What central banks giveth they taketh away with margin calls

By: Daniela Gabor


The Corona crisis reminds us that the market-mechanism-based lender-of-last-resort system is not fit for purpose. Central banks’ dependency on market valuations and haircuts is intended to maintain market discipline. In reality the mechanism potentially exacerbates the very same pressures extraordinary action is supposed to be countering.

Take the European Central Bank’s emergency dollar loans to its banking system as one example.

On March 20, the central banks of the world’s largest financial systems – the US Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, the Swiss National Bank and the Bank of Canada (C6) – announced that they would update the emergency provision of US dollars via central bank swaps. To do so they offered seven-day dollar-denominated repo loans on a daily basis starting March 23, in addition to weekly loans of 84-days maturity.

The take-up was as follows (data courtesy of Dan Hinge).

While the ECB’s exposures are small compared to what they were in 2008, especially relative to other central banks like the BoJ, they still run the risk of inducing potentially systemic implications.

This is because, like many other central banks, the ECB monitors and margins loans on a daily basis which can, in volatile times, undermine their effectiveness if not add to market pressures.

The mechanics

European banks need dollar financing for their dollar assets (loans, bonds, derivative positions etc) or for their clients.

Usually, in non-crisis times, they get dollars from dollar repo markets, other wholesale funding markets or from FX swap markets. In crisis times, willingness to provide dollar funding shrinks in private markets. Some European banks can borrow directly from US Federal Reserve, but most are dependent on the ECB.

The Fed’s swap line agreement with the ECB is a matter of mutual interest: the US Fed wants to preserve the integrity and resilience of the US dollar as international reserve currency while the ECB wants to preserve the stability of its financial system.

In the first leg of the swap, central banks ‘lend’ each other their own currency. The ECB has a dollar deposit account with the Fed, and that account gets credited with the agreed sum, at an agreed exchange rate and for an agreed period. The ECB pays interest, and also creates euro facility for the Fed’s account at the ECB.

If exchange rates fluctuate for the duration of the central bank swap, the central bank whose exchange rate depreciates has to pay the other in what is known as a margin call. The IMF has a good explainer of how this works. These periodic margin calls cover the difference between actual and agreed exchange rates, which creates credit risk between the two central banks.

Margins are kept in a separate account and returned when the swap unwinds.

If central banks expect the US dollar to appreciate, they may prefer to draw down on their US dollar reserves first, before tapping the Fed. So far, only the ECB has drawn on the swap lines, with $45bn outstanding on March 18.

How does the ECB ‘lend’ the US dollars it has in its Fed deposit? It lends US dollars to European banks every week, in three-month repo loans against collateral. To access these loans, banks have to provide collateral securities denominated in either euros or dollars.

The repo loan has a peculiar accounting and legal treatment: it is structured as a sale and repurchase (hence repo) contract. Private banks ‘sell’ collateral to the ECB and promise to repurchase it in 84 days time. The ECB prefers this arrangement – widespread in Europe – because it gets legal title to the underlying collateral and can sell it if the private bank defaults.

The devil, as usual, is in the valuation that the ECB applies to the collateral. The mechanism has three components.

The FX haircut

The ECB asks for a 12 per cent FX haircut to protect itself against foreign currency risk. That means for every $100, it requires banks to give $120 of collateral – either in dollar- or euro-denominated securities or cash (reserves) – at market value. Think of haircuts as safety cushions that protect the parties from adverse movements in the exchange rate.

Since the haircut hikes the costs of dollar funding, it is also intended to prompt European banks to return to private dollar funding markets as soon as possible. It is, in other words, punitive.

FX-related margin calls

But exchange rates can fluctuate by more than 12 per cent in a period of three months. To protect itself further, therefore, the ECB has decided to update the euro value of the dollar loan every eight days. If the dollar appreciates, the ECB makes a margin call: it asks banks to ‘update’ their collateral position to the new exchange rate by sending in more collateral (and vice-versa for the euro appreciation).

These sorts of FX-related margin calls on banks amplify banks’ dollar funding pressures. If the bank cannot meet this margin call, it may be forced to sell dollar or euro assets. This pro-cyclical aspect of the ECB’s dollar-repo collateral framework makes the long-term USD loan equivalent – in terms of funding pressure - to a seven-day repo . Of course, these may need renewing at that day’s exchange rate, but allow banks more freedom to adjust their balance sheets in response to any drastic FX market moves.

