The Great Recession Blog
by David Haggith
The fate of oil companies and nations hangs in the balance of oil prices. Russia could go broke. Some think that’s by US design. Saudi Arabia could experience its Arab Spring if oil prices remain too low too long. And OPEC is dead. That’s the biggest news in this new century for oil.
The House of Saud has stated clearly many times now and again this week in an even more emphatic manner that it intends to move the oil market from decades of OPEC price manipulation to a raw supply-and-demand equation. Rigging the price of oil was the raison d’être of the cartel known as the Organization of Petroleum Exporting Countries, and that function has now ended. But people are slow to get their heads around such big news.
Saudi Arabians enjoyed a tax-free environment as long as oil paid the bills and cheap subsidized fuel. Huge revenue from oil enabled constant pay-offs to the powerful that stabilized the state. All of that has ended or is at risk of ending as the Saudis seek to rebalance their state budget in the face of huge declines in revenue. So, changing the pricing structure of oil is a perilous change of course for the House of Saud, which tells you how serious they are about transforming the market back to a free market.
It’s fraught with peril for all. Among oil companies and banks, it’s not just the little leaguers that are hurting. Royal Dutch Shell reported an 83% decline in profits year on year. Most oil companies reported significant drops in profit for the first quarter of 2016, though many saw their stock values soar upon reporting because investors had feared an even worse hit. Their banks have reported the same.
Oil’s big bang on banking
As I speculated in a recent article, the oil market may be entirely rigged by central banks. We know from experience the Federal Reserve will buy anything in any quantity to save its member banks. So, if low oil prices are hurting major banks, why wouldn’t the Fed start buying oil … if nothing else, through proxies? And why would it tell us if it did?
We learned months ago that trouble in the tar pits was bad enough that the Dallas Federal Reserve Bank was telling its member banks not to foreclose on bad oil loans because they’d just drown themselves in oil debt if they started writing down their balance sheets to match the fire-sale values they’d be creating by foreclosing.
The latest survey by the Federal Reserve … has revealed a pessimistic picture. Banks … are still skeptical about the ability of their energy industry clients to pay back their loans, and they are taking a variety of steps now to minimize the damage…. American banks are saddled with over $140 billion in unfunded loans … in oil and gas…. This will very likely weigh down on banks … and plunge them even deeper into the abyss of unfunded, non-repayable debt…. Basically, the lenders are doing whatever they can to sustain potential losses, apparently having learned a valuable lesson from the Great Recession. (Oilprice.com)
In other words, energy debt will rapidly spiral downward if banks start foreclosing on all the bad debt. It will play out like the collapse of housing debt in 2008 when foreclosures created fire-sale prices throughout the housing market. Banks couldn’t unload the houses as fast as foreclosures were piling up without crashing the market value of all their collateral. So … they stopped foreclosing.
This time they are a little smarter and are avoiding foreclosures as much as possible to prevent the same kind of death spiral with energy loans. If oil prices don’t continue rise, however, the amount of time banks can forestall on foreclosures will run out. Sooner or later, you have to admit the debt is bad if it doesn’t turn around and write it off, selling the collateral for whatever you can get in auction (into a market where few oil companies want to buy more capital assets).
And that downward spiral is picking up speed:
In just the first four months of 2016 there had already been double the amount of bankrupt energy debt than in all of 2015, with the total secured and unsecured defaults rising to $34 billion, double the $17 billion total for all of 2015.
…The only real impact [of Chapter 11 bankruptcies] … will be that their all in production costs will decline substantially, allowing [them] to pump more oil at even lower prices, and thus adding to the global supply imbalance, something that will infuriate Saudi Arabia and add even more output to a market that remains chronically oversupplied. (Oilprice.com)
Moreover, the current crisis is bigger than bad oil debts due to the spillover effect: In regions where oil companies cannot repay their debts, laid off employees also cannot pay theirs, resulting in a rise of mortgage defaults, credit-card defaults and car-loan defaults. There is contagion to all aspects of banking. So, this is a problem big enough for the Fed to secretly intervene, as it did during the housing crisis.
If the oil market is not rigged, it is certainly climbing on speculation that is irrationally exuberant, and nothing looks more like lemmings about to run off a cliff so much as irrational exuberance. It is irrational (if not rigged) because, as I’ve pointed out in previous articles, the price of oil goes up with every scrap of hope for a decline in production or increase in demand but then holds stable against major news that clearly indicates oversupply is likely to worsen.
