Crude price only knew one direction since mid-2014 – down. Until now oil lost 70% already. Previously when oil was losing 10-15% OPEC and Russia had been limiting production to stabilise the price. Today no one is thinking about slowing production as no one wants to lose any more dollars.

Low oil price is a product of a geopolitical game. The US government tries to break Russia and Saudi Arabia counts on crippling competition from shale gas sector. Cheap crude is putting financial sector at risk. The very same sector which was eagerly financing production for very long time.

We can pinpoint to various factors affecting this situation. Before I will examine the price of black gold let me introduce some new developments in oil and gas producing countries.

Saudi Arabia

Saudi King Salman auctioned bonds worth 27 bn USD. This amount should be used to finance budget which lost significant revenue due to the lower price of crude. This is why the IMF thinks that debt of the kingdom can jump from mere 2% to 20%. New bonds had maturity date set for no longer than 12 months and before they have been paid off by surplus from oil exports.

Source: imf.org

Above chart presents a required price of oil to balance the budget for each country – yellow columns. Green diamonds (scale on the right) give us a number of years each country has until they will face insolvency. Fiscal buffer is a currency reserve created to help countries to go through times when it is hard to sell goods they base their budgets on. It is common for any asset that characterises itself with cycles (regular changes in price of an asset).

Saudis are in a bad spot. To prevent deficit their budget requires expensive oil – 106 USD per barrel (USD/bbl). Despite alleged reserves and a low cost of production the problem here is a structure of the state. Oppressive government has such a small financial margin in social expenditures that lowering anything in this department will incite people to protest. King Salman understands that. He gave public sector a rise amounting to a 2-month salary. On the other hand, it is clear to him that to preserve their privileged position in the Middle East they need to face Iran. Iran is slowly getting its powers back and this is why Saudis fight against Syria (Iran’s ally), finance ISIS and support them with weapons and new recruits.

Questions about Saudi oil reserves have not found answers yet but today situation is changing. Amount of crude still to be produced has not been updated for over 25 years. To sell bonds with a sensibly low interest rate they need to answer very uncomfortable questions. This context is even more interesting with Saudi Arabia attacking Yemen right after new oil fields have been found there. Are Saudi reserves smaller than what everyone thinks they are?

Yemen

Yemen was attacked by its neighbour – Saudi Arabia – under pretext of fighting terrorists. Later on this reason changed to a more realistic and probable one. New oil and gas fields have been found in Yemen. Gas discovery is big enough to produce 6 million m3 daily. Yemen has several other problems. Freshly created government is still weak and power is decentralised among tribes holding key territories. If that is not enough, Yemeni budget does not collapse only because of foreign aid. This makes their hands tied and an international political manoeuvring to promote national interest is very much limited.

Yemeni government is not thinking about any licensing round as it has bigger problems with invasion from the North. Saudis want to take over Yemeni coast line of the Red Sea and gain control of transport through the strategic Bab al-Mandab Strait.

Oman

Oman just like other countries in the region makes a living off oil production and just like other countries in the region it also faces big economic problems. Muscat – capital of Omani – is getting ready to lay off masses. Before they start making redundant Omanis, they fired immigrants. In the last few months 1500 jobs were lost. Unions prepare to protest, even though this is illegal due to a significant role of the hydrocarbon sector for the state economy.

Government approved budget with 2.68 bn Omani rials (~7bn USD) deficit. This equals 8.5% GDP. Last year ended with a surplus.

Iran

Partly linked to the end of sanctions in the beginning of January 2016 the Islamic Republic of Iran has welcomed Total, Shell and Lukoil. These companies try to get as much as possible from 70 available projects worth 30 bn USD. According to estimations Iran has the 4th biggest reserves of hydrocarbons in the world. The prize is big here. Iran requires a 50% participation of local firms in every project.

One of the development is building a FLNG (floating LNG) vessel. Ship that will operate in the Persian Gulf waters should boast production power of 5.7 million m3 per day. The Iranian NIOC and anonymous French company secured this deal.

