From our analyst in Dubai, an update on the Energy Markets, including the implications of falling crude oil prices, and why there is more than meets the eye with Saudi Arabia and Russia….
It has been a momentous few months for the Energy Markets, culminating in a 6.7% fall in the price of Crude Oil on ‘Black’ Friday the 28th of November – as the market takes an ominous turn. The latest move lower on Friday was precipitated by OPEC announcing they would not cut production, as they seek to defend their market share. As mentioned in our research prior, we were not of the opinion – despite the plethora of naysayers – that equated a resurgent ISIS with increase an increase in oil prices. ISIS controls a miniscule fraction of Iraq and Syria’s oil production capacity and energy prices were always going to be dependent on other factors. Though we are surprised by the acceleration in price decline.
Oil weakness is a supply side story, and is not led by diminished global demand – though this no doubt has contributed. Back during the twilight of the Bush era oil hit a high of $144, and swiftly US Shale Oil received a Presidential blessing as frackers surged into the market. This as well as major discoveries elsewhere, have all contributed to an oversupply – 3 million more barrels a day are now produced compared to 3 years ago – as free market enthusiasts always said it would.
US Shale Oil
Fracking, which has transformed America into the world’s biggest oil and gas producer, will certainly be tested. On average for US frackers, acceptable returns depend on a barrel being priced at around $70, and at the moment there is little incentive for US producers to slow down, as investors tend to punish exploration and production companies that slow their pace. Though, there are signs of stress as stocks of smaller oil companies which focus on unconventional oil extraction are falling, and Bond holders who have lent to oil prospectors getting jittery.
The ripples will also be felt in other markets; the renewable energy technology sector has contracted, as stocks for solar energy companies have tracked movements in oil prices – down 30% in the last month alone.
Lower oil prices are positive for Western economies, acting as a proxy tax cut consumers, which in turn, translates to lower headline inflation rates. The effect in the Eurozone will be one to watch as economists re-calculate as to whether this may tip the Eurozone into deflation in Q1 of 2015 – though if market analysts expect the ECB to act on this, they will probably be disappointed. Our view is the ECB will do what all central banks do and discount energy price volatility from their calculations.
As is apparent Oil Export led economies will suffer in the short term. Amongst these Venezuela and Nigeria seem particularly vulnerable. Venezuela has stood firm on budgetary promises and has continued subsidies, despite entering a recessionary cycle, and experiencing high inflation. Nigeria has already announced that it is planning to cut its budget by 6% next year. Iran will no doubt follow suit and will find itself under pressure to maintain the largesse it heaps on proxies and allies. Currencies correlated to oil such as the Canadian dollar, Norwegian Kroner, as well as the Gulf Co-Operation Council currencies also have been hurt.
Beware the Wounded Bear
Much of this detracts from the proverbial Bear in the room. President Putin has had a difficult time of it recently however perhaps his biggest challenge is the faltering economy, as more than 70% of Russian exports come from the energy sector. Confidence has taken a knock, with the Ruble tumbling 25% in the last three months, while Western sanctions have also been a nuisance.
There is an increased expectation of a recession as according to a recent Bloomberg poll economists believe Russia has a 75% chance of entering a recession next year. Indeed Russian detractors, point to bungled debt scheduling, over dependence on oil Western sanctions and an overrated military apparatus to highlight Russian vulnerability.
However, this is ignoring the wider scenario. The falling Ruble has made some export industries like farming more competitive, and Russia has sought other trade partners such as Turkey to facilitate business and bypass some sanctions. While Russian debt repayments total $500 billion – 30% due to be renewed next year – is a concern particularly as Western lenders seek to reduce exposure to Russia, The Kremlin has been actively seeking alternative sources of funding. Importantly the Kremlin can call upon its stash of foreign-exchange reserves, some $370 billion according to the central bank’s figures. Furthermore Russians are a proud and resilient nation, so in our view President Putin has time to manoeuvre, probably about two years or so. Needless to say, the pain of a Russian recession will also be felt in the EU, as Putin was at pains to convey to Chancellor Merkel commenting that 300,000 German jobs depend on German-Russian trade.
There is much speculation about why the cut in OPEC production didn’t materalise, however it is worth remembering that Saudi Arabia is the largest and lowest-cost producer – at around $10 a barrel. According to IMF estimates Saudi Arabia needs Brent Oil at $91 a barrel to balance its books, however this is a moot point, as The Kingdom is sitting on a hefty cushion of at least $750 billion in cash reserves built up in the good years to sustain even half a decades worth of depressed oil prices.
Therefore the question we ask is: Are the Saudi’s using their oil weapon to tighten the screws on Iran while simultaneously squeezing US Shale Oil? While relations between The Kingdom and Iran have been warming in recent times, as both look on with trepidation at the rise of ISIS, The Kingdom believes that economic pressure will cool Iranian support for the Assad regime, the Central Government in Iraq and Hezbollah, all viewed by the Saudis as regional nuisances. If Saudi Arabia is able to mute and substantially weaken these factions it reestablish itself ahead of Qatar and Turkey as the regions leading Sunni power.
There is also no doubt that Saudi Arabia – and Russia for that matter – have deep pockets, and can sustain a prolonged period of depressed prices so as squeeze US Shale Oil Projects, and deter others potential entrants to enter the market. A prolonged period of lower price risks will erode profits for even the cheapest suppliers of crude from US Shale, and threatens the viability of others across the globe.
It is easy to forget how crucial oil is to the global political economy – it was only two months ago that Scottish independence campaigners were relying on Oil at $110 a barrel to balance their sums.
Supply seems set to increase, with OPEC keen to defend its market share. If global demand weakens – Japan has already slipped into recession and others are not far behind – then oil prices could fall further. In the absence of any real Middle Eastern supply shocks – read ISIS deposing of the Assad regime, controlling all of Iraq and poised on the borders ready to attack Saudi Arabia – we continue to expect Crude prices to be range bound for the moment, with pressures to the downside. Some are slightly more bullish, American government agencies are still predicting oil prices to average $83 a barrel in 2015 – though still way below the highs for 2014.
WTI Crude recovered on Monday from a low of $64 to close at $70, $60 is the next resistance level and is well supported, though some chartists are calling for a move down to $40. Such a move may be possible and represents the 2005 and 2009 low and provides good support.
Our (Humble) Opinion?
Stay clear of Emerging Market Stocks such as Nigeria – they have taken a battering and the equity index is down 15% since October – as well as other energy heavy equity markets and currencies, such as the Ruble – Barclays believes it is still 10% overvalued – and Canadian Dollar for the moment. The High Yield Market will also suffer – since US frackers have been big issuers of debt – as HSBC points out that 16% of the US high yield market is energy related.
The Norwegian Kroner hit a 5 year low against the dollar last week, and so we like entering tentative longs at these levels, with a stop at 7.70 (low of 2003). We also like going small long of WTI Crude at $60, if it gets down there again, with reserve bullets to add at $40.
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