Collateral-related margin calls

For any repo loan, the ECB marks collateral to market on a daily basis. If securities fall in price, the ECB asks the bank to make up for the difference (another margin call). The daily variation margin is intended to protect the ECB against the risk that the counterparty defaults or if it needs to sell the collateral.

In sum, the ECB’s dollar-denominated repo loans have three important moving components: the FX-related haircut, the weekly margin calls on FX movements for loans longer than seven days and the daily margin calls on euro/dollar collateral. This hardwires pro-cyclicality into the facilities, i.e. exposes the positions to further deterioration as markets move in exactly the direction the facilities were introduced to ameliorate.

Only the daily auctions at seven-day maturities moderate one point of pro-cyclical pressure by allowing banks more flexibility in adjusting their balance sheet in response to the pressures of dollar appreciation.

This poses an important question: why does the ECB, a lender of last resort, need protection against collateral/FX risk?

The quick answer is that the collateral valuation regime is there to ensure that when the borrower defaults, the repo lender can sell the collateral securities it legally owns and recover its cash. Daily valuation is meant to keep the market value of those securities equal to the cash lent. But daily margining can induce the sort of liquidity spirals that turned the collapse of Lehman Brothers in 2008 into a globally systemic event.

We already know, the ECB’s collateral regime on its long-term repo loans threatened to do the same during the sovereign debt crisis, until Mario Draghi promised to do “whatever it takes”. This action alone helped to preserve the liquidity of (Italian) sovereign bond collateral, and with it, the integrity of the Eurozone repo funding markets.

Christine Lagarde, the president of the ECB, reiterated that promise in a recent FT ‘whatever it takes’ submission. But if central banks are there to protect liquidity, as she argues, then calling margin on its banks in the name of market discipline or moral hazard is too blunt a tool.

Lagarde should consider going further. The current collateral valuation regime is only a recent invention. As can be seen below, before the euro was introduced, none of the Eurosystem central banks marked collateral to market or made daily margin calls.


Now would be a good time to return to that regime.

It's good to see the ECB may already be getting the message. The Governing Council has mandated central bankers around the currency area to investigate collateral easing measures in relation to some of its offers of cheap central bank funds.

What we need at this juncture is a step away from market-based protection of central bank balance sheets, and a step towards true loss absorbing capacity.

Daniela Gabor is a professor of economics and macrofinance at the University of West of England, Bristol. In this post, focusing on the ECB example, she explains why now might be a good time for central banks to abandon many of their market-discipline focused measures like margin calls and haircuts.

Fed officials identified US outlook as ‘profoundly uncertain’

Policymakers unleashed a vast array of tools to limit economic damage as coronavirus spreads

James Politi in Washington and Colby Smith in New York

Officials at the Fed are grappling with little clarity on when economic conditions might improve © REUTERS

Federal Reserve officials feared a sharp decline in economic and market conditions last month as they began injecting a heavy dose of monetary stimulus to limit the fallout from the coronavirus pandemic.

According to minutes of emergency meetings of the Federal Open Market Committee in March, US central bankers “viewed the near term US economic outlook as having deteriorated sharply in recent weeks and as having become profoundly uncertain”.

Officials at the Fed were also grappling with little clarity on when economic conditions might improve.

The timing of the resumption of growth in the US economy depended on the containment measures put in place, as well as the success of those measures, and on the responses of other policies, including fiscal policy,” Fed officials said, according to the minutes.

The minutes released on Wednesday came from two emergency meetings of the FOMC held on March 3 and 15, during which the US central bank took action to shield the US economy from the fallout of the coronavirus pandemic.

The Fed lowered interest rates close to zero, launched a sharp expansion of its balance sheet by buying up US Treasury debt and mortgage-backed securities, and set up swap lines with other big central banks.

Since March 15, it has gone even further, ramping up its crisis response well beyond its scope in the 2008 financial crisis, including the announcement of a series of facilities aimed at shoring up the markets for commercial paper, municipal debt and corporate bonds. The central bank also authorised itself to buy an unlimited quantity of US Treasuries and agency mortgage-backed securities.

Participants prominently cited the possibility of the virus outbreak becoming more widespread than expected. Such an event could lead to more wide-ranging temporary shutdowns, with adverse implications for the production of goods and services and for aggregate demand.

The Fed’s actions reflected a brutal change of outlook compared with earlier in 2020. In late January, the FOMC had gathered amid expectations of steady growth in the US economy, holding its main interest rate in a range of 1.5 per cent to 1.75 per cent.