In light of my failed prediction that March would bring the perfect storm against oil prices, I want to reassess the major forces currently pressuring oil prices –those that should tend to drive prices back down into the oil pits and those that should light oil prices on fire — to see where the balance of power lies (absent market interference by entities like central banks).
Pressures that could depress the price of oil again
OPEC is dead
The end of OPEC price manipulation in oil has to be the most significant factor of all when contemplating where oil prices are likely to go. Russia’s biggest oil CEO, Igor Sechin, scorned OPEC with some of his harshest words ever this week:
At the moment a number of objective factors exclude the possibility for any cartels to dictate their will to the market. … As for OPEC, it has practically stopped existing as a united organization. The company (Rosneft) was skeptical from the very beginning about the possibility of reaching any sort of joint agreement with OPEC’s involvement in current conditions. (Newsmax)
Sechin is a close friend of Putin who argued constantly against even trying for a production limit with Saudi Arabia, never believing (just as I argued continuously here) that Saudi Arabia would ever go through with a production cap. He sees the whole Doha meeting as an embarrassment to Russia who spearheaded the meeting (which is why I referred to it as Dohaha), and he hopes to help Russia avoid such embarrassment in the future. The chance of additional talks about production limits has been iced by realization in Russia of how frivolous such hopes were in the first place.
Sechin sees the breakup of the Doha meeting as the effective end of OPEC, and said Russia should abandon any hope of price fixing through production caps, which has been OPEC’s modus operandi. Saudi Arabia seems content to simply agree with that.
That should be clear by Saudi Arabia’s appointment last weekend of a new energy minister, Khaled al-Falih, who offers even less hope of production caps than his predecessor. His words have been consistently clear … if people are willing to listen to them and stop saying “The Saudi’s don’t really mean it.” Yes, they do:
Falih, who took over on Saturday from long-serving Ali al-Naimi, has been very vocal in the past year about his views that the oil market needs to rebalance through low prices and that the Saudis have the resources to wait.
Falih’s ultimate boss, Deputy Crown Prince Mohammed bin Salman, who oversees Saudi oil policies, has also signaled that the world is moving to a new era where supply and demand rather than OPEC will determine prices. (Newsmax)
Al-Naimi’s days appeared to be nearing an end at Doha when he was ordered by the new Saudi crown prince to back down from making the production freeze deal that he had been championing. Then, last weekend, the prince retired the veteran oil minister, whose mere whispers could drive the price of oil, and put Falih in his place.
Clearly, Falih wouldn’t have gotten the position if his outspoken views about letting a free market set the price of oil from this point forward were not the direction the House of Saud intends to move. To think otherwise is to chose denial. The crown prince has clearly stated his intention and has put someone in place to carry that out.
This means the end of the OPEC’s role in capping or lifting the cap on production as a way of fixing oil prices. The rest of OPEC’s member states are powerless to set prices if Saudi Arabia is done doing the lion’s share of the work. The House of Saud’s resolve as social pressures rise around it may be another matter; but for the time being they are resolute, as all of their planning matches their words:
Prince bin Salman has spearheaded a historic initiative to wean the nation from its dependence on oil revenues over the next decade and a half. His “Vision 2030” for the country calls for a partial IPO of Saudi Aramco, using proceeds to setup the world’s largest sovereign wealth fund in order to invest in sectors of the economy not linked to oil. He also is seeking to raise revenues from other sources besides hydrocarbons, implementing new taxes for the first time. (Oilprice.com)
The new prince has clearly taken the reins of the oil industry. He has replaced the old guard with new blood, the former head of Aramco, Saudi Arabia’s state-owned oil company, and he is rebuilding Saudi society to be less dependent on oil.
A new era of oil pricing has begun, in which balancing global supply and demand matters less to Saudi Arabia than it used to. That suggests we’re in for an bumpy ride. (Quartz)
Saudi Arabia’s balancing act
It would be foolish to think the new prince would reverse course from such sweeping changes anytime soon.
Why should Saudi Arabia or OPEC change course? Saudi Arabia decided not to reduce production in the face of oversupply in late 2014…. While it has taken much longer than expected, forcing prices to crash due to high levels of output is finally beginning to bear fruit. Some sixty-odd U.S. shale companies have declared bankruptcy and U.S. oil production is down almost 800,000 barrels per day from a year ago. More declines are forthcoming.