Source: Newscientist.com

Now Iran is able to sell daily 1 million barrels of crude. Their production capacity reaches 2.7 million and is planned to be doubled by 2020. The painful comeback makes Iran a natural ally of Russia to form Eastern energy bloc. Their main client will be India and negotiations are already underway with India demanding big discounts. During a market share war it is a consumer (here India) setting the rules and a seller cannot shrug off any chances to lose a possible deal.

Russia

Moscow is fighting over its share in Europe using discounts. This is a full scale trade war. Putin tries to secure many fronts and the successful visit of Saudi kings proves that. Saudi Arabia will soon start accepting oil payments in ruble and yuan.

Kremlin is also fighting the Brent oil benchmark. The Brent standard is a base of over 70% of global contracts for oil production. Although Russia is dominating this market segment, price is set according to a foreign benchmark. Oil transported by ESPO (pipeline linking Siberia and Vladivostok) is sold cheaper than it should albeit the higher quality. This is because of not fulfilling a condition of transparency in price setting.

Russia’s own benchmark is the answer which enables price setting independently from exchanges in London or New York.

Brazil

Brazilian economy is in shambles. Real reached their historic lows against USD. GDP is negative all year long and the yield of 10 year treasuries equals 16%. Debt to GDP ratio is rising rapidly.

Petrobras is sinking because of low oil price. In just 5 years level of obligations has quadrupled. Debt in USD is already at 128 bn and 84% of it is denominated in foreign currencies. In 24 months bonds worth 24 bn USD will mature. With budget deficit continuing for 8 consecutive years it may just be a ‘mission impossible’ to pay them back.

USA

Shale producers felt low oil price. American production dropped from last year’s peak of 5.3 million bbl/day to 4.67 million bbl/day now.

Two factors play a role here. Average cost of shale production is around 70-90 USD per barrel (depending on the source of data). It is possible to find production wells with smaller costs (monster wells). This stems from shale production method – hydraulic fracturing. The level of production is known only after drilling a well and fracking, not before. This is the reason behind a high average cost of shale production.

Second factor is a profile of production. When starting exploitation production reaches ~10 thousand barrels per month but this number falls quickly. After 2 years an average level of production per month is just 20% and after 5 years it drops below 10% of original levels. Typical life of a well is 30 years. You can tweak your production numbers at the expense of maximum production level from your source.

Production profile presented in the chart below rises quicker the more wells you drill until peak is reached and production is decreasing after wells stabilise their output levels.

It seems that soon shale oil can stop flowing. Stopping investments in sustaining level of US shale production can cut supply significantly. Unless price of oil returns to 100 USD/bbl levels shale production can plummet by 60% in just 5 years and up to 90% after a decade.

OPEC

The Organisation of Oil Producing Countries has serious problems. In 2013 limit of oil supply was lifted to fight against shale for market share. In just four years American shale production more than doubled from 2 million bbl/day to 5 million bbl/day. In the beginning no one believed that prices can fall so low and hold for so long around 40-45 USD. Without a doubt global recession and generally cheap commodities play their role too. The US shale sector is also affected by boom in a junk shale bond market but this is also coming to an end.

Oversupply of oil and what followed nosedive of oil price staggered OPEC countries. Common policy of the cartel disappeared overnight. Last meeting in Vienna on 4th December last year did not bring any decisions and lack of an official OPEC position was far from being fruitful for this institution. Strategy followed by everyone is a war of attrition to push competition into debt and financially eliminate it.

Obviously this approach prevents any collusion of countries all over the world left without any mutual goal. Oversupply continues with Iran adding their 2.7 million bbl/day production to the game. Still agreement with Washington lets Teheran sell only 1 million bbl/day for first 3-4 months but we do not know how effective Teheran can be in bypassing this type of limitations. Having stocks of over 100 million barrels Iran may not have enough patience to adhere to conditions set. It is official – OPEC is dead and until market share war continues, OPEC will stay dead. Times of its greatness is far behind it.

Shale companies rating dropped

In November 2015 rating agency Moody’s gave 29 exploration and production companies from shale sector Baa rating with a negative prospect. Putting rating below Baa to Ba or even B proves that risk of insolvency is high among those companies. I believe you have to approach rating agencies with caution especially given record of their spectacular failures but their opinion here is sensible although late.

