Rory Johnston on Why His $200 Oil Prediction Didn't Turn Out Right

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2:16Tracy Alloway:Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Allaway. Tracy, recording this June 24th at noon, Brent crude is below$74 a barrel. I know. It's crazy to look back when the Iran war started. I don't think we ever got above like$120 per barrel on Brent. Despite this scenario, the closure of the Strait of Hormuz, the thing that oil analysts had talked about as a tail risk event for years and years and years actually happening. No, it is really remarkable. We had two peaks. There was one right at the end of March and then one right at the end of April, basically.

2:58Tracy Alloway:And the closing price right around just a little bit shy of 120 both of those days. But no, absolutely not like some of the doomsday scenarios, at least for now. Well, you know, their crossings are picking up. I guess negotiations are ongoing of some sort. But no, they clearly the doomsday scenarios about how this couldn't even stay closed for a few weeks, let alone two or three months, did not pan out. I see a lot of people on Twitter slash X making fun of the barrel counters right now. Yes. Which I have a lot of sympathy for barrel counters because I like I like my analysis to be grounded in facts and numbers.

3:33But there is clearly a disconnect here between what happened with the price and some of those predictions.

3:39Tracy Alloway:Well, maybe we learned something. Maybe we learned something about the oil market in the last few months. We've gotten a lot of requests for this episode. And so we are going to talk to someone that we talked to right at the very beginning of the war, someone we've talked to a lot, someone whose oil analysis we greatly respect, even if this particular incident did not perhaps pan out the way he and many others, almost all the others expected. We're going to be speaking with Rory Johnston. He is the founder of the Commodity Context Newsletter. And maybe he learned something about the oil market in the last few months.

4:09Tracy Alloway:So, Rory, thank you so much. By fan request, and our request, because we want to learn something too. By fan request, welcome back to the podcast. Thanks for having me, guys. Let's just start with like, what was, let's start with like, okay, early March. Remind listeners what this sort of your take and the sort of general wisdom was. you know, first couple of weeks of March about how long this could persist and why this, remind people why the Strait of Hormuz was seen as sort of the choke point among choke points when it comes to oil. Yeah. So let's transport ourselves back to our last conversation.

4:46I think it was the first week of - We need a time travel machine music, right? They can have that. So yeah, the reason that it was such a massive deal and still remains, I would say, I mean, And while we have avoided the doomsday prophecies, it is still by far the largest supply disruption in the market's history. And for the numbers, for the barrel counting for Tracy, the total flow through Hormuz prior to the war was roughly 20 million barrels a day. Now, we knew we weren't going to lose all of that because we knew that we had some offsets. You know, the Saudi East-West pipeline, the Emirati pipeline to Fujairah on the Gulf of Beaumont.

5:21But overall, netting for all of those known rerouting options, which again, at the time, we didn't know if they would fully work because they'd never been fully tested. But they did work, thankfully. But even netting of those, we were still down roughly 13 million barrels a day of Gulf oil production, excluding Iran, that had been forcibly shut in through the duration of this crisis and is only now beginning to pick back up again. That's a lot of oil. That's 13 plus percent of the global supply. And the reason we thought that prices were going to hit$150 or even$200 a barrel was that when you have a supply shock that large without any more offsets, you end up at demand-destructive pricing really, really fast.

6:02And to destroy that level, the depth of that demand, we had never seen that before. But$200 a barrel seemed like the reasonable price at which that would happen. Now, thankfully, we did not have to destroy that demand. And what we will talk about shortly, I'm sure, is all the ways in which the system adapted and flexed. And I think we saw this most notably above all in China. Yeah. OK, well, why don't we just dive into it? Give us your overview on what happened and why we didn't actually hit$200 a barrel. Yeah, so I would say the two biggest things, one on the fundamentals on the barrel counting side was China.

6:39We always knew that China had huge stockpiles of oil, but we didn't know how they were going to react to this crisis. And what we've seen through this crisis is that Chinese oil imports, crude oil imports into China, the world's largest crude oil importer, fell by upwards of 5 million barrels a day between the three-month average prior to the war through to June. Now, we're not quite done this month, but that's roughly where we're trending for June so far. that 5 million barrels a day was upwards of half of the total spot market supply hit to Asia. And that allowed a lot of those other Asian importers to basically not have the competition that they would have had for the barrels they were importing.

