As Brent crude hits 11-year lows, it’s worth thinking about why it is so low and what the likely outcomes will be. Warren Mosler has a view I think works regarding the Saudis as swing producer, targeting quantity instead of price and I want to run this concept by you to understand where this is headed. I believe oil is headed down. And this will have big implications for capital expenditure and economic growth.
See the situation as Warren described it to me last week on Boom Bust at the 14:08 point in the video below.
Let me put his words into my framing here. His view is that the Saudis own the vast majority of excess supply in the world. They are pumping 10 million-odd barrels per day while they have capacity for 12. The Saudis want to produce more. And so they are lowering their price until they hit 12 million barrels a day, regardless of what happens to other producers.
What this effectively means is that they will continue to discount their price below prevailing levels until they sell more crude. And this will put inexorable downward pressure on prevailing levels in the market. WTI is now below $35 a barrel and Brent is at 11-year lows below $37 a barrel. But expect these prices to go lower until the Saudis stop their practice of discounting vis-a-vis benchmark prices.
I believe the Saudis will continue to offer a discount – irrespective of the budgetary consequences – until they sell appreciably more oil. And this is bearish for oil. But it is an extremely bearish outcome for shale oil producers, who are high cost producers, often with negative cash flow, effectively Ponzi borrowers at prevailing price levels.
So what does this mean for likely outcomes economically?
- Likely the Saudis will continue to drive down the price of oil until higher cost producers shut in capacity or fail and go bankrupt. The goal here is not to reduce excess supply per se but rather to sell more oil. And so it does no good for the Saudis if supply is reduced and they don’t see incremental demand for their supply. Implicitly this means prices will overshoot to the downside if the Saudis don’t relent.
- High cost producers will not just reduce capital expenditure; many will fail and be liquidated. This means a loss of capital expenditure, of jobs and a market impact for high yield bonds and leveraged loans.
- Lower cost producers will cut back on planned capital expenditures. We have already seen this from the majors. We see it in natural gas as well. Increasingly, we will see it in natural gas. And that is another blow to capital expenditure that we have yet to see.
- This is an important piece: Banks will need to start taking credit writedowns on loans that they have been evergreening until now. Contagion will come to markets through this route, as the writedowns will mean a more restrictive environment for high yield borrowers all around.
If the Fed continues to hike rates, the dollar will move higher as well. Combine the oil price outcomes with a strong dollar and a Fed hiking rates, and you have a perfect storm for emerging markets, commodity and oil exporters, and high yield bonds and leveraged loans.
One or more of these markets will have a crisis. And the question then will be how much contagion comes from that crisis and how much real economy contagion develops as well. This situation has been developing for a long time now. And I see no let up unless Saudi Arabia relents.