Question: “so who saw this coming?”
Answer: “absolutely no one!”
So an “unknown unknown” has been wreaking some havoc in markets over the last week in oil, the Russian rouble, energy stocks, energy service stocks and in the last few days the market as a whole.
The history (an abridged version)
The global energy market has been in flux over the last few years because of:
- The US discovering massive new oil and gas reserves which they can access more and more efficiently through fracking
- The natural gas costs per unit to US businesses are now about a third of the imported costs of gas for Japan or China; this is a huge competitive advantage
- The continued development of alternative energies (solar, wind, electric cars, potentially hydrogen fuel cells etc)
- The Japanese nuclear accident which shuttered many nuclear power stations (Germany simply walked away from nuclear power as an example)
- The Chinese economic slowdown which has the potential to lower their energy demands (and they are big)
- The Russian invasion of Ukraine resulting in sanctions, and the threat for disruption to the European gas supplies as their retaliation (which would be in winter to have most effect)
- The return to production of Iraq and the potential for the US to lift the embargo on Iran when a nuclear agreement is reached
- The US political elections giving Republicans control of both houses (which are in favour of the Keystone pipe line, and allowing liquefied natural gas and unrefined crude to be exported both of which have not been supported by Democrats previously)
So a lot of pieces are on the board and most of them have been moving around or potentially could be moving, so in essence a highly unpredictable situation.
Now all was broadly ok up to October time with oil trading in a range of $80-90 a barrel. There were concerns about a slowing global demand for energy and at the same time the total amount of oil and gas being pumped was increasing, so the demand / supply balance was under pressure but all was calm-ish.
OPEC (the Saudis) historically acts as the pressure valve for oil, tapering their production to keep supply in balance and so maintaining price stability, but at their November meeting they said, “Nah, we’re going to keep pumping the same amount”, cue turmoil.
Why would they do that?
Commodity markets saw this same scenario play out last year with fertilisers. A Russian company, Ukralli, vastly oversupplied the market, saying “we don’t care that it will hammer the price down because we have huge reserves and it will hurt you lot (their competitors) far more than us”.
This is hyper aggressive free market economics at work although it’s using a very very blunt instrument. The aim of the big player is firstly to drive down prices to cause pain and anxiety to rivals, but more importantly longer term to create doubt and fear which stops companies from investing in new product (developing new mines or drilling new wells). This in time lowers overall supply and brings the prices back up.
In the oil and gas market this appears to be the Saudi plan.
All oil production is not born equal; in the Middle East it is generally simpler and cheaper to extract. By comparison the costs of drilling in deep water, in Siberia, extracting from sand or by fracking can be much more expensive. This means that if the average US fracking play has a breakeven price of $60-75 per barrel, with Canadian oil sands it is higher still, and the Saudis have a breakeven of around $30-35. You can see their strategy and why it will work.
In essence the lower price causes previously profitable production to become loss making, companies will either endure negative cash flow (if they have the balance sheet strength) for as long as they can and / or shutter production if they can’t.
Lower production, and supply means prices then rise, but having been severely burned there won’t be a rapid rush to ramp production back up as the memory of the scare will linger a long time; so job done.
An additional benefit for a country that only produces oil (Saudi Arabia as an example) is that alternative energies only make present economic sense if they are equal to or cheaper than oil / gas. This is not the case at $60 oil so they inflict some damage and impair the progress of these companies and technologies as well.
Double bubble!
Not just companies, countries
The inter connectedness of global economics and finance (demonstrated by the 2008 credit crisis in the US becoming a global financial pandemic) means that whilst it is of some (but limited) concern that oil companies might be struggling, it is of huge concern that Countries are.
The Russian export economy is about 50% energy dependent, about half of its exports are oil and gas related and the price of oil is down 40%-50%; its income has broadly halved.
To add to its problems it is shut out of Western capital markets due to the Ukraine sanctions and it has debts maturing in dollars (so this cost has doubled in rouble terms) of around $160 billion in the next 18 months.
It is going to face huge inflation troubles because import costs are going through the roof (a rouble buys half what it did 6 months ago) making the currency unattractive to hold internationally so everyone sells it. This means it falls even further and the Russian Central Bank is then forced to increase interest rates as well as spend its foreign currency reserves (dollars) buying back the unwanted Roubles, rather than keeping them in tact to pay bac the dollar dominated loans!
Bad times!
Other countries which have very oil dependent economies such as Nigeria and Venezuela are also being negatively affected, but they don’t have the same political or economic importance as Russia (no massive army or nuclear weapons).
Conclusion
As with most things this will in all likelihood calm down and blow over as:
- The Saudis have made their point
- The US frackers are certainly chastened
- Putin has hopefully come to understand that in the 21st Century destabilising nationalistic behaviour can bite you severely on your own arse and decides therefore to play nicer in future (but who knows?)
Here’s hoping.
The upside (and it’s a big one)
The dramatically lower energy costs will act as a HUGE driver for increased spending on discretionary goods, it’s as big a stimulus as a large interest rate cut but benefits virtually everyone (not just borrowers) through lower petrol and heating costs.
So once the panic is over watch out for some very juiced up consumption numbers which markets will love.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.