7:20So the countries that were hit hardest by this crisis and the governments that were most panicked, governments in South Korea, Australia, Japan, Taiwan, et cetera, there was a period where like the prime minister of Australia was coming out daily and announcing the Australian government's successful acquisition of a cargo of diesel. Like it felt very COVID-y. Now, those importers saw imports collapse through March and April. But through May and into June, they actually recovered basically to pre-war levels. And the largest facilitator of that was the fact that China was not competing for any of the other barrels.

7:53And it absorbed so much of the shock itself. Just on China specifically, I have so many questions already, but do you have any sense of how much of this was genuine demand destruction or substitution in China versus just releasing from stockpiles? It's a good question. And the firm answers, we do not have 100 % certainty as to what the exact composition of that swing was. We know the oil going in fell by five to six million barrels a day, given products as well. But in terms of the actual demand destruction, the thing that we have seen across China is that all of the mobility indicators, and you guys were actually in China very recently, all the mobility indicators showed no notable decline.

8:35The level of implied demand destruction that we see, and importantly here, China does not publish official demand data. It also doesn't, very importantly, publish official inventory data. So we're left kind of feeling around the shadows. The implied demand destruction we saw through this crisis was on par, was the steepest demand destruction implied in history, and on par on the volume with the COVID zero demand shock in 2020. But you guys were in China. I have not seen any reporting that indicates that level of lockdown. So we start asking questions, OK, what's going on in the middle? Also, when you look at typically, you'd assume that that level of demand destruction without COVID zero lockdowns would have had to be driven by massive price increases.

9:17But part of what also happened to this crisis is that China had basically throttled the ability of domestic retail prices through their normal regulatory procedures, prices of petrol in Beijing only rose maybe 30 % versus the doubling we saw globally. So again, it just doesn't track for me that all of that or even most of that was demand destruction. So then we go to this point about substitution or outright releases of strategic petroleum reserves. Now, the one thing we can say is that the inventories we can see, these are the floating roof storage tanks for crude oil, those are still very, very high and roughly where they stood at the beginning of this crisis.

9:56So as far as we can tell, they're not drawing down aggressively on those stocks, at least not yet. The caveat there is that we can't see through those satellite analyses, we can't see underground storage tanks, underground storage caverns and their proper SPR. They have six storage caverns, at least that we know of about 131 million barrels. the likelihood is that they have been drawing down those because the following crude oil imports fell far faster than the decline in refining run rates. So again, had to be made up somewhere. So we're just kind of feeling around the shadows for the Occam's razor here is that they have been releasing silently additional crude inventories.

10:34But above and beyond that, we know that crude refining run rates also fell dramatically by three to three and a half million barrels a day. So where's the implied demand destruction? Now, this is where we either get one of two things. We either get a very large release of refined product stocks. Now, we know that China has large stocks of refined products like gasoline, diesel, jet fuel, etc. We have virtually no firm information on those stock levels or can track them very closely day to day or week to week because unlike crude, they don't have floating roofs. So we have to kind of, again, infer.

11:11Those stockpiles upwards of a billion barrels, but the implication is that they're drawing them down very, very, very rapidly. The other thing we could have seen is, and your colleague Javier Blas was on this very early, was on the potential to switch some of the petrochemical feedstocks from oil-derived products like NAFTA and LPG towards more gas-based products, natural gas, or even the extreme coal-based chemical products. That could, again, have a switch on the margin. And then the other thing that you hear is that like, well, China has massive penetration of electric vehicles. So maybe that was making part of it as well.

11:47The challenge is that it's not the sales penetration, the sales composition that drives fuel demand. It's the fleet composition. And while new energy vehicles in China are like 60 plus percent of new vehicle sales, the overall stock of vehicles in China is still 10 to 1 internal combustion engines to EVs. so the implication would have to be that Beijing had this massive fleet of EVs they're like waiting to roll off the line and that just doesn't seem plausible on the timeline we're talking about

12:15Tracy Alloway:that is a very important stat to keep in mind and I'm I didn't know the exact numbers but I do think that's important because we all yeah we talk about the declining like oil and intensivity of the Chinese economy due to growing EV sales you know it's gonna take a while before it really swings and enough to make a difference. I think, you know - You don't think they have a secret stockpile of EVs. They have a strategic pork reserve. They just swap out everyone's cars. Everyone gets a free EV for a few months. And you get an Apollo. And you get an Apollo. You know what's really cool about the Chinese EVs?