Oil-filled Super tankers stay afloat without destination

Last month peculiar picture made headlines. Almost 40 super tankers wait at the Galveston Texas, all filled with oil. 28.4 million bbl each. They act as big warehouses as every land storage is already brimming.

This situation is nothing new. We saw it in 2008 when oil price plummeted to 38 USD/bbl. Production companies used tankers as a storage to wait until price goes up. This particular use of vessels made price of maritime transportation of fuel reach 7 year maximums. Holding oil this way becomes more and more expensive and at the end it does not make any economic sense.

Nevertheless we need to remember that every day world uses 90 million barrels. Should trade routes become blocked or other logistic disruption materialised, the problem of overflowing terminals would be solved quickly.

Oil price

Regarding events of 2015 that made Middle Eastern war more fierce and worsening global economy, oil price is a problematic issue. Firstly, oil is very cheap now and this limits any further falls. That being said we have full terminals, storages, tankers and an organisational chaos in OPEC structures resulting in an oversupply of energy resources in the market.

Low price is not only a vector of market forces and global trade. It is first and foremost a calculated game, goals of which we can only presume. I think that the main reason behind cheap oil is a fight between the US and Russia. Secondary objectives are economy and situation in the Middle East. Authorities of Saudi Arabia are supported by Washington partners. Saudi budget being compensated for their oil losses by short position on futures and their counterparty and guarantor is the FED.

Retraction of sanctions on Iran added further 3 million bbl/day to world supply formula. The whole peace process would not have been anything new or surprising but for its timing and style. Enabling (re)entrance of one of the biggest producer back to the oversupplied market in time of a 75% slump of oil price is remarkable. This speaks volumes of what the US counts on – increasing supply and continuation of falling trend. It points out also to the way how Iranians treated John Kerry – the US Secretary of State – first laughing at him on twitter and then mocking Americans by entering their military boat and disarming the crew. Therefore, without political warming on the axis Washington – Teheran and in spite of humiliating actions against Obama and his administration both sides continue with their policies and this game has to be about something bigger. In my opinion, the only argument that makes sense is additional supply of oil.

Unquestionable desire to cut competition out of the shale market can be beneficial for the US. Debt of fracking companies amounts to 3 bn USD. Those firms acquired capital from various sources like issuing bonds or shares. Going bust may be a part of the plan and attack against them (also at the expense of OPEC) also hurts Russia a lot.

After frackers go bust some ‘strong hands’ of ‘responsible men’ could take over well-developed infrastructures that will deliver shale and last another 20-30 years without any modernisation. Capital will swap hands and collateral damage will be counted in jobless people and demolished economies of oil exporting countries.

I want to stress one fact. This is nothing new. This scheme has been used many times and recent 2008 bank crisis is a fresh example. After real estate bubble bursted and many people lost roof over their heads we saw one of the biggest bank consolidation in history. Now the whole sector is made up by few corporations too big to fail.

Zerohedge informs that bankruptcies are not going to happen any time soon. The Federal Reserve ordered banks to finance oil production industry no matter their insolvency. Lenders roll shale debt with small regard of lacking basic economic fundamentals. Junk bonds worth 3 bn USD can trigger a disaster in banks’ accounts creating a crisis nearly impossible to contain. Substantial share of producers going bust would push oil production off the cliff for a long fall.

Another factor to consider is an increase in dollar supply by average of 8% per annum. Proof for USD losing its value is the Chapwood index. Currency that loses value every single year is the one which oil is being denominated in. The same oil price fell to levels unseen for 10 years. Real price of oil taking inflation into consideration is now close to historic lows.

I am coming back to the question: does today’s cheap oil exhaust possibility of further falls? Number of demand-supply factors tell that further discount towards 20-25 USD is likely. But in my opinion we already experienced Brent’s bottom few days ago at 28 USD/bbl.

Bankruptcies in production sector and snowballing problems of oil exporting countries will inevitably take few millions of barrels off the supply side in turn stabilising oil price at higher levels. Traders already know that. This is why accounting for future diminished production makes gains of oil price smoother.

 

Independent Trader Team