We entered the fourth quarter of 2018 with some anticipation. Driving this was the advent of complete sanctions imposed by the American government on Iran. The arrival of these sanctions had been discussed at length in an OilPrice article that took the prevailing wisdom and attempted to read through the tea leaves for direction. How wrong we were!
This anticipation was in spite of having endured a steep decline in crude prices as October waned. The oil price volatility we saw from the middle of the 4th quarter was breathtaking. It led to a single month decline of about 15 percent that has continued into early November.
Impressive and depressing at the same time, if you’re an investor.
We closed out the month of October with one significant factor that might reverse this trend. Full sanctions that were to be imposed on Iran, effectively shutting off their source of revenue.
And, then a funny thing happened. The American government did something it had steadfastly sworn it would not do. It granted waivers to these sanctions that essentially made them null in the eyes of crude traders, and they couldn’t get out of their long positions fast enough.
In this article we will review recent events and see if we can pose a thesis that will give an idea of the next move the crude market may take.
A funny thing happened on the way to the $100 oil price
After mid-October, nothing worked consistently for oil, and we saw a kind of seesaw price action, with an overall downward direction. In two weeks, we saw price declines from the high $70’s down to the mid $60’s. There were a lot of reasons for this action in the market. Primary among them.
– The dollar rules other currencies thanks to the inflation fear-driven Fed’s inexorable interest rate increases. You can now get 3 percent in a U.S. passbook account. The whole world is still easing, and the U.S. is increasing to tamp down the roaring American economy. Since crude is priced in dollars, the owners get fewer of them for their oil. Wars have been fought over this.
– We’ve had six straight weeks of major inventory builds thanks to steady drilling in NOR-AM shale plays, and Russian and Saudi pumping in advance of sanctions. Saudi imports to the U.S. are up forty percent from 2016.
– There were demand fears, due to the softening Chinese economy which, of course, is related to U.S. tariffs on imports from China.
And, just when the single thing that remained that might push oil higher; Iran sanctions kicking in on the 4th of November, the U.S. began granting exemptions which will probably make it impossible to police this policy. At least for now.
Oil dropped like a stone from November 4th.
The bromance between Putin and Mohammed bin Salman (MBS)
The question that should be asked, is why do the Kingdom of Saudi Arabia (KSA) and Russia want low oil prices? They have certainly been pumping crude like there was no tomorrow, both reaching daily volumes that have eclipsed previous record amounts. Saudis, largely in response to President Trump’s brow beating from the bully pulpit about high prices. The Russians have their own reasons for fill up the world’s teapot refineries with crude. We will discuss them later in this article.
We have established in previous articles that KSA is and always will be the swing producer of crude oil. In recent months there has been a weird bond form between the Saudis and the Russians when it comes to filling the market’s demand for crude. The two countries are issuing joint communiques, for heaven’s sake, when they have absolutely nothing in common with regard to oil prices. Nonetheless, their assurances about filling gaps left by Iran and Venezuela had worked to calm market fears about shortages due to Iran barrels coming off the market, and is a good part of the reason oil dropped no lower than it did from mid-October.
In answer to the above question, KSA doesn’t want the oil price to go any lower. It simply is not in their economic interest for it to do so. Russia is another story. Mentally the Kremlin is where KSA was four years ago, threatened by the huge export potential of American fracking, and determined to undercut it with their own production to maintain European market share. The final price be damned.
If you’re an oil bull, I think there is still some reason for optimism a few months hence. Let’s take a closer look.
Fun and games in Saudi Arabia
Let’s look at things impacting Saudi Arabia, then we’ll take on the Russians…wait, that didn’t come out right. Deal with the Russians…is that any better? Maybe a little.
Among other things, Saudi through the good offices of MBS has embarked on an ambitious economic restructuring to lessen their dependence on oil revenues at some point in the future. The success of which initiative ironically, depends on oil revenues. No one ever said the world had to make sense, right?
