Saudi Arabia’s price war and the oil and Russian ruble crisis

The Russian rouble was last trading at a rate a tad better than 55 roubles to the US dollar and WTI was over $56 a barrel the last I checked. This could be the end of a mini-crisis or a lull in events. I tend to believe it is a lull and that emerging markets will continue to be vulnerable while the strong dollar and low commodity prices are in place because of the change in Saudi Arabia’s rhetoric on oil prices and production. Some thoughts below

First, given the holiday season, I am going to have an irregular posting schedule. I didn’t post yesterday and I definitely won’t post on Christmas Day but any other weekday is possible, depending on morning schedule during the Holidays.

In terms of the commodities bear market and the emerging markets crisis, this is the third mini-crisis for emerging markets since the prospect of US policy normalization began in 2013. And while US policy is not the driving force that creates vulnerability, it could be the catalyst of the next mini-crisis, one that coul always turn into a major crisis depending on how the fingers of instability come together. I see two major macro events driving this crisis forward. On the one hand, we have Chinese rebalancing and the concomitant slowdown in commodities demand growth. On the other hand, we have the reversal of US easing and the associated shifts in private portfolio preferences. Let’s look at both of these in terms of oil.

According to Bloomberg News, the world oil market is now looking at anywhere from a 540,000 barrel per day market oversupply, using the latest IEA figures, to a 2 million barrel oversupply, using Bloomberg figures. That is a significant market overhang, which is depressing prices. Now, OPEC could cut production targets, with Saudi Arabia as largest and swing producer forced to make the most cuts. But then that would leave non-OPEC members to benefit from the production cuts in terms of price, having already taken market share – and leaving OPEC at the lowest global share in 2 decades, and the lowest demand for their crude since 2003, at 28.9 million barrels a day. In November, they pumped 30.56 million barrels per day.

So OPEC is in a quandary. Oversupply means lower prices but volume cuts mean a continued erosion of market share, giving deepwater, oil sands and shale drillers a price umbrella to fall under in order to take share. The Saudis initially said they would not cut output unless non-OPEC producers cut output, making the prospect of an early recovery in price more likely. But now Saudi Oil Minister Al Naimi is saying the Saudis won’t cut under any circumstances, even if non-OPEC producers cut production. Here’s the money quote:

OPEC doesn’t intend to cut its output “whatever the price is,” Al-Naimi said in an interview with the Middle East Economic Survey. “Whether it goes down to $20, $40, $50, $60, it is irrelevant.”

And Reuters quotes Al Naimi saying this:

“If they want to cut production they are welcome, we are not going to cut, certainly Saudi Arabia is not going to cut,” he said. He added he was “100 percent not pleased” with oil prices. They would improve, he said, but it was unclear when.

The commentary in the FT to this pronouncement is spot on:

“It is not in the interest of Opec producers to cut their production, whatever the price is,” he told the Middle East Economic Survey. “Whether it goes down to $20, $40, $50, $60, it is irrelevant.”

He said the world may never see $100 a barrel oil again.

The comments, from a man who is often described as the most influential figure in the energy industry, marked the first time that Mr Naimi has explained the strategy shift in detail.

They represent a “fundamental change” in Opec policy that is more far-reaching than any seen since the 1970s, said Jamie Webster, oil analyst at IHS Energy.

“We have entered a scary time for the oil market and for the next several years we are going to be dealing with a lot of volatility,” he said. “Just about everything will be touched by this.”

Welcome to the oil price war.

What I see the Saudis saying here is that they see too much supply on the market. In the old policy regime, they would have tried to get OPEC together to restrict output and maintain prices. Trying to cure this excess supply by restricting output would, they believe, continue to erode their market share, which would work against them over the long-term. Therefore, they will let the market work its magic at present output levels, allowing the highest cost oil to leave the market and letting the market settle at whatever price it settles in at. The Saudis want to become price makers instead of price takers. And this constitutes a major change in policy regime for OPEC and Saudi Arabia.

The question now is: how low will prices have to be in order to clear out excess supply? With this new policy regime in place, what new range of prices will be sustained? I don’t know what the answer is, but I do know the answer is lower than $100 a barrel and probably lower than $75 a barrel, at least until demand growth catches up with the excess supply from high cost sources. But then the next question becomes what cost matters in creating the new oil price trading range?

Gary Shilling and Anatole Kaletsky separately argue the relevant lower bound price is marginal cost for OPEC, or $20 a barrel. I want to take a look at their arguments and see if it can give us a sense of where this is headed. First let’s look at Shilling. He writes:

How low can oil prices go? In the current price war, the global market price needed to support government budgets isn’t really the main issue. Nor are the total costs for exploration, drilling and transportation.

