The Great Recession Blog
by David Haggith
Only about a week ago, one reader scoffed at me because oil prices had stabilized (or so the market theory d’jour went). The big stock market crash I had predicted had run its course, he thought. The Saudis and Russia had entered a deal on oil, and Iran was coming on board; the stock market was back up as a result. Everything was normalizing again. Whew! He could write off the doom-and-gloomers.
It was a wet, oily dream — a dream I listened to with detached amusement as oil prices and stock prices rose to support his hopes. How silly, I thought, that these investors all hear exactly what they want to hear. What a bunch of lemmings.
Here is what they should have heard as I would have written the news last week:
The Saudis and Russians agreed this week not to reduce production of oil for months to come but to freeze in place the current high production rates that are crippling the US fracking industry. They also conditioned their freeze at these high production rates on all other suppliers keeping their production rates frozen. In so doing, the Saudis and Russians implied that, if others like the US continue to boost production, they will, too. The price war continues full force.
Iran this week said it might become a party to this deal after it gets its own production rates up to the market share it enjoyed before sanctions. For now it is concentrating on boosting production and sales back to that old level.
That was the upshot of all parties agreeing “to talk.” The real news was clear for anyone with ears to hear if people would just start to listen to things they don’t want to hear: No one is budging. Oil producers are going to keep pumping supplies up at the same high rate for as far as the eye can see, and Iran is going to continue to ramp up production until it gets back to where it was in its pre-sanction days.
There was no good news there at all — not a drop — but people lapped it up as if there was because that’s what they wanted to believe. It’s strange to see so many people crowded around pools of spilled oil surplus, lapping it all up like it tastes good.
The resulting rise last week in speculative oil pricing was beyond silly. The stabilization of the stock market based on seeing oil prices rise shows that investors are running on the thin fumes of mere wishes now. Their heads are filled with carbon monoxide so that they think through a sleepy fog. They bobble like balloons with every little wind of change that blows.
This week, however, we see reality sinking back in as their heads clear a little to see that everything continues exactly as it did before the Arabs and the Russians got together. That, of course, is exactly how I have been saying it is going to continue.
Let’s get down to it: We’re in an oil boom bust
Saudi Arabia’s oil minister says production cuts to boost oil prices won’t work, and that instead the market should be allowed to work even if that forces some operators out of business…. (NewsMax)
You see that? “Production cuts won’t work” means “they’re not going to happen!” So get over it, investors. You’re dreaming of blue skies that are far, far, far away. I don’t see blue. I see seemingly endless fountains of oil, clouding the desert skies for months to come until the spine of the fracking industry in the US lies broken and quivering on the sand with the vultures picking at its meat.
That’s the reality of the US oil industry right now … if you’re willing to step outside of economic denial and see things as they are.
“The producers of these high-cost barrels must find a way to lower their costs, borrow cash or liquidate,” Naimi said. “It sounds harsh, and unfortunately it is, but it is the more efficient way to rebalance markets.”
He means fracking companies in the US, which have a high cost of production compared to the cheap Saudi costs of extraction, are going to have to buck up. They can either keep borrowing more cash until they and their banks die from bad loans or just liquidate now. Saudi Arabia’s oil minister admits that sounds tough, and it is tough. What he’s saying, in other words, is, “This is capitalism, so GET USED TO IT! The problem will only be solved when the weak perish! We’re not cutting production in order to help them survive. This problem of oversupply will be settled by the high-cost frackers liquidating. That is the efficient capitalist way.”
And he’s right, but we live in a world that doesn’t understand economics anymore. They think things should happen the way they want them to. The US stock market and the oil speculators last week forgot all about how ruthlessly capitalism works when it corrects speculative boom cycles. The Saudis quite simply are not about to keep trimming back their market share just to help us get richer at their expense. They can produce oil a lot more cheaply than the booming US fracking industry can, so they are going to keep on pumping and drive the US fracking industry largely out of business.
Anybody who believed anything else for one second just was not thinking. Those weren’t sparks of thought that brought the market up. They were just short circuits — brains fried from things that don’t compute after years and years of free Fed money.
Naimi disputed a common view in the industry: that Saudi Arabia has kept pumping oil to protect its market share and undercut shale producers. “We have not declared war on shale or on production from any given country or company,” he said.
He may be a little disingenuous there, but what he’s saying is, “We’re not targeting anyone because of who they are or whether they frack.” The Saudis are, however, protecting market share. They’re just not specifically targeting frackers or the US because they’d love to see Iran crippled, too. What they are targeting is their share of the market and saying, “We’re going to keep producing this amount of oil to fill this share, come hell or high oil supplies, and whoever that takes out … that’s their tough luck. It might be harsh, but that’s the way this is going down!”
And that’s how everyone should have understood the Russian and Saudi agreement in the first place. It’s how I immediately understood it. It’s what I said would happen even before they met. All they really said is that they are not going to expand to try for an even larger share … so long as no one else does.
