(Redacted News) China and Saudi Arabia just dealt a throat punch to the U.S. dollar. This first week of April we got our clearest sign yet that America is in serious economic trouble after China and Saudi Arabia filed new agreements on oil and trade. But the biggest problem came from the Crown Prince who said he’s done trying to please The United States.
From the very beginning, there was something off about Sunday’s unprecedented countercoup purge unleashed by Mohammad bin Salman on alleged political enemies, including some of Saudi Arabia’s richest and most powerful royals and government officials: it was just too brazen to be a simple “power consolidation” move; in fact most commentators were shocked by the sheer audacity, with one question outstanding: why take such a huge gamble? After all, there was little chatter of an imminent coup threat against either the senile Saudi King or the crown prince, MbS, and a crackdown of such proportions would only boost animosity against the current ruling royals further.
Things gradually started to make sense when it emerged that some $33 billion in oligarch net worth was “at risk” among just the 4 wealthiest arrested Saudis, which included the media-friendly prince Alwaleed.
One day later, a Reuters source reported that in a just as dramatic expansion of the original crackdown, bank accounts of over 1,200 individuals had been frozen, a number which was growing by the minute. Commenting on this land cashgrab, we rhetorically asked “So when could the confiscatory process end? As we jokingly suggested yesterday, the ruling Saudi royal family has realized that not only can it crush any potential dissent by arresting dozens of potential coup-plotters, it can also replenish the country’s foreign reserves, which in the past 3 years have declined by over $250 billion, by confiscating some or all of their generous wealth, which is in the tens if not hundreds of billions. If MbS continues going down the list, he just may recoup a substantial enough amount to what it makes a difference on the sovereign account.”
Then an article overnight from the WSJ confirmed that fundamentally, the purge may be nothing more than a forced extortion scheme, as the Saudi government – already suffering from soaring budget deficits, sliding oil revenues and plunging reserves – was “aiming to confiscate cash and other assets worth as much as $800 billion in its broadening crackdown on alleged corruption among the kingdom’s elite.“
As we reported yesterday, the WSJ writes that the country’s central bank, the Saudi Arabian Monetary Authority, said late Tuesday that it has frozen the bank accounts of “persons of interest” and said the move is “in response to the Attorney General’s request pending the legal cases against them.” But what is more notable, is that while we first suggested – jokingly – on Monday that the ulterior Saudi motive would be to simply “nationalize” the net worth of some of Saudi Arabia’s wealthiest individuals, now the WSJ confirms that this is precisely the case, and what’s more notably is that the amount in question is absolutely staggering: nearly 2x Saudi Arabia’s total foreign reserves!
As the WSJ alleges, “the crackdown could also help replenish state coffers. The government has said that assets accumulated through corruption will become state property, and people familiar with the matter say the government estimates the value of assets it can reclaim at up to 3 trillion Saudi riyal, or $800 billion.”
While much of that money remains abroad – and invested in various assets from bonds to stocks to precious metals and real estate – which will complicate efforts to reclaim it, even a portion of that amount would help shore up Saudi Arabia’s finances.
However, this is problematic: first, not only is the list of names of detained and “frozen” accounts growing by the day…
The government earlier this week vowed that it would arrest more people as part of the corruption investigation, which began around three years ago. As a precautionary measure, authorities have banned a large number of people from traveling outside the country, among them hundreds of royals and people connected to those arrested, according to people familiar with the matter. The government hasn’t officially named the people who were detained.
… but the mere shock of a move that would be more appropriate for the 1950s USSR has prompted crushed any faith and confidence the international community may have had in Saudi governance and business practices.
The biggest irony would be if from this flagrant attempt to shore up the Kingdom’s deteriorating finances, a domestic and international bank run emerged, with locals and foreign individuals and companies quietly, or not so quietly, pulling their assets and capital from confiscation ground zero, in the process precipitating the very economic collapse that the move was meant to avoid.
Judging by the market reaction, which has sent Riyal forward tumbling on rising bets of either a recession, or devaluation, or both, this unorthodox attempt to inject up to $800 billion in assets into the struggling local economy, could soon backfire spectacularly.
A prolonged period of low oil prices forced the government to borrow money on the international bond market and to draw extensively from the country’s foreign reserves, which dropped from $730 billion at their peak in 2014 to $487.6 billion in August, the latest available government data.
Confirming our speculation was advisory firm Eurasia Group, which in a note said that the crown prince “needs cash to fund the government’s investment plans” adding that “It was becoming increasingly clear that additional revenue is needed to improve the economy’s performance. The government will also strike deals with businessmen and royals to avoid arrest, but only as part of a greater commitment to the local economy.”
