Quagmire: Scenario planning a case for lasting oil markets disruption (Ep. 258)

Speaker A: All right, welcome back to Energy Sense, an S and P global energy podcast covering all topics on the intersection of energy and finance. This is your host Hill Vaden, here with your other host Sam Humphries. Sam, how's it going?

Speaker B: Pretty good, thanks Hill. How are you doing?

Speaker A: All right. Uh, and we have just finished a uh, podcast with the uh, with two of our oil uh experts, uh, so Sandy Abdullah and Luis Vertz, um, talking about a um, scenario outlook, a scenario, so a long term planning exercise of um, what may or may what. What could happen if certain things play out Right. And so we've talked a lot about the straight of four moves and what's going on globally right now with oil markets. And this is um, a scenario uh, that um, we call Quagmire, um, that looks at um, what could, you know, how bad things might get, um, if the Strait stays closed, effectively closed for, for many years. Um, can you give people, listeners some things to, to pay over the next 30 minutes or so.

Speaker B: So the biggest um, takeaway, the biggest element of this is demand destruction. And so that is the um, countries, government's response to this continued shutdown on how they might react, whether it's curtailing demand, you know, looking at alternative fuels and what that might look like in uh, global oil markets in the future, um, which is extremely interesting. But what about you? Is there anything in particular you want to call out?

Speaker A: Yeah, I mean I just think that uh, people should you know that the idea is a structural demand, uh, uh, destruction um, and then that has implications for other parts of the economy and other fuels and technologies. So um, Louise and Sandy do a good job going to some of these details and we can hand it off to him now. All right, Louise, Sandy, thank you both for uh, joining us today, uh, to talk about the um, I guess the new scenario that you guys have designed or contributed to for um, the disruption in the Strait of Hormuz and what that may mean for oil markets and just to kind of level set people. Um, I guess so Sam and I've done a few podcast recently on oil markets and what all is happening within this rate of Hormuz. Um, and you guys have built this scenario that is almost um, and I won't spoil it here Louise, but it's almost kind of a worst case scenario of all right, if things don't play out in the way that we might expect them to, here's what could happen. Um, and it's part of the kind of the forecasting art of scenario planning which maybe isn't Something that somebody thinks will happen, but if it does happen, people want to be prepared. So if you could maybe kind of outline kind of the construct of this scenario and I'll let you introduce the name of the scenario because that's a lot of fun too. And then we'll kind of take some questions from there. Maybe fun's the wrong word. It's got an interesting name.

Speaker C: It is interesting indeed. Um, so just for context, we publish our annual strategic workbooks around late February. And these are the annual updates to our sort of crude and refined product outlooks. They're super detailed, they go out to 2060 and as soon as the ink dry but war broke out, so we went back to our outlooks, decided to trace out what the impact actually the war might look like in different cases. And there are actually three additional cases. Uh, the most reassuring one that's rapid recovery, um, where markets are sort of um, constrained for more like months rather than years. Uh, we redid our base case, uh, and recovery is slower. It's a more cautious return. And then we have the high case, what we call the high case and we named it Quagmire. And I think that's quite relatable. Right. We have a deal, we don't have a deal. Suggests we're sort of taking a step forward towards resolution and then we sink back down again. Um, in Quagmire it's really built on this uncertainty, this stop start over a, ah, three year period. So significant demand losses range of 6 to 7 million barrels per day. And uh, really a loss of trust in the ability to get that resolution. And it's demand destruction that rebalances the market in a Quagmire case as opposed to sort of supply being restored as in the other two cases. And it is also a high price environment. So we've got Brent over 100, uh, in the Quagmire case. And we really wanted to explore what kind of environment that would look like and how things would rebalance.

Speaker B: Well that sets us up nicely. So I think to get into this conversation we maybe need to explore some of these definitions a little bit more. And you mentioned there demand destruction. So Sandy, maybe you could sort of expand on that a little bit more. How would that actually play out? How do you see, ah, policymakers or investors kind of fundamentally influencing that, uh, change?