12:49Yeah.

12:49Tracy Alloway:Or sorry, the Chinese automatic driving vehicles. All cars, whether they're the official robo-taxis or when you're in a car that you push on self-driving mode, they have this blue light that shows up. So it's not like the typical red light. And so you can see every single car on the road in China that is currently operating in an autonomous manner and know if there's a human. Oh, I see. Yeah, it's pretty nice. You know, you mentioned, Tracy, at the beginning of the episode, barrel counting. I think one of the reasons we like talking to Rory is that I do consider you to be a humble barrel counter because it's so easy in oil conversation to get tempted by grand threads about geopolitics, right?

13:31Tracy Alloway:Because it's sort of intertwined. So I really do appreciate the humble barrel counter. But when we talk about this sort of like China's willingness to either draw down stocks, et cetera, there's two sort of related questions that I have. It's like, one is, could China just be like, have done its neighbors a solid in the sense that it's like, you know what, we really do have quite a big buffer. And we know that Singapore and Taiwan and Korea are really going to be, Japan, are going to really be under strain. So from like a sort of soft power, goodwill thing, like we don't really need to be adding.

14:04Tracy Alloway:And B, given that we know, and B, given the EV penetration, even if it's small now, it's going to grow. Is the consensus in oil world that the massive stockpiles in China, do they exist in the event of like preparation for a theoretical war? which would be a very oil-intensive process. Yeah, so let's work in reverse there. And I think so. Back in 2023, I wrote a piece called Chinese Oil Demand Outs, which was about how in 2023 with this massive growth in Chinese imperant demand, again, remember, China doesn't publish official demand stats. It was so big, and China was still pretty weak coming out of COVID zero at that point.

14:45It didn't seem plausible. And I kind of speculated that maybe they were building refined product stocks, which we can't see because of the way we calculate this stuff. And at the time, the worry was that it was in anticipation of a war or an invasion of Taiwan. At that stage, you had an increased bellicosity of Beijing, a lot of saber rattling, them buzzing airspace, naval drills, etc. So I think that was definitely part of it. That was the thought at the time. Now, what we've seen is that obviously came in very, very handy. Now, for much the same reason, although not getting blockaded through Malacca, but just the lack of Hormuz itself, which again was always part of China's kind of strategic or perception of strategic precarity of its stockpiles.

15:27But I think to this point of like, why? This is the question that continues, I continue to obsess about, because it also kind of tells you like when they're going to reenter the market. Because as we will talk right now, not only are crude oil prices collapsing, but we've actually seen prompt Brent time spreads, the difference between the first and the second contract actually flip into outright contango today. So I think it's a particular suspicious We're swimming in oil, at least relative to demand. And I think part of that is that China just still hasn't stepped back in as a competitive importer.

15:57So to your point, Joe, this idea that like maybe Beijing was playing the altruistic neighbor, which I think is I think one of the theories I'm holding as well, which is not only do they want to kind of be seen as the good neighbor, not only do they want to be seen as kind of standing up and defending its neighbors. when very clearly in their telling, Washington has abandoned you and kind of stuck you with this massive energy crisis. Yeah. The challenge, I think, with that, I want to think also if China is trying to pivot away from the US market, its only other market options are Asia or Europe, really, in terms of like a sizable sources of demand.

16:33So it's not in its interest to see those economies kind of collapse while North America remains relatively insulated given domestic supplies. I think the only challenge with this theory is that if that was true, I would have expected China to say something about it. And the fact is, is that so far we have seen, we've heard virtually nothing from Beijing or any of the regulatory authorities that this is happening, why it's happening, or the scale of what we're talking about. The other, I think, more nefarious option, and you were just talking about how I'm a humble barrel counter, I don't like to go grand strategy, but I think there is like the put my tinfoil hat on for a second.

