become more expensive and there are no cheaper alternatives, they will reduce spending on other goods and services. That could become a catalyst for dreadful earnings reports in western companies and major declines in the S&P.

One thing many people forgot, or chose to ignore because it was convenient, was that China had become accustomed to the extraordinarily cheap energy it was able to buy from Iran, Russia, and Venezuela as a result of U.S. sanctions.

Sanctions are generally assumed to increase the price of goods exported by sanctioned countries. Paradoxically, however, they can reduce the price those countries receive. This happens because not everyone follows the sanctions.

When Russia and Iran were sanctioned, energy costs increased for Europeans, Americans, and Canadians. At the same time, energy costs fell for Indians and Chinese buyers. If Iran and Russia cannot sell to the entire world, the remaining buyers gain bargaining power.

China and India were therefore able to purchase Russian and Iranian oil at substantial discounts below the market price. China became accustomed to these low energy prices, and the rest of the world benefited indirectly through an artificially elevated standard of living supported by cheap Chinese production.

Now, although we have seen some sanctions relief, we have also seen a dramatic increase in energy prices—and they could still rise much further. Chinese industry has already changed its appetite as prices have increased. Whether China eventually accepts these higher prices or continues to rein in consumption remains to be seen.

However, if the relative-valuation metrics tell us anything, it is that once these relationships become stretched, they tend to snap back. When they do, the adjustment is often violent and fast.