Speaker D: So we see it really as a mixture of policies. So in a Quagmire scenario I think um, the first wave of policy might be more focused on nationalism. So preserving what's produced within the country and you could see a lot of that play out in a quagmire scenario. And then while that's so, you know, preserving what's happening and then maintaining that country's basically, um, gdp, for lack of a better word, so their economy. And then globally we would then start to see countries make changes to their, their working infrastructure. So whether that's working from home more and that may be more localized depending on the countries that are the haves and the have nots, those that have the resources and those that do not. Um, and, um, Luis has more details on in terms of what we would predict for specific demand and policies. So I can kind of let you go into that.

Speaker C: Yeah, sure. I think. Um, so when we talk about demand destruction and it's not something that our analysts use lightly, right. So often you'll hear, we'll talk about demand curtailment. Quagmire is very different to the other cases because that demand simply is lost. It can't come back. Right. Um, whereas in the recovery, um, we can see most of demand, not all, but most of demand come back. Right. And, um, governments have to decide how to basically reallocate the demand that is there. Um, they have to weigh up, um, energy security versus the typical triangle energy security, uh, sustainability, affordability. And clearly energy security sort of rises to the forefront. Um, and in terms of policy, we're going to see things like governments, um, intervening to ensure that we have stockpiles. They're going to invest potentially in alternative routes, uh, storage additions. And of course it's going to involve intervention in trade. Right. Um, we've already seen, for example, export bans, that protectionism that Sandy talked about. Um, we're going to see that also change some of the geopolitical relationships, um, um, looking for secure corridors or trusted supplies, suppliers. And ultimately I think we might see a shift, um, to a less efficient system, um, as we reroute, um, what demand we have, um, to where it needs to be, but one that does have some redundancy built in. Um, so a European refinery might not be doing very well, but closing it in a quagmire scenario, probably not as acceptable as it might have been before the war. Um, I think also it might involve a rethink of what, how we define a strategic asset. And one thing we are seeing, um, is that logistics, not usually a headline sort of policy area, would be very much in the forefront, um, of government policy in a quagmire scenario.

Speaker A: Okay. And I think one of you guys mentioned that high, um, prices would be a feature of um, this scenario. And it's I guess first just to kind of level set us. This is a low probability scenario. And I don't know if you guys have a general percentage of how to think about that low probability, but by definition the base case is a higher probability event. Um, so Sandy, if you could maybe help us kind of put it in perspective, um, how to think about the probability of this quagmire scenario and then kind of more interestingly perhaps the price. So there's all this um, crude like this is very much a uh, um supply movement, uh issue. Then there's a bunch of oil kind of sitting around wanting to find, wanting to fuel demand. Right. Um, so how quickly would prices rise in this quagmire scenario and what happens to that crude that is um, in some ways available for market now? It just gets stuck in the Middle East.

Speaker C: Yeah.

