Oil predators and prey

[abomvubuso.livejournal.com]

Here's a joke I recently heard. It's about the way the political rhetoric coming from the Kremlin is going to "evolve"...

Oil: $145 a barrel: "The world order needs an overhaul!"
Oil: $130 a barrel: "Moscow should become the world's financial center!"
Oil: $120 a barrel: "We're gonna launch the Eurasian Union!"
Oil: $110 a barrel: "Crimea is Russian!"
Oil: $100 a barrel: "East Ukraine is Russian!"
Oil: $90 a barrel: "We do not fear a new Cold War, we are not afraid of your sanctions!"
Oil: $80 a barrel: "No, there are no Russian troops in Ukraine!"
Oil: $75 a barrel: "Why is the whole world against us!?"
Oil: $70 a barrel: "We have a nuclear suitcase, our finger is on the red button!"
Oil: $65 a barrel: "We are prepared for peaceful negotiations with Ukraine..."
Oil: $60 a barrel: "We support Ukraine's NATO membership..."
Oil: $55 a barrel: "Putin has fled, Moscow is free!"
Oil: $50 a barrel: "Long live King Soros!"

"That was a great decision", Saudi minister of petroleum Ali Al-Naimi said with his typical smile on his way out of the OPEC meeting in Vienna last month. And exactly how great the decision not to decrease the oil production was, the world learned almost instantaneously. The oil prices continued their freefall and reached their lowest level since 2009. There's been a 44% plunge for the last half a year. And now the main question is whether there's a problem in demand or there's something wrong with supply. If the former, then the world economy is seriously staggering. Fortunately, that's not really the case. The OPEC assesses that the demand will be growing through the next year, albeit a bit slowly. The chairlady of the IMF, Christine Lagarde told the WSJ this was "mostly an effect of overproduction" and wasn't a bad thing.

The price growth since 2009 has shrunken oil demand, which made such oil-obsessed consumers like the Americans look for more effective cars, something that is not very typical of them. Or should I say, "un-American". And what's more important, it caused a boom at the US shale oil market, which has been meeting an increasing part of the demand in the world's largest economy.

The OPEC meeting actually was supposed to make a decision whether the production rates should be decreased in order to raise the prices. Although this seemed logical, it didn't happen. One of the reasons is that the awkward cartel of wealthy emirates, conflict-torn countries with economic difficulties and some of the major geopolitical players, seems to have stopped functioning. OPEC was created in the 60s in order to wrestle control on oil production from the huge Western companies. For decades, the OPEC members have called the shots on the oil market, they were deciding whether the prices should go up or down, by respectively decreasing or increasing production. But now, due to the differences in the goals of the various members of the cartel, and because of the shrinking demand, and last but not least important, because of the shale boom in the US, OPEC doesn't seem capable of exerting that control as effectively as it used to. No surprise that the chief analyst at the Bank of America has concluded that "OPEC is dead", and the oil prices will keep slumping.

But the most interesting part of the connundrum is actually hidden behind the soft smile of Mr Naimi. The question is, why OPEC's main player and largest oil producer, the Saudis have decided not to touch the market and leave it naturally find its new equilibrium. This is the first occasion where the Saudi sheikhs have blocked a decision on decreasing the production rates. On previous occasions, that was done at prices above $100 a barrel, which was a very different situation. The next meeting of the cartel is in half a year, and there are no intermediary meetings scheduled inbetween. Which clearly shows that Riyadh is okay with the current development.

There's a (mainly Russian) conspiracy theory claiming that the Saudis may've reached an agreement with the US to keep the oil prices low in order to harm Russia and Iran. That could be similar to the situation in the early 80s, when the USSR entered the same cycle, and suffered a severe shortage of oil revenue, thus being rendered incapable of sustaining its creaking and cracking planned economy.

The other possible explanation is that Riyadh wants to hit the US shale oil producers, which have been so efficient for the last few years that they've managed to increase the US oil output by 1/3. Bloomberg concludes that the average price that's needed for the US shale oil suppliers to operate normally is around $80 a barrel. Many of them could work at $50 a barrel, Citigroup claims. That's not as low a price as the cost of the easily accessible Saudi oil, granted, but it's still way below the profitable rate for most OPEC producers. And since the cartel members heavily rely on oil revenue to wrap up their budgets, all of them (including the Saudis) are currently hurting from the lower prices. But Ryiadh may've figured the pain would be more bearable for them, and would ultimately be worth it in the long run.

