Oil, Solar, Wind and Water Don’t Mix

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2005-2015-Oil-Prices
It would seem that the Saudis want every one of their oil competitors to go bust in the attempt to tear down the shale oil revolution, only to push oil prices back up again in the future. But do they still have control of the market? Judging by the persistent weakness observed in the oil market, it seems that everything is falling apart, all around the Arabian peninsula. And given events in Nice on Thursday, and Turkey yesterday, it appears that turmoil, is extending further afield.

Oil prices have still not fully recovered from the lows seen at the peak of the financial crisis (in February of 2009). If the current trend remains in place, the market will remain subdued for an extended period. On the one hand, this maybe exactly what the Saudis, and to some extent, the Iranians, want, in order to regain their market share and push other recent entrants out of the market; on the other hand, given that the worst of the recession is behind us, with prices  now in the $50-$60 range, that would still be below marginal costs for many oil exploring areas. In fact, one could ask whether these low prices are just the result of OPEC’s output decisions or whether they hide other developments.

Saudi Arabia’s task has been easier than it could have hoped for, due to a mix of international developments. Unlike events in 2009, when oil prices were boosted by a declining US dollar driven by the FED’s massive asset purchases, now QE has for the moment ended, and the interest rates are being talked up again. Anticipation of this event alone has driven the dollar higher, although weakness of other currencies has also contributed, (Brexit, of course, making the pound particularly vulnerable) which has had a negative impact on commodity prices in general, and of course, oil in particular.

2016 – US Outlook

While a rise in US interest rates would have a direct negative impact on oil prices, the eventual effect is usually positive. The reason for this is the fact that a rate hike usually comes at times when the economy is improving and we would then see rising economic activity. This would usually come with higher aggregate demand, which would boost the appetite for energy products.

However, as suppliers attempt to increase production to fill the higher demand for their products, this may be limited as fracked wells do not respond well to just opening spigots, they require more wells, and this requires capital. So, this time, not even an improving US economy might be able to spare oil these losses. Many feel that the excess oil production has been so large for so long, with stocks piling up everywhere, that more demand will merely offset the surplus effect stemming from aggregate output. But that may be just half the story.

Back in November 2015, the IEA predicted a rise in demand for oil of less than 1% per year until circa 2020 and modest growth rates thereafter. If these predictions transpire, it may take years for the current stockpiles to normalise and, unless OPEC and the wider world cuts production, the bearish trend for oil prices may continue for years.

This bearish oil market, is the consequence of depressed demand and over-production, and may not be reversible for several reasons.

The world is in an unfavourable growth scenario, with the US running at the front of the developed world pack, but Europe is still struggling with the aftershocks of the global recession. At the same time, the threat of rate hikes in the US is hitting oil prices and leading to capital outflows in the once high-flying emerging economies.

If the number of SUVs with new more efficient engines, Toyota Priuses, Nissan Leafs and Teslas, I’ve seen locally is anything to go by, the world is moving away from its oil dependence for transport. China is no longer hungrily demanding raw materials to grow its economy, as it moves from an investment-driven economy towards a more consumer-orientated one. Given the China outlook, any change in demand is likely to be lower, and lead commodities into a further bearish market. Because the finding and extraction of raw materials takes years to achieve, past decisions to expand capacity will take time to be reversed, as countries and companies adjust to the new reality. In the meantime, prices will take care of the imbalances but huge volatility is expected. In fact Dr.Kent Moors, sees problems for the oil production companies in the U.S., for a few years yet

So these and other important shifts in the world, – Wind power, Tidal, Solar, and increased Nuclear, with increases in efficiency are all taking their toll. Faced with high oil prices and being dependent on a small group of countries, governments and companies in oil-dependent countries invested in the development of these new energy sources and improvements in the efficiency of the existing ones. Cars, household appliances, consumer gadgets et-al, today need a fraction of the energy they once did.