Speaker D: So you have a lot of um, interesting questions. So I think we got asked a lot about the probability of different scenarios. The, the precarious recovery base case is what we view the most likely scenario. But the way I really think about the scenarios isn't necessarily like oh there is an 80% chance of precarious recovery. It's more of here are some of the extremes that we could see in terms of what would happen and you will see pieces of that pulled into what we think in the base case. So you know, precarious recovery is more of there isn't maybe a long term change or transition toward electrification, biofuels, people start to resume their typical thinking and their typical behaviors because it's short lived. And in quagmire we see more of that long term demand destruction and the high prices. But there will, I would not be surprised if we see periods of time in the precarious recovery or in our base case where we have those pieces of quagmire where we have price spikes and volatility. I think both cases are really marked by uncertainty and that uncertainty is really what's playing out with the pricing. So like if you were to look at both cases maybe five years out or like you're, you know, you're a person standing now having lived in say 2030 and you know what the outcome was that's really different than what we'll see with the prices and the nature of um, how we all view that uncertainty and how it goes, moves through the system through prices while living in it. So if a tweak can change the prices then we expect to see that volatility play out. Um, and so I Think that's been a surprise and also a piece of what's in our quagmire scenario. So we see a lot of that uncertainty playing out with higher product prices and product cracks, whereas what's really constrained is on the crude supply side. So if you were looking at this thinking, well, we have all this crude, we can't get out of the Middle east, why aren't crude prices $300 and product cracks maybe $5, when that's not really what we've been seeing? And it's not necessarily what we would anticipate either. And that's really, uh, maybe driven by a disconnect between what's happening while the street's closed and what's happening when it opens. And how do we live with that uncertainty as, you know, purchasers, people running a refinery, investors, traders, um, you know, people making decisions whether to explore or to build a new refinery. So living in that uncertainty really colors our prices. So we still predict that a lot of that uncertainty lives in higher product cracks. So we need those prices to kind of, um, for lack of a better word, kill demand to meet that supply constraint. But a lot of that, um, we're seeing that in higher diesel cracks, specifically higher gasoline cracks. So that's what's required for the physical market. I don't know if that makes sense. And I can get into more details on why we view crude prices as lower as well than one would expect. Kind of standing on the back end and thinking, oh, the strait is closed for two or three years. Crude prices would be 3 or $400 to spark exploration. Um, I think kind of the resistance to that is as soon as it opens, we do have a lot of spare capacity that can come online. And we do know that there is this oversupply of crude, like in the fundamentals. So, meaning, like we are able to bring online a lot of crude fast. And so as soon as that decision's made, crude prices can come down rather quickly. And so that's what kind of is a resistance to having really high crude prices. Whereas, um, you know, there's then the physical world, which is, um, you know, airports need jet, inventories are low, and that's what drives up high product prices to sort of weigh on consumers. So we do predict diesel and gasoline prices, you know, above or around $200 in our quagmire scenario.

Speaker B: So following on from that, obviously these scenarios are looking at the globe, but the impact of what is happening will not be equally felt across the regions. So, um, I think there is a highlight around um, APAC and sort of the impact there. Louise, I don't know if you could kind of expand on that a little bit on what, you know, those variations across the globe on what this scenario would mean for prices and you know, for the markets in general.

Speaker C: Yeah, you're absolutely right. I think Asian markets, um, and not just non OECD Asia as well, um, very much exposed, right? It is 70 to 80% of the Hormuz oil would typically go to those Asian markets. And um, they're facing high costs, uh, competition with other world regions for uh, available barrels. Um, so lower income countries obviously going to suffer most too. And that's true of all the emerging markets. But Asia is definitely um, disproportionately hit, shall we say in terms of product demand. Um, so volumetrically China can actually absorb quite a lot of the cuts. Right? They have the flexibility, uh, we've seen not, uh, just with its electrified passenger car fleet, but also interestingly on the trucking side at ah, making big strides away from diesel, um, but also scope in pet chems. So the way we were looking at it is really taking kind of country product pairings, right, and seeing where um, we felt that import flows or profitability would be kind um, of most vulnerable. Vulnerable. Um, and it could be things like Napsa crackers in Japan or Korea using um, a lot of product, um, but potentially structurally already um, sort of headed for rationalization. So a catalyst to some of the movement that was already going on. Um, and then it's not to say that it's not just an Asian story, right? All world regions will be impacted. And again looking at those country product pairings we see, I mean diesel is the big one, right? Everybody's talking about diesel already. Like where are we going to find enough diesel? How are the flows going to be impacted, the diesel crack spiking. Um, and even in Europe you might see things like our uh, older passenger car fleet running on diesel move over more to um, either gasoline, hybrid, electric miles. So there are pockets around the world and these, as I say, product country pairings where we can expect to see sort of a greater impact.