Despite the disease’s appearance and proliferation in the city of Wuhan, China, in previous weeks, it was only just starting to register as a threat to the global economic picture. Fed officials had agreed that it “warranted close watching” at the time, according to the minutes from the late-January meeting.

Just a month and a half later, market turmoil had become vivid worry at the US central bank, including conditions of “high volatility and illiquidity” in markets for US Treasuries and government-supported mortgage-backed securities.

“Participants expressed concern about the disruptions to the functioning of these markets, especially in view of their status as cornerstones for the operation of the US and global financial systems and for the transmission of monetary policy”, the minutes said.

Treasuries sold off following the release of the minutes, with the yield on the benchmark 10-year note rising roughly 0.06 percentage points to 0.77 per cent. The more policy-sensitive two-year note yield edged higher to 0.26 per cent. Yields rise when prices fall. The S&P 500 extended earlier gains, rising more than 3 per cent.

Investors have welcomed the Fed’s wide-ranging steps, noting the actions have helped immensely to address strains that emerged across financial markets.

“The Fed has done a phenomenal job in terms of being as transparent as possible and as open as possible to continue down the path of providing support,” said Nick Maroutsos, co-head of global bonds at Janus Henderson. “They are providing a backstop and helping those who need it, but ultimately they are leaving the door open for more stimulus.”

Still, some warn there are limits to what policymakers can do.

“There will be some collateral damage,” said Padhraic Garvey, regional head of research at ING, pointing specifically to the corporate sector, which has been hard hit by government-mandated closures and orders for citizens to stay home.

“There is residual credit risk out there that I’m fearful of, and I do feel like the next phase of this is trying to assess what the default rate will be for the corporate sector,” he said. “You have to assume a default rate that is probably double digits.”

Jay Powell, the Fed chairman, is expected to deliver remarks on Thursday morning, which could offer further clues to the US central bank’s thinking. The next FOMC meeting is set for the end of April.

During the March meetings, officials fretted that their heavy-handed action might be interpreted as an overly pessimistic signal for the economy, or entrench expectations of negative interest rates, which the Fed has so far resisted. But Fed officials stressed they still had room for additional policy action with interest rates close to zero.

“In particular, new forward guidance or balance sheet measures could be introduced,” the minutes said.

Most recently, the Fed eased a capital rule for large banks to encourage lending and unveiled a new facility to allow central banks and other international entities to swap their Treasury holdings for dollars. The move is aimed at easing a global shortage of the US currency that had already prompted it to lower the cost of borrowing dollars globally through existing swap lines.

Since the outbreak of the coronavirus in the US, the Fed has been pushing banks to offer more credit to the economy, on the grounds that they are in a much better position than during the 2008 financial crisis and can play a key role in propping up many companies. But according to the minutes, some Fed officials said the banks should be “discouraged from repurchasing shares from, or paying dividends to, their equity holders”.

It was the debate around how the crisis might unfold that was among the most heated.

Some Fed officials stressed that the shock would be temporary in nature, the financial system was solid compared with a decade ago, and central bank action would offer strong support. Yet on the other hand some US central bankers were concerned that the situation might even be worse than assumed.

“Participants prominently cited the possibility of the virus outbreak becoming more widespread than expected. Such an event could lead to more wide-ranging temporary shutdowns, with adverse implications for the production of goods and services and for aggregate demand,” the minutes said.

ETFs Have Passed Their Covid-19 Stress Test

Exchange-traded bond funds are proving an integral part of today’s financial architecture

By Jon Sindreu

The NYSE closed temporarily for the first time as a result of coronavirus concerns on Tuesday. ETF prices have become “the effective benchmark prices of the underlying market,” according to analysts at French bank Société Générale. / Photo: Kearney Ferguson/Associated Press .

What doesn’t kill a useful financial instrument will probably make it stronger.

During both the coronavirus selloff and this week’s bounce, big gaps have opened up between the value of exchange-traded bond funds and that of their holdings.

Over the past two weeks, the iShares iBoxx $ Investment Grade Corporate Bond ETF—the largest of its type—has traded at both its largest discount and its largest premium to net asset value in 11 years.

ETFs have long been a popular way for investors to track equity indexes, but over the past decade they have come to dominate bond markets too. Many professional investors, however, suspect them of posing a 2008-style systemic risk—fears to which signs of stress lend weight.

