Welcome to Finance and Fury, The Say What Wednesday Edition

Question from one of my friends – What is happening to oil prices? Is it a time to buy oil linked companies due to large losses?

Over the past few days the price of oil has plummeted

  1. On Monday – the Brent has dropped as much as 31% to just $33
    1. one of the most dramatic bouts of selling ever and is the biggest one-day drop in Brent on record
    2. Goldman’s shocking price target cut, which now expected Brent dropping into the $20s
  2. What is going on – Oil pricing war between Russia and Saudi Arabia – See different headlines –
    1. Putin Launches “War On US Shale” After Dumping Mohammed bin Salman & Breaking Up OPEC+
    2. Saudi Arabia Starts All-Out Oil War: MbS Destroys OPEC By Flooding Market, Slashing Oil Prices
  3. Truth is somewhere in the middle – OPEC and Russia oil price war – with the US industry as potential targets


Important first step when looking at oil price

OPEC – The Organisation of the Petroleum Exporting Countries – intergovernmental organisation of 14 nations – headquartered since 1965 in Vienna, Austria – International cartel

  1. Mission of the organization is to “coordinate and unify the petroleum policies of its member countries and ensure the stabilization of oil markets, in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry.”
    1. Cartel wording – to keep prices high enough to turn a profit for its members
  2. The current OPEC members are the following: Algeria, Angola, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, the Republic of the Congo, Saudi Arabia (the de facto leader), the United Arab Emirates and Venezuela. Ecuador, Indonesia and Qatar are former members
  3. But two of the world largest producers – USA as number 1 and Russia as number 3 – Are not OPEC Members – Those members not officially in OPEC are members of OPEC+ – which is where the drama starts


It appears that OPEC+ is no more

  1. Last week OPEC+ was meeting in Vienna to discuss how much supply of oil should be allowed for the year
    1. To keep prices high – supply needs to be cut
  2. Heading into Friday’s session, OPEC had been pushing for an additional 1.5 million barrels per day of cuts, reducing production by 3.6% of the world’s total supply
    1. would have required Russia and other non-OPEC states (but mostly Russia) to contribute 500,000 bpd to the extra cut.
  3. Russia said that they were unwilling to cut oil production further – The Kremlin had decided that propping up prices as the coronavirus has impacts to reduce the global energy demand would be a gift to the U.S. shale industry. 
    1. Russian Energy Minister Alexander Novak said that “considering the decision taken today, from April 1 of this year onwards, neither we nor any OPEC or non-OPEC country is required to make (oil) output cuts.”
    2. Over the past few years – US frackers had added millions of barrels of oil to the global market while Russian companies kept wells idle – and higher prices were helping USA more than Russians with lower production costs
    3. On the news – Oil prices fell more than 10% – wasn’t just the market that got a shock – a lot of the ministers were caught by surprise – like any treaty or agreement – when one party doesn’t agree – why should you do anything? So deal to cut supply fell apart


Saudi Arabia’s turn was next – Had to respond

  1. That is where the OPEC and Russia oil price war really kicked off over the weekend when Saudi Arabia aggressively cut the relative price at which it sells its crude – this was by the most in at least 20 years – in an effort to push as many barrels into the market as possible
    1. This was the first major decision since the Saudi state producer Aramco, which IPOed just before the price of oil started to drop in Jan
  2. Aramco widened the discount for its flagship Arab Light crude to refiners in north-west Europe by a hefty $8 a barrel, offering it at $10.25 a barrel under the Brent benchmark – so prices dropped
    1. In contrast, Urals, the Russian flagship crude blend, trades at a discount of about $2 a barrel under Brent –
    2. Saudis move is trying to reduce the ability of Russian companies to sell crude in Europe – which is their major market
    3. Cannibalistic competition – you take a loss short term to price out competitors then create a monopoly
    4. a flood of Saudi supply as demand is in freefall – could send oil into the $20s – what is the worst-case scenario for oil prices? Brent traded at an all-time low of $9.55 a barrel in December 1998 – also during one of the rare price wars that Saudi Arabia has launched over the last 40 years – similar to now
  3. In addition – a second announcement came right after – in addition to huge price cuts, Saudi Arabia was set to flood the market with a glut of oil to steal market share and capitalise on its just-announced massive price cuts as the kingdom plans to increase oil output next month
    1. told some market participants it could raise production much higher if needed – going well above 10 million barrels a day – up to 12 million barrels a day if needed
    2. Currently sitting at 9.7mb/d – then in April going to 10m b/d – then up to 12m if needed
  4. This is the oil markets equivalent of a declaration of war – a price war at least – but at least petrol should be cheaper


All of this means that the OPEC oil cartel is now effectively dead – at least for now

– Why do this on the Saudi’s end?