Speaker A: So Sandy, y' all have talked about how part of the, I guess the hallmarks of this quagmire scenario are one of kind of resource nationalism and reordering perhaps of trade. Um, if we're thinking about um, the winners, right? If there are certain areas that if this is going to be negative for certain uh, areas of the energy complex, where would be the winners in this, in this scenario? In Terms of where does the rent go?

Speaker D: Um, I think, you know, the North America energy complex is a clear winner. Whether you're on the crude side or the refining side, they have most of the advantages having the resources here. Um, you know there is the ability to have crude available quickly versus um, having to purchase it, then wait for it to become available and then ship it across the world when you have backwardated prices because of again that kind of um, the difference between what's happening in the prompt market and what's happening in terms of what people view could happen in the future, which we think would stay, you know, throughout the quagmire unless there was a significant change. So a lot of those advantages in terms of the timing are captured in the Atlantic Basin and specifically North America. Um, yeah, and to a lesser extent in Europe as well. Again really because of resourcing and time, time becomes really an advantage. And one other thing just to what Luis was saying on the diesel side, I think another interesting point when we think about pricing is you know here in the US some as I live in the US we think that gasoline prices have like a big impact on how much demand there is. And in Europe really what's, what is required to sort of take away the demand that's needed for Quagmire is it's not really a price sensitive um, like the US is with gasoline. It's really more around what's happening economically and with jobs. So we see a lot more sensitivity to um, jobs and recessions and the price is rather insensitive in Europe. So it's a really different um, kind of scenario and requires a lot more government involvement to curtail demand in Europe versus in the U.S. so I guess

Speaker B: the next question I have, um, Louise I'm going to ask you is there has to be. If this, this scenario was to play out and we see this long term shift, there must be some winners for um, energy. Whether that's electrification, whether it's biofuels. What opportunities do you see emerging under this scenario that you think um, would be the most advantageous? What's really sort of going to lead the way do you think?

Speaker C: Yeah, I think, I mean some of the obvious candidates. Right, you mentioned electrification, biofuels. We're all looking to how can we substitute that demand? Um, it's a difficult one. Right. And initially when we started this we were like well maybe it's a no brainer, everyone will switch rapidly to electric cars. We know the trucking sector is harder to electrify, but um, surely passenger cars are a good candidate. And if you look at, for example, biggest gasoline market in the U.S. um, when we kind of asked our mobility team, well how fast can they switch, the US actually moved away, the production lines moved away from EVs and we're looking at a five year sort of time period for this study. And you can't bring the production lines up, uh, ramp up scale, um, all of that in time to see a meaningful, uh, switch in demand. Right. Um, hybrids, We've seen a lot more hybrids. I think hybrids are generally, um, doing a lot better than we may have initially thought. And that's even in our base case. Um, for a forecaster, hybrids are a bit of a nightmare, right, because you're like, you're not taking that demand away, it might come back afterwards. So one of the things that we have been exploring is how many electric miles versus fossil miles do we have when we have um, hybrids? And what might come back, you might have multi car households, um, using one car rather than the other. So there is uncertainty around demand destruction there, but certainly opportunities for EVs just maybe not as easy as we thought. One area we looked at was southeast Asia, um, two wheelers, right? So two three wheelers, 60, 70% of many of the market's gasoline demand. Um, you can swap out the battery, it's a much easier fix. Um, but we were also, um, talking to our Asian colleagues. They said the speed, the range m the ev, the passenger car market's actually moving faster than the motorcycle markets in many cases. Um, so, um, it wasn't an obvious solution either. Biofuels, I think there will be interest. We're definitely seeing incremental stage demand, um, where there are blend mandates, um, maybe increasing those. But you're kind of up against, um, technical limitations if you like, for blend rates. So typically ethanol, E10, unless you're driving a flex fuel vehicle, and I think only Brazil really has a massive flex fuel fleet to get that sort of flexibility. And then feedstocks, um, always an issue. You know, used cooking oil market is finite, um, and there is a lot of competition for feedstocks. Obviously, you know, this is putting aside the cost if cost weren't in issue and ramping up production capacity. Right. So even to get that biofuels onto the market. So you might say, okay, we're short on jet, can we put sustainable aviation fuel in? Um, but we are not going to get the meaningful volumes in order to satisfy that demand. So biofuels, if you're looking, the market's about 3 1/2% of what we call refined product markets. Um, we're, um, our base case doubles that by 2060. So if you're going to double it in five years, even, you're still only looking at about 7%, uh, of demand.