They do have that little ‘American’ problem that has led KSA to make decisions that don’t necessarily support their economic interests. Let’s understand, KSA is not a very secure place in the modern world. They have an ugly proxy war with Iran playing out in Yemen that is costing them billions, some estimates approach $50 bn a year for them to maintain. And, they are entirely dependent upon U.S. arms sales to continue it. That’s the little problem. They’ve had to appease Trump’s demands for a lower oil price…so far. Nor, has the Khashoggi debacle done them any favors, with bashing Saudi (and rightly so with the information available) being American politician’s new favorite pastime. In spite of the Saudis good intentions and soothing words, the wheels are about to come off this push to appease the Americans with lower oil prices.
The gorgeous, and frustrating thing about American energy policy is it often speaks out of both sides of its proverbial mouth, making it absurdly difficult for others to interpret and react to. That’s the position KSA finds itself in as it struggles to meet its own economic needs. We tell them we are going to crush their arch enemy, Iran with economic sanctions, and would they please fill up the tankers with oil…and, then we take all the teeth out of said sanctions. The Saudis would be entitled to a pout over this behavior.
A survey of sources reveals that KSA needs an oil price in the middle $80s to balance its budget. That’s probably conservative, but let’s use it, and we are currently far from it. And, heading in the wrong direction.
Bottom line, the Saudis have no interest in a lower oil price and will move to rein in supplies at their earliest opportunity. The periodic party in Vienna, should be a lively affair come December 6th.
What’s Putin up to
Russia seems to be going for market share in Europe, something that American crude exports have put at risk. The official Russian position is that oil prices will fall back into the $50’s. This is to directly blunt the impact and viability of U.S. imports. The Russians are of the opinion that U.S. needs these higher prices to for shale to remain viable, in spite of evidence to the contrary generated in the shale surge of 2017. As recently as mid-2017 the oil price was comfortably in the $40s and shale drillers were picking rigs like mad.
European countries have been held hostage to Russian energy whims for decades. Recently U.S. exports have begun to change that dynamic and the Kremlin is scrambling to protect its turf.
Russia will probably play the spoiler role, but their ability to impact the final oil price is less than KSA’s. Simply put, their goal is to maintain export markets in Europe, and stymie the U.S. for real and political reasons in the MEA. Always nice to have a strategy. Perhaps America should try have one when it comes to energy policy. A debate for a future article perhaps.
Great, what happens now?
I see a couple of things on the horizon that could bring about a reversal of fortune for oil.
The first, obviously is the outcome of the Winter OPEC meeting. Among the topics making the gossip rounds is news that a Saudi think tank (I am quoting here) is gaming a future where they go their own way. I am not going to delve into that hot mess of a topic in this article, but I would kill to be a fly on the wall.
If they decide to curtail production, and I think there is a good chance they will, given the oil currently sloshing around the world looking for buyers, the case for a rebound in prices is set in motion.
Another thing that will play a role going forward is the U.S. trade imbroglio with China. The outcome of this could actually play a role by raising demand forecasts for oil, which have weakened as the rhetoric has sharpened.
I have stated previously that I think a deal will be forthcoming. China and the U.S. have a symbiotic relationship in truth. The fact is, we need each other. There is no global market to replace the U.S as an outlet for Chinese manufacturing, and there is no alternative manufacturing in place for the cheap goods to which Americans have become addicted.
I think a deal gets done in the next couple of months.
KSA has no interest in a lower oil price and will stop answering the phone when Trump calls. Bottom line- they know long term U.S. interests center around a strong Saudi Arabia to balance Iran’s influence in the MEA, and will use that certainty to repair their balance sheet.
Russia is harder to forecast because of the political element’s influence, but on the balance, I think political goals will win the day. Putin would like to blunt U.S. influence in the MEA region and may use the price of oil to achieve this goal, even at the cost of some of their European sales. The Russians also have competing goals, maintaining their traditional European markets and buddying up to the Saudis. Trying to strike this balance will probably result in support for the oil price.
Given all of this, and in spite of the ill winds blowing currently, I don’t see oil prices falling off a cliff.