What matters are marginal costs — the expense of retrieving oil once the holes have been drilled and pipelines laid. That number is more like $10 to $20 a barrel in the Persian Gulf, and about the same for U.S. shale-oil producers. The estimated $50 to $69 a barrel break-even point for most new U.S. shale-oil production is less relevant.

As scary as this sounds, logically it seems correct. Basically he is saying that exploration and well set-up capital expenditure is irrelevant over the short run for wells already producing. And that means the relevant cost basis to use for production already online is the marginal cost – and I would argue here – the highest marginal cost of the first barrel of excess production. That means every producer who cannot sustain existing production when price falls will shut in production, go out of business, or reduce output in some capacity to stop the losses from mounting. At some point, supply and demand will come into balance, but this will happen at the marginal cost of the last shut-in or closed marginal barrel of excess supply. Shilling is saying this could be as low as $20 a barrel.

Kaletsky makes a similar argument:

It is inconceivable that just a few months of falling prices will be enough time for the Saudis to either break the Iranian-Russian axis or reverse the growth of shale oil production in the United States. It is equally inconceivable that the oil market could quickly transition from OPEC domination to a normal competitive one. The many bullish oil investors who still expect prices to rebound quickly to their pre-slump trading range are likely to be disappointed. The best that oil bulls can hope for is that a new, and substantially lower, trading range may be established as the multi-year battles over Middle East dominance and oil-market share play out.

The key question is whether the present price of around $55 will prove closer to the floor or the ceiling of this new range…

[…]

There are several reasons to expect a new trading range as low as $20 to $50, as in the period from 1986 to 2004. Technological and environmental pressures are reducing long-term oil demand and threatening to turn much of the high-cost oil outside the Middle East into a “stranded asset” similar to the earth’s vast unwanted coal reserves. Additional pressures for low oil prices in the long term include the possible lifting of sanctions on Iran and Russia and the ending of civil wars in Iraq and Libya, which between them would release additional oil reserves bigger than Saudi Arabia’s on to the world markets.

The U.S. shale revolution is perhaps the strongest argument for a return to competitive pricing instead of the OPEC-dominated monopoly regimes of 1974-85 and 2005-14. Although shale oil is relatively costly, production can be turned on and off much more easily – and cheaply – than from conventional oilfields. This means that shale prospectors should now be the “swing producers” in global oil markets instead of the Saudis. In a truly competitive market, the Saudis and other low-cost producers would always be pumping at maximum output, while shale shuts off when demand is weak and ramps up when demand is strong. This competitive logic suggests that marginal costs of U.S. shale oil, generally estimated at $40 to $50, should in the future be a ceiling for global oil prices, not a floor.

The message here is stark in terms of thinking about peak oil dynamics having given way to a secular age of oversupply, meaning supply constraints brought on so much extra capacity and demand growth has slowed so much that demand constraints are now the secular paradigm which will rule the roost for years to come. This is an interesting thesis that’s not entirely inconsistent with a peak oil view of the world but it does suggest that peak oil dynamics are inoperable for a long period while demand catches up to a whole additional and vast stream of fossil fuel supply at the next price level up. I am sceptical about the $20 number, honestly. But I do think the logic makes sense.

In any event, what this means for people following the Rouble crisis and the crushing impact on Russia’s dollar export revenue is that the Russian crisis is not over by a long stretch and that emerging markets are going to be under pressure more generally. I haven’t mentioned China here at all but they should continue to play the swing demand growth generator because of the capital intensity of their growth model. And while their economy adjusts to a lower capital intensity level, demand growth should remain weak, putting downward pressure not just on oil prices but on commodity prices more generally.

To me, all the hallmarks of a strong dollar period are in place. And even if the US economy is brought down early in 2015 to a lower growth level due to the building capital investment collapse in the oil sector, I see the US Federal Reserve resisting the temptation to delay its wanted schedule of hikes because of economic weakness or foreign currency turmoil. The Fed is on track to raise rates in June and right now the bar is high for this to be unwound. Only when the Fed does pull the trigger will we see the real shift in private portfolio preferences. For now, its a mini-crisis in emerging markets focused only on Russia. But vulnerability is widespread, with Steve Hanke telling us yesterday that Indonesia, Turkey and even China remain vulnerable because of hot money flows. if the Fed hikes, mindsets will change and the emerging markets will suffer from private portfolio preference shifts. I believe the nexus of Saudi intentions, Chinese policy, oil prices, dollar strength and Fed policy is going to be driving risk markets in 2015.