17:10Why would China do this and not talk about it? The other option, I still think this is less likely because it seems very nefarious, but we had the Trump administration visiting Beijing a couple months ago. At the time, it seemed like nothing much came out of those meetings. It seemed pretty lukewarm at best. But I think there's a chance that you saw some kind of discussion between the Trump administration and Beijing over like, help us out with this, and we will do something for you in the future. Now, what could that be? One of the things that was happening at the time was with all of the military equipment destroyed in the Middle East from the Iranian attacks, lots of advanced radar systems, anti-ship, anti-aircraft missiles, et cetera, et cetera, Washington began migrating all of its kit that had been in Asia back over to the Middle East.

17:59So maybe this is part of this broader kind of Dunro doctrine that Trump sees himself as pulling out of Asia And maybe someone somewhere made that point and said, like, if you help us, we'll keep this going. That said, again, I don't think any of this perfectly fits. And I think the easy answer is that it remains a mystery as to why China is doing this. The only problem is, is that given that we still don't understand why China did this, or even to that degree, how exactly they managed to pull it off, it makes it difficult to handicap when they're going to enter back into the market, because obviously a 5 million barrel a day swing is massive in this context.

18:35And right now, I think part of the reason that crude prices and time spreads are back in the contango today is that we have this rising surge of exiting transits out of Hormuz that are running up against a still relatively weak import market driven first and foremost by China.

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20:41Make every journey more rewarding with a$300 annual travel credit and access to a network of airport lounges, whether you're looking for pre-flight productivity or time to rest and recharge. Chase Sapphire Reserve for Business. It's the card that gives back all you put in. Learn more at chase.com forward slash reserve business. Chase for Business. Make more of what's yours. Accounts subject to credit approval. Restrictions and limitations apply. Cards are issued by JPMorgan Chase Bank N.A., member FDIC. So China isn't the only one that's been releasing from stockpiles. So the U.S. also has a strategic petroleum reserve.

21:19And I think we were getting pretty close to the operational minimum on that thing. And Jeff Curry, who's been on the podcast a number of times, he had a really good line basically saying this is not supply responding to price. It's inventory responding to price and inventory, unlike production, has a floor. So devil's advocate question. But like, if this kept going, if the Hormuz shuts again, or if it hadn't been opened in recent days, and I guess I should mention we're recording this on June 24th, could that inventory response have gone away? And could we see prices shoot up? Absolutely. You know, when we started this crisis, we had been in a surplus in the oil market for upwards of a year.

22:05We had built substantial stockpiles, both commercial and strategic, obviously in the case of China strategic. We were as buffered as humanly possible to weather this shock. I still didn't think it was enough at the time, and that proved out to be thankfully incorrect. But now we have drawn down massive volumes of oil. To put in perspective, that 13 million barrels a day of Middle Eastern production has been shut in. The cumulative volume of that to date is roughly 1.3 billion barrels. Like we're talking massive, massive gobs of oil. The collective IEA SPR release at its upper end is pegged at about 400 million barrels.

22:44The cumulative reduction in Chinese imports over this period, again, relative to three months prior to the war, is between$400 million and$500 million. So at least on that basis alone, China swung as much and likely more than the collective IEA member states. And what I will say about SPRs, in my modeling, in my mental model, I think about SPRs not as inventory per se, but as discretionary supply and demand. That when you think about the effect of inventories on prices, and I think they are the primary thing that drives prices and perceptions of scarcity. It's mainly the commercial kind of merchant inventories that catch the residual, the remaining surplus or deficit after all is said and done that drives that kind of marginal pricing influence.

23:28But an SPR release, as an example, manifests in the market as new supply, not new production, but new supply that wasn't available before. And we're actually seeing another stock or strategic stock release of that kind in a way right now in Hormuz itself. We've had for this whole period. We've had well over 100 million barrels of oil trapped in Hormuz. These are the ships that have been trapped and unable to escape. Those are the ships that we're seeing rise very quickly in terms of their exit pace out of Hormuz again. But because that is the stockpile, the floating oil available in Hormuz is drawing down faster than it is being replenished with new loadings.

24:08The pace that we're seeing come out of Hormuz right now also is inherently unsustainable and itself represents some kind of stockpile release from a stockpile that was not accessible to the market in the Gulf to now a stockpile that is accessible to the market in the broader market, in the broader world. But that's right now what's running up against the lack of Chinese import demand.