Why would Saudi Arabia do anything that lessens the pain of other oil producers just as their strategy for regaining market share is starting to bear fruit?
To underline their resolve, the new head of Saudi Arabia’s state oil company Aramco, Amin Nasser, said that Aramco, which controls all Saudi oil, intends to meet all future global demand increases He said he expects global demand to grow this year by 1.2 million barrels per day. Nasser believes the company can meet all of that with its current capacity, so will not be increasing capacity immediately, but it has room with its present capacity to expand production and sales.
“Saudi Aramco will continue to expand,” Nasser said at the company headquarters in Dhahran in eastern Saudi Arabia. “We will soon be publishing our annual book and you will see there is significant growth in our annual oil production compared to previous years.” (Bloomberg)
Falih said the same thing over the weekend:
“We are committed to meeting existing and additional hydrocarbons demand from our expanding global customer base, backed by our current maximum sustainable capacity….” The emphasis on maximum sustainable capacity once again hints that any incremental increase in global demand will be promptly met by a boost in Saudi output. (Oilprice.com)
So, do not expect an increase in global demand to reduce the oversupply problem. Saudi Arabia produced an average of 10.2 million barrels per day in 2015, and Aramco has the capacity to produce 12 million per day at a sustainable rate, 12.5 million all-out maximum capacity. Nasser also said the company will expand in the future if it needs to in order to meet future capacity requirements.
Current production increases at some fields have been seen as a force that could suppress prices back down to where they were, but Saudi Arabia says those increases have been aimed at compensating for declining production at other fields.
The latest stage of its expansion project at the southeastern Shaybah oil field would be finished “in a couple of weeks.” The increased capacity of 250,000 bpd … is aimed at rebalancing Saudi Arabia’s crude oil quality and at compensating for falling output at other fields as they mature. (Newsmax)
“Mohammed bin Salman has changed everything,” Helima Croft, head of commodities strategy at RBC Capital Markets, told the WSJ. “He doesn’t feel the economic burden to have to cooperate with OPEC.” (Oilprice.com)
The combination of the new prince ascending in power and the new oil minister means Saudi Arabia has doubled down on maintaining production at a high enough level to the recapture market share it lost to producers in other nations (such as the US) and to meet any increase in future demand.
More than an oil price war, it’s all-out war
There is a larger balance-of-power struggle here that supersedes everything else in the Saudi mind. The House of Saud, a bastion of Sunni Muslims, perceives Shiite Iran as its greatest threat, not the Saudi people. The Saudis see Iran as a nation hell-bent on creating an Iranian Islamic caliphate while they see themselves as being the natural center for control of any Islamic kingdom because Mecca and Medina are under their government.
The connection between Islam and Saudi Arabia … is uniquely strong. The kingdom, which sometimes is called the “home of Islam” … is … the only one to have been created by jihad, the only one to claim the Quran as its constitution…. Muhammad bin Saud, brought a fiercely puritanical strain of Sunni Islam … to the Arabian Peninsula…. This interpretation of Islam became the state religion … espoused by Muhammad bin Saud and his successors (the Al Saud family), who eventually created the modern kingdom of Saudi Arabia in 1932…. [Saudi Arabia] has influence well beyond its borders, thanks in large part to the country’s largess towards Islamic causes funded by its oil exports since 1970s. (Wikipedia)
With Iran hurting from years of sanctions, the Saudis want to do all they can to keep their greatest Islamic competitor from regaining market share in oil that will restore their economy and fund future military development. So, this is far more than a price war. It is a political and religious war with deep roots of hatred, ideological competition and distrust.
Ask yourself, which forces are most likely to control Saudi Arabia’s production decisions (as the world’s largest oil producer) — budgetary problems (which can be handled with loans) or hundreds of years of religious and political rivalry when there is finally opportunity to see the rival melt into their own desert sands? That’s adds a whole new meaning to “price war” where oil prices become ammunition.
