Zoltan Pozsar - Oil, Gold, and LCLp(SP)R - Summary

Zoltan describes that the market’s worry about the current level of financial reserves in the U.S. banking system are misplaced. As the equity market is dropping, the market searches for a level at which the financial reserve system would break, which would repeat the 2019 repo blowup.

Such fears are misplaced because there are risks lurking in funding markets, but they have nothing to do with the draining of reserves via QT

• The fundamental difference between QT during 2018-2019 and QT today is that the first episode of QT happened while balances in the overnight RRP facility were zero

• Demand for repo funding is weak today, in sharp contrast to demand during 2018-2019

• Demand for dollar funding in the FX swap market is weak too

• Balances in the New York Fed's overnight RRP facility- ($2 trillion) represent reserves that the financial system did not bid for during the day - so effectively a financial cushion.

If for some reason the system ends up in a situation of LCLoR miscalibration, it has two pools of liquidity to tap: the $2 trillion in the o/n RRP facility or the SRF

LCLoR today is a red herring from a QT perspective, so don't worry about it.

The real issue - Commodities, especially Oil and Gold

The oil market is tight, with demand exceeding supply. When we want to compare financial capacity with the capacity in the commodity market, we can say that excess reserves in large banks' HQLA (High Quality Liquid Assets - government bonds, certain types of corporate bonds, and cash equivalent) portfolios are like excess production capacity for large oil producers.

The SPR (Strategic Petroleum Reserve) is like the onRRP facility (overnight reverse repurchase agreement facility). Recent releases from the SPR have brought reserves down to levels not seen since the 1980s.

The SPR helps to police prices but the SPR is currently sitting at 400 million barrels. This is barely enough to police the market for a year at a rate of 1 million barrels per day. Releasing more from the SPR has its limits, and future releases will have to be big to have an impact.

In the worst case, the SPR could be empty by next April, leaving the oil market in the same spot as the repo market was in 2019

Unlike reserves, oil cannot be easily printed

President Biden plans to refill the SPR when oil prices get down to $75 per barrel, but this is hard to reconcile with OPEC+'s price target near $100 per barrel. It will be difficult to get oil prices down to $75 per barrel, so the U.S. will need to find a way to refill the SPR.

Coming in - Russia

Could a price on Russian oil be part of the strategy to refill the SPR?

Russia has been broadly sanctioned by the Western world. China and India are one of the few large countries that trade with Russia and access their Oil exports. Russian crude sells at a steep discount of $30 relative to Brent.

India is making a crack out of the arbitrage by buying cheap Russian oil, refining it to Diesel and selling that for $140pB to the market. Treasury Secretary Jannet Yellen said that the US is ok with India buying Russian oil and refining it if India steers clear of Western insurance, finance, and maritime services. This could become a backdoor mechanism to refill the SPR, using the discount that India receives to stay below Biden’s $75 target.

Russia’s price for oil is set at $60pb. But there is a different between a tough bargain and an administered price. Europe needs oil at capped prices, but Putin will not cap its prices out of principles.

We’re in the middle of World War III

The US needs to re-fill the SPR or it gives up the control of domestic oil prices in case of geopolitic issues. If Russia doesn’t want India to export diesel to the US, the can ask for payment in Gold instead of rupees.

If Russia countered the price peg of $60 with offering two barrels of oil at the peg for a gram of gold, gold prices would double. And it would also ensure that more oil goes to Europe than to the U.S. through India. Most important, gold going from $1,800 to close to $3,600 would increase the value of Russia's gold reserves and its gold output at home and in a range of countries in Africa.

It’s a crazy scenario but not impossible.

Banks active in the paper gold market would face a liquidity shortfall if this happened. That's a risk that could complicate the coming year-end turn.

As a sharp move in gold prices could force an unexpected mobilization of reserves and expansions in balance sheets and risk-weighted assets. Basel III won't protect from states doing things that could end up hurting banks. Banks have been managing their paper gold books with the assumption that states would ensure gold wouldn't come back as a settlement medium.

The U.S. dollar may be "revalued" versus Russian oil if Russia would go this way. In a world where most banks gave up their precious metal sovereignty for fiat money, this revaluation would lead to a huge liquidity crunch.

I hope you enjoyed this summary as much as I do. I really enjoy reading Zoltan’s posts and summarizing them. I mostly keep them to myself but here I am publishing it.

Let me know if you need further explanation or summaries!

Here is the link to a twitter post that contains the the original article.