The issue, they argue, is that ETF shares are easy to trade in good times, obscuring the fact that many of the corporate bonds held—particularly those rated below investment grade—become hard to sell in bad times.

This illiquidity can then spread to the ETFs, which are passive vehicles that can’t remove problematic issues from their baskets. As investors rush to sell their ETF shares, the pain could infect even resilient bonds.

Furthermore, middlemen may find it hard to buy and cancel shares—which is how ETF liquidity is ultimately backstopped—because doing so would involve absorbing illiquid bonds that would be prohibitively expensive to hedge.

So far, though, this nightmare contagion scenario hasn’t played out, despite extreme market moves. While the iShares ETF and its sister junk-bond product recently experienced their largest outflows on record, activity in the “primary” market—where banks create and destroy shares—hasn’t been abnormally elevated relative to the high turnover of the ETFs’ shares on stock exchanges. ETFs have essentially been able to rely on their own liquidity, rather than that of the underlying bonds.

This is fundamentally different from 2008 when investors abandoned complex credit derivatives even as some of the underlying mortgage-backed securities pared the blow. In this case, ETF prices have become “the effective benchmark prices of the underlying market,” analysts at French bank Société Généralepoint out. Bond prices may need to catch up, but this doesn’t mean something is fundamentally broken.

Some ETF prices may now be more “real” than the markets they track—a reversal that should interest the philosophically inclined. This isn’t unlike how oil futures contracts have superseded actual spot transactions as a way to measure the price of crude.

In today’s globalized, highly complex financial markets, top-down macroeconomic information may simply be more relevant than bottom-up facts. During the coronavirus selloff in particular, traders have often been clueless about the worth of individual issues, while still having strong views about the economic shock. They have expressed them primarily through ETFs, but also through index-based credit-default swaps—another way to bet on the broader corporate-bond market.

Investors should still avoid complex, poorly designed ETFs, like the inverse-volatility ones that imploded in 2018, or those that track assets too illiquid to have a reasonable price. But the fact that even junk-bond ETFs are functioning properly suggests that the threshold is higher than some feared.

For those still doubtful, the U.S. Federal Reserve’s announcement this week that it would buy shares in investment-grade corporate-bond ETFs as part of its stimulus policies—even though it is also directly buying the underlying bonds—sends an “all clear” signal. This is a piece of financial engineering that has become too useful to fail.

Why Saudi Arabia’s Oil Price War Won’t Work

By: Caroline D. Rose

For nearly three years, since the 2016 oil market crash and the U.S. shale boom, Russia and Saudi Arabia worked together to stabilize global oil prices as part of the OPEC+ alliance. But it seems this partnership is now on the brink of collapse.

As the coronavirus pandemic threatens to shutter businesses, ground airlines and put a massive dent in consumer spending, demand for fuel has sharply declined – especially with the world’s top oil importer, China, being among the countries most affected by the outbreak early on.

With a vaccine for COVID-19 at least a year away, there are few signs that demand will recover any time soon. Earlier this month, OPEC members urged producers to curb output, but one country refused to toe the line.

Russia resisted OPEC’s call to cut production by 1 million barrels per day, hoping instead to take advantage of other producers’ willingness to do so. In response, Saudi Arabia has deployed a strategy of brinkmanship, announcing that it would increase output by 2.5 million bpd in April to drive prices down and force Russia into compliance.

The Saudi strategy is twofold. It’s attempting to lower prices to attract customers who are willing to stockpile supplies. At the same time, it’s hoping low prices will squeeze Russian finances and force Moscow to surrender to OPEC demands. But this strategy will come at a high cost to the Saudis.

It is forcing Riyadh to draw more from its sovereign wealth fund than it had previously intended, drying up funds that it hoped to use to support its engagements abroad and to diversify its economy.

The coronavirus crisis has highlighted countries’ prioritization of national interests over the collective, and the oil price war is no different. Russia and Saudi Arabia have raised the stakes to generate revenue, increase market shares and compete for dominance in the global oil market.

Can Saudi Arabia Keep Up?

The Saudi government has indicated that it is in a race to increase pressure on the Kremlin, cranking up production to nearly five times that of Russian crude output. But can it play the long game, balancing its budget at a lower price than Russia can?

From its perspective, getting Russia to capitulate is a long-term objective, and one worth incurring revenue losses in the short term, because it will demonstrate that the Saudis really call the shots for OPEC+ members. Saudi Arabia believes its ability to produce oil cheaper than Russia ($8.98 per barrel compared to $19.21 for Russia) and larger global market share give it an advantage.