  1. Could be an attempt to impose maximum pain in the quickest possible way to both Russia and other producers, most notably shale, in an effort to bring them back to the negotiating table, and then quickly reverse the production surge and start cutting output if a deal is achieved – form of heavy-handed negotiating tactic
    1. Estimates that Russian producers may lose $100m a day out of the lower prices
    2. But it has already been tried once – back in 2014/2015 – and the result was humiliation for Saudis as not only did US shale come out stronger, but Russia had no problems absorbing the lower prices.
  2. Most likely outcome is that Russia will be able to withstand a shock price far longer than Saudi Arabia, which has budgeted for a Brent price of $58/b for 2020 (which would lead to a 6.4% budget deficit)
    1. Could lead to social unrest and government turmoil in Saudi Arabia, and may explain why earlier today Saudi crown prince launched another crackdown on dozens of royals and army officers following the arrest of powerful princes, who may compete for the throne once the public mood in Saudi Arabia turns nasty in the coming weeks
  3. Russian Minister stated – “Of course, to upset Saudi Arabia could be a risky thing, but this is Russia’s strategy at the moment – flexible geometry of interests,”
    1. Rather than flexible geometry – Russia is much more flexible in its budget at the moment – unlike the rest of OPEC+, Russia’s budget is much better prepared for a lower oil price than it was six years ago
    2. So for now the Kremlin can now sit back and wait as one after another OPEC nation and their oil producers sink into the negative territory – and its production permanently taken offline amid social unrest, resulting in far lower long-term output – Look what happened to Venezuela last time oil went down – they nationalised oil under socialist policies and wasted the premier oil manufacturer in the world – but a lot of the other OPEC nations are not much better off – third world or developing nations that rely heavily on oil
  4. All of this has Shocked OPEC and the oil markets – But now Saudi which now faces social unrest with the price of oil far below Riyadh’s budget, and – in a repeat of the Thanksgiving 2014 OPEC massacre – sending oil prices plunging by the most since the financial crisis.


The ultimate target is potentially the US shale – at least if the Russian translations can be trusted

  1. Russian state-run think tank Institute of World Economy and International Relations president Alexander Dynkin as saying, “The Kremlin has decided to sacrifice OPEC+ to stop U.S. shale producers and punish the U.S. for messing with Nord Stream 2.”Nord Stream 2is a new export gas pipeline running from Russia to Europe across the Baltic Sea
    1. Narva Bay – Just south of Finland and entering Germany in Greifswald
    2. US may look at enforcing sanctions on the completion of the pipeline
  2. So Russian initial Strategy – to not cut production and to look at boosting sales into Germany and rest of Europe – one pipeline is completed will be lower cost on exports
    1. That way Russian oil would be better than US oil for Europe – which is a big market
  3. Then Saudi strategy – drag the price of oil low enough for long enough – to make it not profitable
  4. US in the middle – A decade ago, the shale industry barely existed, and falling oil prices cushioned the blow to the U.S. economy by making energy cheaper. Today, an oil market bust could pretty quickly plunge Texas, North Dakota and Appalachia, among other places, into a recession.
    1. Estimates show that if crude drops further – 25% of shale industry producers in USA wouldn’t be producing profitably due to costs
  5. Russia may just succeed where Saudi Arabia failed in 2014, after shale – funded generously by junk bonds – not only survived the great oil price crash of 2014/2015, but has since reached record output
    1. But market isn’t the same at back then due to the fears of demand drop due to coronavirus
  6. Summary – This is nothing new – commodity world went through this in Nov 2014 with Saudi decision to (temporarily) break apart OPEC, and flood the market with oil in failed hopes of crushing US shale producers – who survived thanks to generous banks extending loan terms and even more generous buyers of junk bonds
    1. Nonetheless resulted in a painful manufacturing recession as the price of Brent cratered as low as the mid-$20’s in late 2015/early 2016
    2. And over the weekend – seems to be a repeat as Saudi Arabia launched its second scorched earth, or rather scorched oil campaign in 6 years


Effects on our market 

  1. ASX saw a massive drop on Monday 8% – Oil search down 35%, Santos down 27%, Worley down 20% – for a reason- profits due to lower demand and increased supply likely to be affected –
  2. If oil prices continue to drop – some of these companies will be put to the test – but long term – should come back up
    1. But when depends on
    2. Why I haven’t been a fan of long investment into resource companies that focus on one commodity – especially one that is controlled in the price and the supply by an international cartel
    3. We are a long way off from ‘green’ energy replacing oil – so if things bottom out – could be a good speculative buy –
  3. But Could the price drop even lower now than it did in 2014? Yes: back in 2014 there was no coronavirus panic having the potential to reduce global oil demand due to fear-mongering and Government responses
  4. But what happened to oil companies back in 2014? Compare prices to 2016 then recently before drop
    1. Worley went from $16 down to $3 – but back to $16 before their recent drop to $10
    2. Oil Search went from $10 to $6, back to $8 but has dropped to $3.36
    3. Santos – Went from $13 down to $2.84 – Went back to $8.50 before dropping to $4.92 –
  5. So these companies are volatile – but further losses are possible if prices get pushed down further than $20 – which is what the market has priced in – Could hit their 2016 low prices or less –
  6. If they rebound? Depends on what happens to the price of oil and demand

Thank you for listening to today’s episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/



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