Why OPEC is taking down the US oil boom
The OPEC rationale is simple. Back in the days when OPEC countries were the main players on the oil sands, they could all agree to cut back production in equal proportions in order to raise oil prices. Now that the US is producing as much oil as Saudi Arabia and is continually increasing its production, any cutback by OPEC is a low spot in the market that US oil just flows right into.
Every time OPEC would cut back in order to increase prices, the US would increase its market share by just continuing to ramp up more production. The US did not, in other words, ever participate in the cutbacks. It just sucked up the slack created whenever the Saudis pulled back on production.
The Saudis saw where that was going and essentially said, “That’s the end of that. We’re not cutting back at all anymore more — not this year, not next. We’re going back to the production we were at and will let normal market dynamics solve the oil supply glut. So, may the best nation win.” Thus, as the oil minister continued to say,
Cutting low-cost production to subsidize higher-cost supplies only delays an inevitable reckoning.
Give up your oil pipe dreams, America, that make you think the Saudis are ever going to trim back production. “The way production will be trimmed,” they are plainly saying, “is by others whose costs are higher going out of business! It’s an inevitable day of reckoning because those with much higher costs will over time certainly be the ones to die out.
The Saudi oil minister concluded that this is just another inevitable oil boom-and-bust cycle. The boom is over; the bust is here. So, don’t even ratchet up your glee a tiny bit just because the Saudis and Russians have agreed not to increase production further so long as no one else does. That only means, they’re not going to make things worse than already are, but they are not going to flex an inch to make anything better either. So get ready for a long, hard ride. This is a war of attrition, and the people with bigger mouths to feed will be the first to die. That is the US fracking companies, starting with the smaller, less diverse companies.
As this news was finally digested, we saw oil prices plummet again this week. Anyone who entered bids in the stock market based on the notion that oil prices had risen and would stabilize a little higher was a wishful thinker. Reality is a harsh task master.
As the real meaning of the Saudi-Russian agreement sank in, oil prices went right back down into the tar pit. I’ve said consistently that is where oil prices are staying for awhile. In fact, with Iran’s production coming on, they are bound to go even lower. And then, when all the tanks in the world are full, crude prices could really go bust because who wants to buy any oil for immediate delivery when they have nowhere to put it? The only boom left is kaboom!
So, give up on the idea that oil prices are going to improve. It’s a Keystone pipe dream that isn’t going to happen. When the market goes up on such news, it just shows how far from reality market thinking is and how desperate for hints of favorable economic news. Those who believe it, wind up looking silly … and poor.
The oil bust is here to stay, so glub, glub.
“It’s just another boom-and-bust cycle.” As a result, here is where we stand today:
In less than a month, the U.S. oil bust could claim two of its biggest victims yet.
Energy XXI Ltd. and SandRidge Energy Inc., oil and gas drillers with a combined $7.6 billion of debt, didn’t pay interest on their bonds last week. They have until the middle of next month to either pay the interest, work out a deal with their creditors or face a default that could tip them into bankruptcy.
If the two companies fail in March, it would be the biggest cluster of oil and gas defaults in a month since energy prices plunged in early 2015.
“We’re just beginning to see how bad 2016 is going to be.”
Indeed, we are. 2015 was just the beginning as the weakest were quick to fall. Now we move outward to the next tier that is starting to crumble around the fringe of the oil pit.
The U.S. shale boom was fueled by junk debt. Companies spent more on drilling than they earned selling oil and gas, plugging the difference with other peoples’ money. Drillers piled up a staggering $237 billion of borrowings at the end of September.
There were lots of other people willing to speculate on unprofitable businesses. Sound familiar. It was the dot-com boom, only in oil. Those days are over. No one wants to issue that high-yield debt now that they know the boom has gone bust and that the Saudis and Russians are in this for the long haul. The cost of junk credit for oil companies has skyrocketed, and its not about to come down, so the frequency and size of oil and gas company crashes will get greater all through the year. Accept that reality.
The banks that are owed money on the loans mentioned above include the Royal Bank of Scotland and the huge Swiss bank, UBS, the UK’s Barclays, the Royal Bank of Canada, and a large French multi-national bank. You see, the damage extends fully beyond the US, and that’s the way it will be with all of these greasy junk bonds.
There will be bank failures because of this. The only question that remains is which of these banks is weak enough and involved enough in the US shale patch to be the first to collapse because of the oil bust along with other problems?
It’s a time bomb.
The number of all US companies that are nearing default has reached a peak not matched since the worst peak of the Great Recession. (There that comparison is again. It’s inescapable now.) That means across all industries, but oil and gas companies are leading the pack.
We are just seeing the beginning of the second set of waves come onshore now. So, hold onto your body boards and get ready to plunge into the onshore oil slick because we’re going to take a pounding.
Fracking up is hard to do.