In reality, however, Riyadh may be forced to yield before Moscow. Saudi Arabia needs oil prices at $91 per barrel – more than three times the current price – to balance its 2020 budget. In contrast, Russia’s 2020 budget is based on oil priced at $42.40 per barrel, meaning that it can actually tolerate low prices for longer than the Saudis.

West Texas Intermediate Crude Oil Price Crash

Currently, Brent crude is at $28.70 per barrel, while Saudi Light is priced at $26.54. Some experts have predicted that prices could plummet even further to just $10 per barrel, as businesses big and small feel the fallout of the coronavirus crisis. Some observers believe the low prices could lead to a 2-4 percent decline in Saudi Arabia’s gross domestic product.

Even with the country’s reserves – some of the largest in the world, with assets worth $320 billion – current prices are unsustainable, particularly given that the crisis could last eight months to a year. True, this isn’t Riyadh’s first time facing a crash in oil prices; it has managed to manipulate the market to its advantage during other times of crisis. During the oil surplus in the 1980s, it reduced its own production to try to keep prices high.

It also manipulated the market in 2014 to counteract the U.S. shale boom. But in the current environment, increasing demand will be far more difficult, especially as the pandemic and an oncoming recession paralyze importers and sectors dependent on fuel. Even stimulus packages worth billions of dollars may not be enough to produce a surge in energy demand. They may help keep some companies and industries afloat, but they likely won’t produce an immediate and prolonged spike in oil sales.

In addition, Russia’s energy sector is showing no sign of slowing down. In fact, the country has increased its output by 500,000 bpd – half of Saudi Arabia’s own increased output – proving it can weather the storm. Furthermore, the Kremlin said it had enough cash to get through six to 10 years of oil prices between $25 to $30 per barrel. Russia will take a hit, of course, but in the long term its outlook is more optimistic than Saudi Arabia’s.

Domestic Considerations

Even before OPEC+ negotiations collapsed, Riyadh anticipated declining demand. The Saudi Finance Ministry asked government agencies to cut spending by 20-30 percent at the beginning of March in anticipation of a crash in prices. Now, with the coronavirus pandemic and the ongoing price war, Saudi Arabia has pumped the brakes even harder on spending.

Last week, the government announced it would slash its 2020 budget by 5 percent, or 50 billion riyals ($13.2 billion). The government said the cuts would have no socio-economic impact, but the reality is that most of the cut funds were intended for projects in its non-oil sector.

As oil demand wanes further and prices fall, Riyadh will have to draw more money from its Sovereign Wealth Fund than it originally intended – funds that were meant to support long-term objectives, like its involvement in Yemen’s civil war, countering Iran’s expansion in the Middle East and diversifying its economy.

Despite reduced spending, Saudi Arabia is still looking at a $61 billion deficit for this year, according to some experts, as revenue falls short of the government’s 2020 projection ($210 billion) and spending hovers around $270 billion. And the country is simultaneously facing another challenge: domestic control.

Saudi Arabia's Debt-to-GDP Ratio (2012-2018)

Over the past few weeks, members of the royal family and activists alike have criticized Riyadh’s management of the coronavirus crisis, despite the fact that Saudi Arabia has not been hit as hard by the outbreak as many other countries, registering about 1,000 confirmed cases so far.

The government’s decision to suspend prayer at mosques in Mecca and Medina, Islam’s two holiest cities, has undermined its credibility as the guardian of the Islamic faith and sparked concerns in the Islamic community that the coronavirus threat will continue well into the summer and force the government to shut down the hajj pilgrimage, which is set to take place in July and August.

This, too, carries serious economic consequences; the hajj brings 2.5 million visitors to Saudi Arabia every year and just over $12 billion in revenue, accounting for about 20 percent of the country’s non-oil economy.

Though the royal family still has a strong grip on power, public frustration with low oil prices could test the Saudi leadership. Approximately 20 percent of the country’s population holds shares in Saudi Aramco, so low oil prices resulting in part from Riyadh’s efforts to force Russia to capitulate could lead to widespread anger – even dissent. This could intensify if a recession emerges in Saudi Arabia, where unemployment has been high since 2015, reaching roughly 12 percent at the end of 2019.

