Yves here. Stocks around the world took a nosedive today, due to WTI sliding to under $30 a barrel, as well as disappointing earnings announcements from Chevron and BP, along with a warning from Standard & Poors.
But the bigger cause of the sour mood which apparently swept from oil stocks into the broader market, was that a rumored deal among Russia, Iran, and the Saudis is nowhere near as imminent as the hype of last week would have investors believe. And there’s an obvious reason why.
As we indicated last year, when Saudi Arabia embarked on its oil-price-cutting strategy, which is what refusing to reduce production to support prices amounted to, it looked like a masterstroke. It had several sets of opponents in its crosshairs. The firs was US frackers, who posed an intermediate-term threat if the shale boom and resulting government subsidies supported the construction of LNG transport facilities (which on a cold-blooded economic calculation are not justifiable given that under the old normal, shale production would have peaked around 2022 and started declining gradually, then more sharply around 2030, and that assumed no curbs due to earthquakes or water supply impact). Second was clean energy, which becomes much less attractive if conventional energy becomes cheap. Third was Saudi Arabia’s geopolitical opponents, most important Russia and iran.
Recall that the Western media went all in on the story of Russian vulnerability. In 2015, Europe tightened sanctions, and the Western leaders were in barely-veiled terms calling for regime change in Russia, on the premise that Putin could not survive the one-two punch of low oil prices and foreign sanction.
Here we are, in 2016, with barely an acknowledgment of that period. Not only did the Europeans overestimate Putin’s vulnerability, but the Saudis badly underestimated theirs.
It’s impossible to know what scenarios the Saudi officialdom ran, but it appears their downside case was not that much more dire than that of conventional wisdom as of early 2015: that oil prices would be low for the first half of 2015, and would recover to more or less their former level in the second half of the year. One has to think the Saudis allowed for some overshoot in terms of what then would have been seen as a dire scenario, say oil below $60 for nine months.
In other words, the Saudis simply did not anticipate that both government and private producers had the same incentives: to keep pumping because they needed the revenues so badly. And the deterioration of the Chinese economy and lousy fundamentals in Europe mean that low oil prices haven’t led to an upswing in consumption to offset the surplus supply.
And they further underestimated the staying power of some of those players. As John Dizard pointed out early on, US shale players would keep going as long as they had access to funding (and they also got adept about cost reduction, in cutting back at higher cost sites and increasing output at ones with better economics). And even though oil is an important export for Russia, it is far more diverse an economy than is widely understood and much closer to being an autarky than one-trick-pony Saudi Arabia.
So the severity and probable extended duration of low oil prices has blown back on Saudi Arabia in a very nasty way, particularly since its government and society have become very dependent on a high level of oil revenues.
Russia and Iran are thus able to exploit the fact that the Saudis are hoist on their own petard. They won’t do an oil deal unless they also get a deal on Syria. That is something the Saudis will find very hard to swallow. But all that Russia and Iran have to do is stand pat. The Saudis can’t take protracted budgetary hemorrhaging and they know that. But it may nevertheless take time for the Saudis to swallow their pride and make the necessary concessions (and figure out how to make them look like peace with honor). And the longer this impasse persists, the more Mr. Market will continue to fret.
By Michael McDonald, an assistant professor of finance and a consultant to companies regarding capital structure decisions and investments. Originally published at OilPrice
Much of the rout in oil prices has been predicated upon the staying power of Saudi Arabia and other OPEC producers. As oil prices have continued to fall, virtually all of OPEC has been pumping oil as fast as possible to generate increased revenues at lower prices. That practice has helped to fuel the oil glut and led to a price that would have been unthinkably low just a couple of years ago. Oil markets have been largely assuming that OPEC producers could go on producing at these levels for years, but what if that’s not the case?
Take the strongest of the OPEC producers, Saudi Arabia for instance. Saudi Arabia has very low cost per barrel of production – much lower than any shale producer in the U.S. But as a country, Saudi Arabia also has other significant obligations that it has to meet and oil revenues are effectively its only way of meeting these obligations. The same principle holds true for all other OPEC producers, though most are in worse shape than the Saudis. With oil at these prices, all of OPEC is bleeding fast. The oil revenues that the Saudis and others are bringing in are simply not enough to meet their on-going obligations. As a result, Saudi Arabia and others have been forced to turn to their savings – foreign currency reserves.
Saudi Arabia started 2015 with roughly $720B in reserves. By August it was down to $650B. As of December, Saudi Arabia has around $620B in reserves. If oil averages $20 a barrel going forward for the next couple of years, Saudi Arabia will be broke by mid-2018 even after accounting for its recent budget cuts that trimmed internal spending. $30 a barrel oil buys the country about 6 months, tiding it over to early 2019. Libya, Iraq, and Nigeria are all in much worse shape, as of course is Venezuela.
Even before Saudi Arabia gets to the point of bankruptcy though, panic may begin to set in for OPEC. Saudi Arabia is the most stable member of OPEC, and other than its rival Iran, who is use to budgetary pressure, the rest of OPEC is largely bloated and ill-prepared for a long period of low oil prices.
Saudi Arabia will likely end 2016 with around $450B in reserves, and other OPEC members will be in much worse shape. With reserves that low, many OPEC members may be forced to turn to the bond markets. Unfortunately for OPEC, the interest rate environment around the world is starting to tighten and bond rates will likely be higher by the end of this year. Add to that the continuing uncertainty around oil prices, and some countries may find bond market access very difficult. Even the Saudis may find that their financial strain is causing concern among bond investors.
There is reason to think that the price of oil will remain subdued for a long time to come if the Saudis have anything to say about the matter. In particular, the Kingdom is concerned about the rest of the world switching to other forms of energy sources, and sees low oil prices as a way to delay the adoption of substitute forms of energy. It’s a wise long-term plan.
But even the Saudis don’t want to see oil prices this low, nor can they afford a prolonged period of oil prices below $50 a barrel. To say that oil is crucial to Saudi Arabia is an understatement; oil is to Saudi Arabia what gambling is to Las Vegas. The Saudi’s cannot withstand low oil prices forever, and if drastic changes don’t happen, then within two years, the world’s largest oil producer maybe facing very hard times.