Iran is charging into the oil price war head on, not about to capitulate to Saudi insistence that Iran agree to freeze production if Saudi Arabia is to do so. At the start of this year, many market gurus said it would take Iran a long time to ramp up production as it was threatening to do, so that Iran didn’t matter much in this equation. Some even thought Iran might sign on to the Doha deal. I said consistently that Iran will definitely not sign on to the deal and that it will rapidly succeed in upping its production so that will be a significant factor in oil pricing very soon. It is now clear Iran is well on its way to higher production goals:
Helima Croft, chief commodity strategist at RBC Capital Markets [said,] “Iran came back much faster than expected…. And if it’s bigger and stronger consistently, to me that’s the most bearish supply story….” If Iran succeeds with reaching and sustaining production at those levels, it could upset the balance of the entire oil market, according to Croft. (Marketwatch)
Russia not about to reduce production
The Saudis are also in an oil price war with Russia for market share in China where they have been losing ground, which is one more reason talk with Russia of a production freeze was never anything more than talk.
While China’s oil imports grew 13.4 percent year-over-year to 7.3 million barrels a day in the first quarter of 2016, its imports from Saudi Arabia grew just 7.3 percent…. Meanwhile, Chinese oil imports from Russia surged 42 percent…. If the Saudis want to regain Chinese market share from the Russians, they may well have no choice but to either aggressively boost production or cut prices, or both, once again. (Oilprice.com)
Russia is committed to maintaining high production so long as prices are low in order to keep building its Chinese market. In fact, some of Russia’s oil executives say the costs Russian companies have already paid out in capacity expansion and exploration practically force their hand to maintain production during this time of low prices to try to make back in volume a small part of their decrease in profit margins (in that there is still a tiny bit of profit in the margin):
“We must understand that the oil prices cannot change drastically because we are now reaching the projected output level that we set out to achieve with the investments that we historically made six, five, four years ago, and the production cannot be curtailed,” said Vagit Alekperov, LUKoil’s Chief Executive Officer….
“What we see here, is that amidst the oil prices slump the Persian Gulf countries attempt to increase their production output to cover their budget deficits caused by slashed oil revenues, including compensating for the part of budget they need for procuring arms”, Alekperov noted.
However, LUKoil’s CEO believes oil prices are passed [sic.] their lowest point, and the equilibrium price should fluctuate around $50 per barrel for the rest of 2016 (Oilprice.com)
The Chairman of the Russian Union of Industrialists and Entrepreneurs, Alexander Shohin, says
As we have seen, the oil price did not react to the Doha agreement derailment, and in my opinion, the price of $40, $41, $42 per barrel shall remain as an equilibrium price under current market situation through 2016.
Industry leaders in Russia expect the price has stabilized in its current $40-50 range, which is still low enough to keep squeezing out US shale-oil producers, putting a tighter crimp on their already worried bankers.
Forces that could ignite the price of oil
Global oil rig count continues to fall
Baker Hughes’s “International Rig Count” (http://www.wtrg.com/rotaryrigs.html) reported that the global oil rig count dropped again in April. Total International Rigs (which does not include the US, Canada or China) dropped dropped by 39, putting the total count at 964 oil rigs. That is a drop of 436 from its July, 2014, peak.
The US rig count dropped by another 41 in April, bringing the total number of operating oil rigs down to 437. That is a huge overall decline from its peak of 1,925 in November, 2014.
Canadian rig count has taken the worst plunge percentage-wise: The total count has gone down from a peak of 626 operating rigs at its peak in February, 2014, to just 41 rigs total!
Bear in mind, however, this primarily affects the future of oil and gas supply. Rigs are for drilling, not pumping. So, these declines mean that, in light of low oil prices, there is much less oil and gas exploration and much less drilling of new wells in areas already known to produce oil and gas. That, by itself, doesn’t diminish current oil supply because there are still roughly enough wells coming online to make up for wells running out of oil and going out of production.
It does mean that, once a number of players are completely out of business, we could see (in a year or two) a huge increase in oil prices due to a supply shortage as the pendulum swings the other way. While the lower rig count doesn’t do much to lower today’s supply, it definitely reduce’s tomorrow’s … if you look far enough down the road.
Drilling is a massive cost that can be cut without any immediate effect on revenue. Therefore, stopping exploration and new well expansion is a measure taken when companies have to worry more about immediate survival than long-term survival. In the oil business, it’s like stopping R&D.