Most important, the price war will put at risk Saudi Arabia’s most vital domestic objective of the first quarter of the century: reducing its dependence on oil through the Vision 2030 campaign. In 2016, the country promised it would be able to “live without oil” by 2020. But 2020 has arrived and Saudi Arabia remains reliant on energy – even more so now that the price war is chipping away at funds intended for investment in non-oil industries.

Crown Prince Mohammed bin Salman has touted Vision 2030 as a strategy to diversify the economy, bolster the private sector, increase social spending and reduce unemployment to 7 percent. But Vision 2030 has been hampered by declining oil prices and has struggled to attract foreign investment. The current price war will only exacerbate these problems.

Both Russia and Saudi Arabia acknowledge that this game cannot last; one or the other will succumb to the fiscal pressure and slow down production. Neither country wants to be the first to do so, however. For MBS, the pressure to mitigate the ripple effects of low prices while also keeping the heat on Russia is mounting. Winning the price war is critical to Saudi Arabia’s credibility, both at home and abroad.

Geopolitical Outcomes

As the gap between Moscow and Riyadh widens, there have been broader effects on the oil market and other producers. One of the unintended victims of the price war has been the U.S. shale industry. Producers have already begun to slash spending, prevent share buybacks, furlough employees and announce service discounts to stay afloat. By the beginning of this week, WTI shed 60 percent of the value it had accumulated since the start of this year.

There is now talk of a wave of bankruptcies as debt accumulates and write-downs skyrocket.

Regulators in Texas are beginning to consider curbing production – for the first time in 50 years.

But new opportunities have also opened up. The U.S. has tried to convince Saudi Arabia to ease up and even publicly acknowledged the possibility of a U.S.-Saudi oil alliance. That acknowledgment came after reports that some U.S. energy officials were interested in establishing an agreement with the Saudis to stabilize prices. Such an alliance would inevitably act as a counterbalance to Russia’s oil industry.

Washington already appears to be making attempts to align closer with the Saudis. On Monday, the U.S. fast-tracked the appointment of Victoria Coates as a special energy representative to Saudi Arabia. The U.S. also announced plans to dispatch Coates to Riyadh for the next few months for negotiations with Riyadh. There has also been talk of the U.S. potentially arranging a meeting with Saudi leaders to convince Riyadh to match cuts made by the United States.

As it stands, the road to recovery is long. Saudi Arabia, unable to set prices or increase demand, is running out of options and adopting a series of risky moves, hoping that it can either force Russia to capitulate or find new partners with which to navigate the oil market.

OPEC+ as a price control regime is fragmenting, and Saudi Arabia is increasingly unable to sustain its pressure campaign on the Russian energy industry. And as the coronavirus crisis intensifies and a global recession looms, it will become even more difficult for the Saudis to coerce the Russians into compliance.

More on that oil storage problem

By: Izabella Kaminska

© Bloomberg

We warned last week that oil has a storage problem, which could translate to permanent production capacity shutdowns.

On Thursday, Goldman’s commodities research team, headed by Damien Courvalin, offered some further insight into the issue and the inflationary pressures that are likely to come about as a result.

Here are the key pars from their report, with our emphasis:

Global isolation measures are leading to an unprecedented collapse in oil demand which we now forecast will fall by 10.5 mb/d in March and by 18.7 mb/d in April (our 2020 yoy demand forecast is now -4.25 mb/d).

A demand shock of this magnitude will overwhelm any supply response including any potential core-OPEC output freeze or cut.

Such a collapse in demand will be an unprecedented shock for the global refining system with margins simply not low enough given the required level of run cuts. Product storage saturation at refineries is therefore set to occur over the next several weeks.

At that point, the product surplus will become a crude one and we expect its unprecedented velocity will create similar logistical crude storage constraints.

This is the point at which crude prices will fall below cash-costs to reflect producers having to shut-in production. While seaborne crudes like Brent can remain near $20/bbl in 2Q, many inland crude benchmarks where saturation will prove binding are likely to fall much further (US, Canada, Russia, China).

The scale of the demand collapse will require a large amount of production to be shut-in, of potential several million barrels per day. Such a hit on production will not be reversed quickly, however, as shutting-in can often permanently damage reservoirs and conventional producing wells.

We therefore increasingly see risks that the rebound in prices will be much sharper than our base-case rally back to $40/bbl Brent by 4Q20, with a normalization in activity increasingly likely to be accompanied by a large inflationary oil shock.

And here’s the chart that matters:

File under evidence to suggest an inflationary paradigm shift is on the horizon.