Speaker A: All right, so, Sandy, I've got a question that may be beyond the scope of the study, so bear with me. And if it is, we can pivot. Um, but as we think about this quagmire scenario, if we zoom out and think about the macro economy, um, is this a Mad Max type world where GDP has collapsed and taxes have gone up to subsidize all this redundancy and all these less economic fuels, and then resource nationalism has limited trade, where we start hoarding things? And what would the world look like in this quagmire? Or is this accelerated growth for certain parts of the world, but not other parts of the world? Um, do you all get into that at all? Um, and if the answer is no, then I'll pivot to a different question.

Speaker D: Um, we do. I think that, um, you know, economies would definitely struggle. The word recession doesn't, you know, something that people don't want to talk about. But I think that would. It would be hard to predict a world without a recession at that point. And nationalism would definitely. You would start to see governments pull back on what they're exporting. We already have started to see governments pull back on, um, what they're exporting. We've heard discussions from Japan, obviously. You know, we hear Russia in the news a lot, but we've heard other countries as well. You know, China and Japan being two of them. And that's just, you know, we're not in quagmire. Right. So if, when the tanks run empty, you would start to see behaviors change, and that would be.

Speaker B: It would.

Speaker D: The world would look really different, I don't think. We don't maybe get into what the details of that look like. But if you were to think about, um, you know, looking at. From another way, when we look at Covid, and we looked at Covid when we started talking about Quagmire, um, you know, it took years to get back to where we predicted demand would come back to. It wasn't. And it's still a lower track than what we thought in 2019. So it's not like, you know, now we look at it again coming out of it, Hindsight's so different, but we never really kind of got back there. And so the quagmire scenario is, you know, what happens when the tanks run Dry. And we don't go quite into the details of how crazy does it get, but more of what prices are needed to sustain all that demand to stay low. And that's where the details come out is uh, for how long and how high do prices get? And that's where we see that 200 plus product prices to basically kill demand on this side of the world in the Atlantic Basin because we see in Asia, you know, um, maybe they have different capabilities or, and less visibility. Um, so I think there is some um, truth to your Mad Max scenario, to be honest. But I don't think that's necessarily what we would maybe put on in paper, you know,

Speaker B: so kind of on that, say we were in that quagmire scenario, say it's three years time or four years time. This is the scenario we find ourselves in. Is that a permanent scenario or is there a way back to, you know, that more global trading routes, you know, more sustainable pricing, or is it sort of this is it. Louise, maybe you can take that one.

Speaker C: Okay. There is a reason we, we limited our uh, forecast to five years. But yes, of course we have looked past that. Um, but the publication is for five years, um, because it's a really interesting question. We end quagmire Dan, about 2.8 million bars per day in terms of all product demand. That's a lot compared to our base case. And that demand does not fully come back. Um, what it will do is kind of shift our uh, peak, uh, later in the forecast. Right. Already a lot of debate over have we peaked? Will we peak? Um, it creates volatility. We get used to a market with ongoing volatility. But what does happen? And we do think that the market will find a way because we've seen, for example, how refiners can be very resilient, very flexible and we think the logistics will start to come back. So we talked about this redundancy. We will have alternatives, uh, supply routes as we accept that the climate scenario is more durable. So we're starting to build during those five years, we're starting to build alternative routes out. It's not that we find new, massive new sort of exploration boom, new resources. It is that we find ways to get around the, um, sort of step into and get it.