OPEC must have learned the lessons from the 80s by realising that by decreasing production for the sake of keeping prices high, it tends to allow those outside OPEC to produce more (mainly the US), which ultimately takes away from OPEC's share of the global oil market. Now, by flooding an over-saturated market, they want to limit the growth of the share of the non-OPEC producers. The obvious target is shale oil, which costs between $65 and 90 a barrel, but that would also hit other long-term investments, like the potential development of the Russian Arctic oil zone, and the Brazilian deepwater reserves - both of them needing prices well over $100 in order to be viable.

That could turn out to be an efficient strategy, because many of the US innovators in the oil sphere are neck-deep in debt, and any price decrease threatens them with bankruptcy. Thanks to their sovereign fund of $800 bn, the Saudis could clear up the field of competitors, but at what price? That wouldn't stop the long-term development of the shale sector, which is already bringing huge benefits to the US, and could soon be developed in other places. Meanwhile, a longer period of low prices would mean serious problems for OPEC. Both the IMF and Citi Research indicate that the only two OPEC members that could possibly withstand such a fiscal pressure, are Kuwait and Qatar. Everyone else's budget is already in the red zone, some are already burning pretty bad. Among the biggest casualties is Venezuela, which is losing $700 million at every dollar of price drop, Petroleos de Venezuela itself has admitted. Iran, which continues to be pressured by sanctions and needs prices way beyond $100, and Russia, which is not an OPEC member but is enormosuly dependent on oil and gas export, are among the other major losers.

This means that minister Naimi must have had a very tense meeting in Vienna last month. One might wonder why the hell would the Saudis want to help Iran, Russia or the US shale producers? Or why would they want to decrease their output right now? They seem to have agreed to allow the market decide the price, which essentially means it won't be going up any time soon.

If that's really the chosen strategy, then some major players are in for a very tough year. The already mentioned Venezuela for example would hardly be able to afford even a short(ish) period of such low rates, and some (mostly US) analysts are already predicting a Venezuelan default. The largest African producer Nigeria is already devaluating its currency. Most Arab producers would also hardly withstand the low prices, and countries which are practically in a state of war like Libya and Iraq would have yet one more serious problem in a future that already looks pretty bleak. The news is bad for the large oil companies as well: their new projects which were supposed to replace the old oil fields, are mostly located in places like the Arctic, which requires lots of investments, and it's hard to see how that'd be profitable at prices below $65 a barrel.

But the biggest question, and Europe's most pressing problem, remains Russia. Putin's quasi-empire has suffered from the sanctions, its economy is shrinking, the ruble is in a freefall, foreign capital is fleeing, and inflation is rising dangerously. Russia does have a small reserve fund which it collected in the years of oil boom, but it's waning fast, too. The Russian central bank has already spent about $70 bn since the beginning of the year in order to sustain the ruble. The national currency did collapse against the dollar by 70% despite that, which is causing shockwaves down the chain: prices are soaring, and employers don't intend to raise salaries for the time being. Inflation as of mid December is nearing 10% on yearly basis. This has put a dilemma to the central bank: should they fight inflation, or should they stimulate growth? It recently became evident that they're opting for the former, because they raised the interest rates for the second time in a couple of months, now at 10.5%.

Oil revenue still constitutes about 10% of Russia's GDP, and almost half the income for the national budget. The low oil prices are an immense blow on the Russian economy, which was already suffering. And the trouble won't just come from oil, Morgan Stanley assesses that every 10-dollar drop in the oil price means $32.4 bn loss of oil revenue for Russia.

Trouble is, with an ever shrinking income for the budget and waning options for economic growth, Putin's Russia could become even more unpredictable, which could hang like a menacing cloud over any faint prospects for European recovery. The good news is that some countries could review their gas agreements and wring somewhat lower prices from Russia now.

For everyone who imports oil rather than exporting, this should be considered relatively good news. Seems like the news will be better for countries like China, the US and India (which has agreed on a 10-year import contract with Russia). Europe, much less. Oxford Economics predicts that much of the EU will enter into a period of deflation, which would be yet another problem for already stumbling Europe.

How long the low oil prices would persist, no one really dares to bet. The dominant view seems to be that in the second half of 2015 there'll be a decrease in production, which would raise the prices slightly, but that still puts them at $80 a barrel. Of course, we should take these predictions with a big grain of salt, because the Energy Information Administration for example failed to predict both the shale gas boom in the US and the oil price drop of the early 80s. It's a market that's always been very hard to predict, and it has become even more volatile now.