Asian stock markets continued to fall today, propelled at least in part by the adverse reaction to the Saudi announcement yesterday that they would let oil prices fall to $80 a barrel. And further reports indicate that the Saudis intend to keep oil prices low enough to force a realignment of prices not just among various grades of crude, but also for intermediate and long-term substitutes.
It is critical to remember that the Saudis have no compunction about imposing costs on other nations to maximize the value of their oil resource long term and hence the power they derive from it. The 1970s oil shock produced a nasty recession in the US and most other advanced economies and gave a further impetus to inflation, which was already hard to manage and dampened growth by discouraging investment.
The current alignment of factors gives the Saudis the opportunity to make life miserable for a long list of parties they would like to discipline, including the US.
The sharp rise in the dollar means that lowering the price of oil in dollar terms is unlikely to leave the desert kingdom worse off in local currency terms. But it undermines US energy development, both fracking and development in the Bakken, as well as more development by the majors, who were regularly criticized by analysts for how much they were spending on exploration when the math didn’t pencil out well at over $100 a barrel. Countries whose oil is output is mainly heavy, sour crude, like Iran and Venezuela, find it hard to sell their oil when prices are below $100 a barrel (or at least when the dollar was weaker, but the $80 price point, even with a strong dollar, may be low enough to cause discomfort).
In other words, this is a classic case of predatory pricing: set your price low enough long enough to do real damage to competitors, and reduce their market share, not just immediately, but in the middle to long term.
Now admittedly some pet targets may not be hurt as badly as hoped. Russia will suffer more of an opportunity loss than an actual cost from the price reduction, since the ruble has fallen significantly against the dollar. The Saudis may hope to partially displace Russia as a supplier of oil to Europe (now roughly 1/3 of the total) but refineries would need to be retooled to refine the Saudi’s light crude, so it isn’t clear whether even what amounts to bargain prices will offset this cost (and readers point out that Russian crude may also produced a better mix of distillates for European use, since they are much heavier users of diesel fuel than the US).
But aside from the not-inconsiderable economic impact, the surprise Saudi step looks to be an even bigger geopolitical winner. The US and Riyadh have been at odds for over a year; the Saudis were particularly unhappy over the US failure to try to topple Assad last summer (you may recall the intensity of the Administration warmongering versus the dubious US interest; even Congress showed an unexpected amount of backbone and made its lack of support for Syrian adventurism clear). The Saudis have also long been less than happy with the US refusal to attack Iran (which is a rare case of the US acting as a responsible hegemon and curbing a putative ally with a bad case of blood lust). That unhappiness has ben compounded by the US now effectively helping the Assad regime and working in as distanced a manner as possible with Iran in targeting ISIS.
These parts of Marcy Wheeler’s analysis are spot on:
Cutting prices will make it far harder for Iraq’s Shia led government to invest in the fight against ISIL. So long as Western sanctions continue, it will destabilize Iran significantly, not only making it a lot harder for Iran to help Iraq and Syria, but also undermining the government that has chosen to deal with the US. The cuts will also destabilize Iran’s allies in Venezuela and Ecuador. Oligarchic forces have been trying to foment a coup in the former country for some time and this may well help to do so…The Saudis have been trying to undercut Russia for some time and — to the extent the ruble exchange with the dollar doesn’t shelter Russia from these changes [Update: though see Mark Adomanis on how this is hurting Russian consumers] — this price cut will hurt Russia too.
Ultimately, though, I suspect the US is just as much the target of this move as Iran and Russia are. Since the US refused to take out Assad last year and inched forward with its Iran deal, the Saudis have been worried about having Shia Iran and Iraq take over its role as the swing producer in the world, mirroring what happened in 1976 when the US replaced Iran’s Shah with the Saudis. By destabilizing the government in negotiations with the US, the price cut will make it a lot harder to achieve such a deal.
Just as importantly, the US is now a petro-state. And this price cut will make fracking (and deepwater drilling) unprofitable. We’ve been fracking largely to give ourselves some breathing room from the Saudis; cutting the price will make it far harder for us to sustain that effort (and will make some renewables uncompetitive).
To me, then, this move looks like part of an effort to force the outcome the Saudis have been chasing for a decade and even more aggressively since the Arab Spring: to paralyze Shia governments just as the chaos of ISIL threatens to remap the Middle East.
The Saudis may well claim to be supporting our fight against ISIL, but the long-term commitment to dropping oil prices, looks more like an effort to undercut it.
And as Pam Martens and Russ Martens point out in a post today, Oil Price War Throws the Fed into Crisis Mode, the Saudi move has the effect of increasing deflationary forces, which is a nightmare for the Fed and other central banks. So just as the Saudis used their oil weapon to amp up inflation in the 1970s, so they again they look to be willing to provide more firepower to another war central bankers are losing. From their article:
It was only a matter of time until the evidence became irrefutable that the only way out of a global deflation on the order of the Great Depression was to address the fact that 571 U.S. billionaires simply don’t have enough hours in the day to spend adequate money to buy enough goods that would require the restocking of shelves, create new factory orders and thereby ramp up job hiring to keep a nation of 317 million people afloat.
A nation where the top 10 percent reaps more than 50 percent of the income is doomed to end up in the quicksand of deflation, dragging down the rich along with everyone else….
A key component that has allowed both the Fed and Congress to keep from taking strong measures to address a looming deflation has been the price of crude oil. Because oil impacts everything from transportation costs that inflate the price of food and other products to the cost of an airline ticket or heating a home, the high price of this commodity has, to a degree, masked the growing deflation threat.
Now the mask has been removed. Oil prices are in freefall and an oil price war has broken out among OPEC members, raising the specter of 1986 when oil prices fell by 50 percent in just an eight month span. A serious global slowdown has effectively turned the oil cartel, OPEC, into a beggar thy neighbor band of go-it-alone dealmakers who hope to sign individual contracts with customers and grab market share before prices decline further…
In other words, a sudden, sharp drop in inflation expectations caused by an oil price war raging around the globe was not present in the Fed’s crystal ball just a month ago. But it should have been: other commodity prices have been sending up red flags for some time now…
The market has delivered epiphanies to the Fed on multiple fronts – some of them blazing with sirens – but the Fed seems to have had its head in the sand just as securely as it did heading into the 2008 crisis.
Yves again. As much as central bankers detest inflation, they fear deflation even more, particularly when debt loads are high. I differ with the Martens as to the Saudi cuts being driven by desperation; oil market analysts expected them to hold the line at $90 a barrel. But whether this move is informed opportunism or aggressively defensive is moot. It throws a massive wrench into the global geopolitical and economic equations, both of which were already looking plenty rocky.
As much as I am no fan of Riyadh, it’s hard not to admire their strategy. The Saudis look to have executed a masterstroke. They come out winners on many fronts that are critical to them and appear to at least hold their ground on others. And I have a sneaking suspicion that the neocons, who have US energy independence as one of their core assumptions, were caught flat footed by this audacious move.