Speaker D: And you know, at the back end of that might actually be lower energy prices. Right? Because now you're dealing with a smaller pool, so you have less demand. You still have similar resources. Barring something, you know, unforeseen happening like we've seen like the Russia, Ukraine, War and having drone strikes, you, you know, we could see more damage during the war. But when you come out of that and you settle back, it's hard to see a world where energy prices remain high because now you have more penetration from electrification. And I mean, you know, this is like years out, right? Not that midterm period. You have a smaller demand pool and you still have a lot of or similar resources in terms of crude supply.

Speaker A: All right, so part of the value of scenario planning is to kind of understand where the economy is or where producers are, uh, within each of these kind of high, mid, uh, low case scenarios. So if we're thinking about quagmire, um, which sounds perhaps kind of spooky from the Mad Max perspective, um, ask a question to each of you, and I don't know which one of you wants to start with this, um, but Sandy, maybe we'll start with you. Um, what are some signposts that we should be looking for? Um, to either say, hey, we're probably not headed to a quagmire, or oh dear, this signpost indicates we might be headed toward a quagmire. Um, and if one of you could take the positive signpost and the other one take the negative signpost, um, that'll give us something to hold on to before we all go out and buy a bunch of can openers to be ready.

Speaker D: Um, I think a few things we've talked about, that wave of energy, security and nationalism, I think that would be a clear sign we're heading toward, um, kind of that chaos. Um, another maybe sign that things could accelerate in that direction would be, um, a change from what we're seeing with China. So an increase in demand from China could move us in the direction of a quagmire where we're kind of feeling fairly comfortable. I think the difference really between a, uh, quagmire and a precarious covery is, you know, obviously the resolution piece, but also how are we managing? So if, you know, we see changes that accelerate and make us unable to manage the system that moves us more toward that quagmire case, um, and really it's more in terms of, I think, a shift in thinking and acceptance. So we might see more signs of long term demand destruction. Um, whether that's a change in consumer behavior, government policies that seem longer lasting, and certainly, like Luis was saying, a change in the two wheelers, electrification in the west, those would be some further signs because the real major difference between the two is that long term demand destruction, aside from the short term Pain.

Speaker A: All right, uh, Louise, let's look for some more optimism. Um, and what are some things that we can keep our eyes open for that suggest we're not headed toward a quagmire?

Speaker C: Well, I guess the, uh, central premise is that it's a stop start situation. Right. And I don't know when we will actually get clear signals on whether that, uh, you know, that deal is going to stick this time. Um, but I think there will be signposts as forecasts. We love to look for the edge cases, the signposts. This is a really tricky one. Um, so I agree. It's really about managing the impact. Impact, um, sort of which quagmire m. We land and we may not have the supply, but do we manage that lack of supply? And I think we're looking for are, ah, we going to see rapid deployment of capital into those alternative routes, into building those stockpiles, those reserves, anything that bolsters energy security and sort of rapid and early fuel conservation measures. What we can save now means that the depth of the sort of, I wouldn't say despair of quagmire is kind of spread out. Uh, you got me with the Mad Max.

Speaker A: Right.

Speaker C: And I think a positive sign would be more coordination. Right. Among nations. Um, I'm thinking European Union, for example, coming out with a concerted and very clear messaging about how we are going to manage, um, a potential, um, shortage, um, over the longer term. But hopefully all this can remain hypothetical because we're not going to get near equipment.

Speaker B: Yeah, fingers crossed.

Speaker A: All right, well, thank you. Thank you both. This is an interesting, uh, idea to explore, um, and I hope listeners are left with some levels of optimism because, uh, I'll reinforce, again, this is not our base case, um, but this is a scenario that, uh, is plausible should certain things line up. So, Sandy, Louise, thanks for exploring the idea with us, and, uh, we welcome you back at some point to, uh, figure out where we are within these trajectories.

Speaker C: Great. Thank you for having us.

Speaker D: Thank you.