This means that for the oil market to remain stable and growing, needs higher global GDP growth rates than hitherto. Unlike what many predicted decades ago, it won’t be the supply side controlling this market, leading prices higher, but rather a suspicion of ever decreasing demand. Saudi Arabia may already not be in control of this market and may run into trouble, along with any other entity that is dependent on petro-dollars. Of course, the value of the dollar, as well as whether oil is marketed worldwide in dollars, will ultimately define markets. But reports of a 45% split between oil and the water that is used in the waterflood of old oil wells, is also increasing costs of extraction for Saudi fields, and thus requires a higher commodity price, to balance Saudi national budgets.

Shares in the biggest oil companies trading in the FTSE, like Royal Dutch Shell and BP, lost 40% in the last year before their bounce back in recent months. In less than a year, oil prices retreated 60% and these companies couldn’t avoid the downturn. Smaller companies, including low-cost producers face an even bleaker outlook, as share price declines have surpassed 80% in many cases. Companies operating in the shale oil revolution have been decimated and many won’t be around by year end.

2016 – OPEC Outlook

If OPEC has in the past helped to boost a number of energy alternatives and driven gains in user-efficiency (via higher oil prices), they are now contributing to the development of improved technology on the supply side, as the low price is a great incentive for the remaining companies to increase cost efficiency. A low price will certainly drive many companies towards bankruptcy, but will also force the surviving companies to become highly efficient. Oil projects in remote areas or regions with high risks (being economic, political, or of any other type) will be delayed indefinitely, but part of the shale industry in more productive areas will remain. That industry has effectively placed a cap on oil prices. OPEC won’t be able to drive prices above a certain level, because many companies would enter the market again and force prices down.

The strategy followed by Saudi Arabia has severe shortcomings. This is no longer about the shale oil industry but also about OPEC members. The high production strategy is crippling growth, leading to capital outflows and increasing budget deficits in all OPEC members. Venezuela and Angola are heading towards complete economic and social chaos, with growth spiralling down and oil income not enough to finance government spending.

2016 – Angola & Venezuela

At the beginning of 2007, one US dollar would buy 75 Angolan kwanzas. In early July this year the exchange rate stands at 1 to 165, as a result of declining oil prices. That’s a decline of 50%, but the official rate doesn’t even reflect the observed reality, which is that people aren’t able to get US dollars from banks, and instead are forced to exchange them on the streets at a rate of 1 to circa 300. Many construction companies are already shutting down their business in the country, as the government is delaying payments.

Venezuela, is in even worse shape. In 2011, the Venezuelan Bolivar was 4.3 to the USD, but today stands at circa $1:10.0(VEF). This loss of purchasing power, caused riots after Hugo Chavez died, and the oil revenues upon which the nation depended, bought less and less on world markets. Queues for such luxuries as Toilet Rolls were seen, and the Socialist miracle of Venezuela, is gone, possibly for good.

Angola and Venezuela are the weakest links in the OPEC group and are thus expected to be the first to experience a deterioration in their financial positions following oil price declines. But they won’t be alone in the medium term.

The Long and Short of the Oil Market?

Take the Saudi Arabia case, for example. The country had a debt-to-GDP ratio of less than 2% at the end of 2014 and foreign reserves of around $738 billion (at today’s exchange rate). In a country where people don’t even have any experience of taxes, there seems to be a lot of margin to drive all others bankrupt before feeling the heat. Nevertheless, the country lost $90 billion in foreign reserves in the year to October. If this pace continues, the country will run into trouble in a matter of just a few years. From a balanced budget the country is going to hit a deficit of near 20% this year and another 20% next year (as predicted by the IMF). Oil-producing countries in the Gulf are already tapping money from their sovereign wealth funds to keep afloat.

OPEC long ago shot itself in the foot and will never recover from the damage. While Saudi Arabia tries hard to bust everyone, let’s enjoy the lower oil prices as consumers. As investors, or traders, it may be time to look for something sweeter than oil like cocoa and wait for the markets to stabilise, as price declines aren’t over yet. In the meantime, perhaps time to sell any oil-holdings, and time to buy, commodities that are undervalued and thus oversold? Can you say Gold, Silver, Platinum, Palladium or Crypto Currencies?

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