The new era of arctic deep-sea drilling pronounced dead on arrival
One area of reduction in rig counts is the Arctic Ocean. The dawning era of deep-sea exploration and drilling in the arctic has been issued its toe tag. Drilling costs are exceptionally high in the arctic due to austere conditions, environmental concerns, and remote location. As a result, it’s become the area of first total retreat by major oil companies, who have now ended their arctic drilling, even though that means sacrificing government leases that give them drilling rights.
Several companies officially forfeited their rights to drill in the Arctic on May 1, having declined to pay the U.S. government to renew licenses…. Shell, Eni, Statoil, and ConocoPhillips all decided against paying to hold onto those drilling rights in recent weeks. “Hopefully, today marks the end of the ecologically and economically risky push to drill in the Arctic Ocean,” Michael LeVine, senior regional counsel for Oceana…. Arctic drilling is now dead for years at least…. The Interior Department could theoretically hold another auction for drilling rights, but even if it did so, it would be years away. (Oilprice.com)
Libyan oil production could hit the zero bound
While it doesn’t amount to much on a global scale, Libyan production could go all the way down to nothing within a month. Libya’s Hariga port is under blockade over a dispute between rival governments. The Tripoli government says it will have to halt oil production within a month if the port does not soon reopen.
“In less than four weeks we will have to shut production completely because the tanks at Hariga will be full,” Mohamed Harari, a spokesman for the National Oil Company, said in an e-mailed statement late on Monday. (Oilprice.com)
International Energy Agency says oversupply slowing down
The [IEA] projects that oversupply will be at 1.3 million bpd through the first half of this year (down from last month’s projection of 1.5 million bpd), as demand has been stronger than expected from China, India and Russia. It maintains its demand growth expectation for this year at 1.2 million bpd, but sees oversupply dropping to only 200,000 bpd in the latter half of the year. (Oilprice.com)
While the IEA is feeling more optimistic, oversupply is still oversupply, even if it is revised lower than what they were projecting. Continued oversupply still means, sooner or later tanks in storage facilities start to overflow.
Short-term factors raising oil prices
Nigeria has reported over 3,100 breaks in its oil pipeline system as a result of “vandalism.” The reduction of Nigerian supply from this could increase if the violence against the state-run system continues. This could be just a short-term reduction in global supply from Africa’s largest oil exporter that ends as soon as the leaks can be fixed; but militancy has been on the rise.
Canadian oil production is down by a whopping 1.6 million barrels per day due to wildfires in Alberta. That is enough to completely wipe out the world’s oversupply situation and was enough to keep prices up, even with all the bad news about Saudi Arabia staying in the price war.
However, the fall-off in Canadian supply may be short-lived reprieve for oil companies and banks worried about oil prices because the fire could be out in a matter of weeks. Or course, it could rage on into the summer; so, as with Libya the length of its effect is unknown. Local winds changed this week to blow the fire back away from the oil sands area, giving, at least, some temporary reprieve from the threat of destruction of oil production and storage facilities.
Some are looking for increased demand from China to help lift crude oil prices. I think they are dreaming. China has recently tried spending its way back up to higher manufacturing, and the results so far have not been good.
The summer season is here when gasoline demand normally rises.
So, where are oil prices headed?
Oil oversupply continues to fill tank farms. The report this week of a 1.4-million barrel build at Cushing, Oklahoma, one of the nation’s major oil storage regions, exceeded expectations and temporarily drove oil prices down at the start of the week, but they quickly recovered. It also could mean the IEA is already off on its optimistic revisions of its oversupply projections.
Prices will take a drop from which they cannot recover right away if tank farms actually fill up. Some weeks we’ve heard the build-up has slowed or reduced, but then the next week, we hear the build up was worse than feared. On balance, the build continues toward that point of total market saturation for crude oil.
In my mind, the forces pressing back toward lower oil prices — or, in the very least, oil prices that stagnate in the low to mid forties for the rest of the year — are larger and more plentiful than the forces that have recently pushed prices up.
There is, of course, the normal summer increase in gasoline demand, which is about to begin. Even that, however, is just a seasonal improvement, while the Saudis and Russians are clearly planning for a longterm battle for greater market share. I expect defaults in the energy sector to continue to add pressure against banks throughout the year.
I also expect the Fed and other central banks are already doing anything they have to in order to mitigate this threat to banks, which they will continue to do. That may be what the recent emergency Federal Reserve board meetings were about. The bigger question is how many plates can central banks keep spinning, as their recovery unwinds. The energy sector is only one area in which banks are facing increased stress.