Mar 30, 2023

OPEC Plays Chess

Only Four Moves Left to Checkmate

We are witnessing Whack-A-Mole at its finest.

To address voters' top concern about inflation during the midterms, the Biden administration took action by releasing 1 million barrels per day from the US Strategic Petroleum Reserves.

It wasn’t the administration’s only drawdown of our critical oil reserve assets.

Biden’s first drawdown of emergency oil stockpiles came in November 2021, with the Department of Energy selling 18 million barrels and releasing 32 million barrels in exchange for future deliveries to the reserve.¹

Since then the Biden administration has depleted our oil reserves by roughly 250 million barrels.

Few will accuse the Biden administration of playing chess.

We at Brentwood Research screamed from the rooftops at the time. We held the belief that the administration and the Federal Reserve were colluding in an attempt to manipulate the inflation issue, which they themselves had created. The Federal Reserve further assisted this by labeling it as "transitory" and injecting the economy with an abundance of easy credit.

Except inflation was real. The Fed knew it. The Biden administration knew it.

We knew it too and called it out as it was occurring.

Biden played checkers by dumping national security reserves of oil on the market to keep oil prices down.

Over the last 18 months, the U.S. Strategic Petroleum Reserve (SPR) has eroded from 615 million barrels of oil in October of ‘21, to less than 375 million barrels today.

The actions helped the democrats to win a surprise victory in the midterms as oil prices fell from over $100 per barrel. Falling oil prices have also helped the Federal Reserve to bring inflation down in the short term.

Great, but what about our long-term stockpiles of oil for emergency needs, you may wonder?

Not to worry, Biden told us. The administration had a plan. With help from the Federal Reserve’s aggressive rate hikes, oil prices would fall, and the administration would buy it all back on the cheap.

On Oct 19, 2022, the Department of Energy (DOE) formally announced "its intent to do the SPR repurchases…when WTI crude oil is at or below $67/b-$72/b.” ³

Oil prices fell to $64 a barrel in March.

How many barrels of the oil reserves did the Biden administration refill at these prices?

Zero Barrels.

How much can they refill today between their price target of $67-72 per barrel?

Zero Barrels.

You see, while the Biden administration has been playing checkers, the OPEC nations have been playing chess. This weekend, in a surprise announcement, OPEC announced to the world that they would cut oil production by more than 1 million barrels per day beginning in May.

The headlines came in all at once.

“Saudi Arabia To Cut Oil Output By 500,000 Per Day”

“Iraq Decides To Start A Voluntary Oil Production Cut Of 211,000 Barrels Per Day As Of May And Until End Of 2023”

“Kuwait To Voluntarily Cut Oil Production By 128,000 BPD Starting From May To End Of 2023”

“Oman To Reduce Oil Production Voluntarily By 40,000 BPD Starting From May To End Of 2023”

Naturally, oil prices skyrocketed today to over $80 per barrel on the news.

Our myopic approach to curbing inflation is likely to only release more of it over time. By cutting supply, OPEC now plans to put a floor on oil prices above $75. It’s a chess move the administration has not considered.

A White House Spokesperson called the decision of OPEC “ill advised.” ⁴

We call it another nail in the coffin of disinflation. Higher oil prices in a slowing economy mean stagflation. It also means that our emergency reserves may not be refilled adding to our national security risk. Lastly, it means that the Fed will likely need to keep on jacking up interest rates next month.

Add it to a series of bad decisions that we believe indicate that it's a checkmate for the dollar.

Newton’s Laws of Motion tell us that “every action has an equal and opposite reaction.”

Fifteen years of interest rate manipulation taken to "juice" the economy has led to a reaction whereby interest rates must now be raised with alarming speed.

Did we expect to get the gain without any of the pain?

Did anyone really believe that $32 trillion dollars of debt wouldn't have consequences?

It’s not only energy insecurity that should concern Americans. Our lack of ability to play chess has also led to a very predictable banking crisis that has come by forcing banks to hold our “safe” government debt.

Government debt is considered the least risky asset a commercial bank can hold. These securities are meant to be the most secure because they are deemed to be high quality and very liquid.

One of the key components of Basel III, the banking regulations passed after the 2008 financial collapse, was the implementation of new capital requirements for banks. This included stricter rules around the types of assets that could be held as capital. As a result, many banks turned to government debt as a way to meet these new requirements.

HQLA stands for "High-Quality Liquid Assets," which are assets that financial institutions can hold as a form of liquid reserve that can be quickly converted to cash in times of financial stress.

U.S. Treasuries are considered to be the highest-quality liquid asset by many financial institutions and have become the benchmark for other high-quality liquid assets. This is because U.S. Treasuries are issued by the U.S. government, which is considered to be one of the most creditworthy borrowers in the world, and they are backed by the full faith and credit of the U.S. government.

Treasuries are the oil that greases the monetary system.

We see this as the actual problem.

Our book, The Great Devaluation made the case that the massive debts of the United States would make it impossible to normalize interest rates without causing a debt spiral. Raising rates into unpayable debts is akin eating your own arm to survive when you are hungry.

It’s why we believe the ultimate path is one paved by very negative real interest rates.

The main concern about rising interest rates is that they significantly increase the cost of servicing debt, which crowds out other essential government expenditures. In other words, when interest rates rise, governments are forced to spend a larger portion of their budgets on paying interest on their debt, leaving less money available for other important programs and services. This could have significant implications for areas such as healthcare, education, and social services, which rely on government funding to function effectively.

