(Public) Memo - Trying To Find Clarity Amidst The Insanity

By: Wilson

Nothing I can say to you today will offer you solace amidst this chaos. Unless, of course, you are in cash like Warren Buffett, in which case I'm sure you find all this chaos rather amusing.

Instead, I will do my best to offer you my thoughts about the latest tariffs and their impact on global energy markets.

Too Crazy To Be Real

As some of you may be keenly aware, the tariff rate math imposed by the US on all of its trading partners is 1) asinine and 2) flawed in logic.

If you have not seen the mathematical computation of the tariff math, here's a good snapshot from NY Times.

Source: NYT

The market, which was already feeling rather uncomfortable about the size of the tariffs announced, received even more bad news today when China imposed the same 34%, an asinine calculated figure to begin with, on the US.

The market turmoil you are seeing today is the result of that, as some market participants had hoped cooler heads would prevail amidst this chaos.

Sadly, that's not how it works, and I suspect cooler heads won't prevail until something actually breaks in the global economy. With China threatening tariffs on the US, Trump will have to show strength by reimposing tariffs.

Since the mathematical calculation was the trade deficit divided by 2, Trump has room to double the tariff rate back to 67%.

This tid for tat will continue until someone folds, and judging by the sensitivity of Trump to both 1) the stock market and 2) interest rates, the market will inevitably have to force it. So in another way, the worse things get (i.e. lower stock market or higher interest rates), the faster this all gets resolved before real damage is inflicted.

In other words, the faster the market declines, the better it is in the long-run as no real tariffs will be implemented and cooler heads will prevail.

There are other aspects of this tariff announcement that lead me to believe that it won't be sustained. The tit-for-tat nature of what's to come is so damaging to all sides that it reminds me of the Saudi oil price war in 2020.

Leading up to March 2020, Saudis tried to convince the Russians that a large production cut was needed to shore up the oil market in an effort to prevent massive storage builds. The Russians didn't think that was wise, so the Saudis did the opposite. It unleashed all of its spare capacity into the market in an effort to shut-in Russian oil production.

More specifically, it targeted Europe which caused Russian crude to sell for below operating breakeven. This tactic led me, at the time, to believe that the price war wouldn't last past a month. In a report I published on March 19, 2020 titled, "Everything That Has Happened So Far Indicates The Price War Won't Last." I said:

We did a deep dive into Rosneft's financials. Rosneft accounts for 40% of Russia's oil production. In 2019, it generated the following figures at $63/bbl Urals:

• Generated ~$21 billion in OCF in 2019.

• Generated $11.16 billion in FCF.

• Spending $12.63 billion in capex in 2020.

• Expected OCF at today's price is $5.5 to $6 billion.

Rosneft has yet to announce a capex cut but it has debt obligation due totaling $12 billion and including other financial commitments, a total of $25 billion due this year.

Rosneft will be negative FCF at these prices, so it will be forced to announce a capex cut soon. In addition, this scenario does not take into consideration the possibility of Rosneft being completely displaced in Europe, which the Saudis are now intending to do.

Rosneft will not even survive 6 months in today's oil price environment if it can't sell its oil. So the idea that Russia, the country can withstand the oil price decline is completely irrelevant to the analysis. If the largest producer requires a bailout from the government in the near-term, the price war will end before it even begins.

In the case of the tariff war, the math is also straightforward.

According to Brad Setser (shared from Citrini Research), the tariff announcement effectively amounts to an increase in the price of oil by $100/bbl.

And given the sensitivity of Trump to higher oil prices (or higher prices in general), the longer this painful sell-off lasts, the faster he will fold.

Energy Markets

If WTI manages to stay around $60 amidst this chaos, then you can say goodbye to the drill baby drill narrative.

Based on our latest model, US crude oil production will fall to average ~12.75 million b/d with an exit closer to ~12.4 million b/d.

Associated gas production will fall by ~2.5 Bcf/d, which would push Lower 48 gas production down to ~104 to ~104.5 Bcf/d by year-end.

Aside from the possibility that LNG exports get smacked alongside everything else the US exports, US natural gas market is going to be one of the more interesting markets for the rest of the year if production disappoints to the downside.

On the demand side, tariff uncertainty, whether implemented or not, is going to be negative for oil demand. Businesses will throttle back investments in the event that Trump restarts tariffs, but I think the negativity from this will be offset by the fiscal stimulus spending from China and Europe.

As for US oil demand, I fully expect weaker growth as I think businesses will be reluctant to spend/invest/hire amidst all of this uncertainty.

On the supply side, OPEC+ increasing production early definitely sent mixed signals in the market (we explained here). But with prices where they are now, non-OPEC supply growth is all but certain to disappoint to the downside. And since tariffs are not yet implemented and only marginal demand growth is impacted, the impact on inventory balances may be negligible.

All-in-all, based on everything I know today, these are the concrete conclusions I can reach:

• US crude oil production will fall this year versus the growth everyone expects.

• Relatively speaking, oil demand growth this year will be weaker than previously expected, but if the tariffs aren't implemented, then it will be marginally lower.

• Non-OPEC supply growth will disappoint materially to the downside.

Conclusion

The market may inevitably force Trump or other countries to fold, but it's likely to get worse before it gets better. The math behind the tariff is so asinine that it makes you think all of this is just a joke. But logic seldom exists when people are panicking, and given the size of the liquidation we are seeing across the board, calmer heads won't return until there's more clarity around the tariff situation.

I reason that this whole situation won't last because it's too damaging to all parties involved (similar to the oil price war in 2020). Cooler heads will prevail, but the market may need to force that on them.

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Analyst's Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.