Another concern, one which we are witnessing in real-time across the global banking system, is that a devaluation of government debt could lead to banks' balance sheets becoming illiquid and ultimately insolvent. If the value of government debt declines significantly, banks may be left holding large amounts of assets that are no longer worth their stated value. This could make it difficult for banks to meet their obligations to depositors and other creditors, potentially leading to a broader financial crisis.

Rather than offer a secure investment, we believe that U.S. Treasuries may be among the least secure assets available. This is because our government's creditworthiness has been called into question due to ongoing issues with debt and deficits. As a result, investors may face significant risks when investing in U.S. Treasuries, and may not receive the returns or security they are expecting.

Too few are paying attention.

Given the rapid succession of crises that are being immediately resolved by newly created Fed emergency programs, it is not surprising that we may be losing sight of the potential risks of a near-term default. It is crucial that we acknowledge the current state of our Treasury accounts, which are being depleted, and our growing deficit.

The Treasury spent over $200 billion last month alone. As of 3/28 our Treasury balance stood at $200 Billion. This was down from $415 billion to begin the month and a dire sign of how rapidly our spending has been increasing.⁵

Foreign central banks are dumping treasuries and buying gold.

China's U.S. government bond holdings hit their lowest in over 12 years at the end of December, against a backdrop of American interest rate hikes and bilateral tensions. According to Refinitiv Data, Beijing's stash of U.S. government bonds ended last year at $862.3 billion, the lowest since May 2010.⁶

The PBOC announced another gold reserve increase in January, marking the fourth month in a row of rising gold purchases.⁷

Foreign central banks are becoming increasingly hesitant to hold US debt, and this is not solely due to the depreciation of the Treasury's value. Another significant concern has arisen in connection with holding US Treasuries in the current climate.

They can be frozen.

The recent actions of the Biden administration against Russia have highlighted this risk, as it involved the freezing of Russia's dollar reserves. This freezing of assets held by foreign entities has far-reaching implications for the stability of the global financial system.

Foreign central banks have been preparing.

Over the past nine years, the reserve structure of foreign central banks has undergone significant changes. Luke Gromen's chart, shown below, illustrates the mismatch between the decline in Treasury holdings and the increase in central bank gold purchases.

Notice that the total amount of U.S. Treasuries held by foreign central banks has declined by more than $450 billion. Interestingly, during this same period, foreign central banks have increased their purchases of gold, buying roughly $300 billion worth of the precious metals. This is a spread of $750 billion and accounts for roughly 5% of all global reserve assets.⁸

While central banks have been divesting from Treasuries, commercial banks have been forced to hold them. This action has created a duration mismatch between assets and liabilities on the balance sheets of commercial banks worldwide.

The result? We now have a banking crisis.

But don’t worry, it’s all good, right?

"I can reassure the members of the committee that our banking system remains sound, and that Americans can feel confident that their deposits will be there when they need them. This week's actions demonstrate our resolute commitment to ensure that depositors' savings remain safe." ⁹
Janet Yellen – March 16, 2023

Yellen now promises the issue with government debt on commercial bank balance sheets is one of liquidity rather than solvency. In other words, while banks would lose money if they sold these treasuries in the short term, these securities are supposedly all good in the long term.

Do we really want to listen to Janet Yellen’s promises?

Keep in mind it was just five years ago when acting as Federal Reserve Chair that Yellen promised we would never again see another banking crisis in our lifetimes.

“Would I say there will never, ever be another financial crisis? You know probably that would be going too far but I do think we’re much safer and I hope that it will not be in our lifetimes and I don’t believe it will be.” ¹⁰
Janet Yellen – June 17, 2017

Maybe Yellen was right.

Given that the Federal Reserve can simply create a new program, such as the BTFP (Bank Term Funding Program), over the course of a weekend that promises to buy back underwater bonds at par to resolve the issue, can we really classify the recent bank failures as a crisis?

Voila! Just like magic, the banking crisis is averted!

The sheer amount of emergency Federal Reserve magic raises questions about the extent to which the Fed's actions are masking larger underlying issues in the financial system.

Magic, we should never forget, is simply the art of manipulation.

Magic focuses the attention in one place so as to perform a sleight of hand elsewhere. The result leaves the audience with a sense of awe and astonishment.

In the movie, The Prestige, Michael Caine’s character says, “Every magic trick consists of three parts. The first part is The Pledge. The magician shows you something ordinary. The second act is called The Turn. The magician takes the ordinary and makes it into something extraordinary. But you wouldn’t clap yet, because making something disappear isn’t enough. You have to Bring It Back.”

Investors have enjoyed the greatest magic show in history over the past 15 years.

The sad reality for investors today is that the magicians of the Federal Reserve cannot bring it all back to normal.

While the details of today's banking crisis are different from those 90 years ago, the solutions are very much the same. Bank runs are caused by a lack of faith. It’s no coincidence that the Federal Deposit Insurance Company was created exactly ninety years ago to re-instill faith in the banks during the Great Depression.

The Fed’s new BTFP facility is just the reincarnation of an old scheme.

It’s all so predictable. We just need to remember.

Everything happening today has happened before.

Perhaps it's time to stop playing checkers with your portfolio... What do you think?

Macroeconomics

OPEC Plays Chess: Only Four Moves Left to Checkmate