Of course, there is a major danger that such a draconian cash grab would result in a violent blow back by everyone who has funds parked in the Kingdom. To assuage fears, Saudi Arabia’s minister of commerce, Majid al Qasabi, on Tuesday sought to reassure the private sector that the corruption investigation wouldn’t interfere with normal business operations. The procedures and investigations undertaken by the anti-corruption agency won’t affect ongoing business or projects, he said. Furthermore, the Saudi central bank said that individual accounts had been frozen, not corporate accounts. “It is business as usual for both banks and corporates,” the central bank said.
Meanwhile, for those still confused about the current political scene in Saudi Arabia, here is an infographic courtesy of the WSJ which explains “Who Has Been Promoted, Who Has Been Detained in Saudi Arabia“
The formation of a BRICS gold marketplace, which could bypass the U.S. Petrodollar in bilateral trade, continues to take shape as Russia’s largest bank, state-owned Sberbank, announced this week that its Swiss subsidiary had begun trading in gold on the Shanghai Gold Exchange.
Russian officials have repeatedly signaled that they plan to conduct transactions with China using gold as a means of marginalizing the power of the US dollar in bilateral trade between the geopolitically powerful nations. This latest movement is quite simply the manifestation of a larger geopolitical game afoot between great powers.
According to a report published by Reuters:
Sberbank was granted international membership of the Shanghai exchange in September last year and in July completed a pilot transaction with 200 kg of gold kilobars sold to local financial institutions, the bank said.
Sberbank plans to expand its presence on the Chinese precious metals market and anticipates total delivery of 5-6 tonnes of gold to China in the remaining months of 2017.
Gold bars will be delivered directly to the official importers in China as well as through the exchange, Sberbank said.
Russia’s second-largest bank VTB is also a member of the Shanghai Gold Exchange.
To be clear, there is a revolutionary transformation of the entire global monetary system currently underway, being driven by an almost perfect storm. The implications of this transformation are extremely profound for U.S. policy in the Middle East, which for nearly the past half century has been underpinned by its strategic relationship with Saudi Arabia.
The dollar was established as the global reserve currency in 1944 with the Bretton Woods agreement, commonly referred to as the gold standard. The U.S. leveraged itself into this power position by holding the largest reserve of gold in the world. The dollar was pegged at $35 an ounce — and freely exchangeable into gold.
By the 1960s, a surplus of U.S. dollars caused by foreign aid, military spending, and foreign investment threatened this system, as the U.S. did not have enough gold to cover the volume of dollars in worldwide circulation at the rate of $35 per ounce; as a result, the dollar was overvalued.
America temporarily embraced a new paradigm in 1971, as the dollar became a pure fiat currency (decoupled from any physical store of value), until the petrodollar agreement was concluded by President Nixon in 1973.
The quid pro quo was that Saudi Arabia would denominate all oil trades in U.S. dollars, and in return, the U.S. would agree to sell Saudi Arabia military hardware and guarantee the defense of the Kingdom.
A report by the Centre for Research on Globalization clarifies the implications of these most recent moves by the Russians and the Chinese in an ongoing drive to replace the US petrodollar as the global reserve currency:
Fast forward to March 2017; the Russian Central Bank opened its first overseas office in Beijing as an early step in phasing in a gold-backed standard of trade. This would be done by finalizing the issuance of the first federal loan bonds denominated in Chinese yuan and to allow gold imports from Russia.
The Chinese government wishes to internationalize the yuan, and conduct trade in yuan as it has been doing, and is beginning to increase trade with Russia. They’ve been taking these steps with bilateral trading, native trading systems and so on. However, when Russia and China agreed on their bilateral US$400 billion pipeline deal, China wished to, and did, pay for the pipeline with yuan treasury bonds, and then later for Russian oil in yuan.
This evasion of, and unprecedented breakaway from, the reign of the US dollar monetary system is taking many forms, but one of the most threatening is the Russians trading Chinese yuan for gold. The Russians are already taking Chinese yuan, made from the sales of their oil to China, back to the Shanghai Gold Exchange to then buy gold with yuan-denominated gold futures contracts – basically a barter system or trade.
The Chinese are hoping that by starting to assimilate the yuan futures contract for oil, facilitating the payment of oil in yuan, the hedging of which will be done in Shanghai, it will allow the yuan to be perceived as a primary currency for trading oil. The world’s top importer (China) and exporter (Russia) are taking steps to convert payments into gold. This is known. So, who would be the greatest asset to lure into trading oil for yuan? The Saudis, of course.
All the Chinese need is for the Saudis to sell China oil in exchange for yuan. If the House of Saud decides to pursue that exchange, the Gulf petro-monarchies will follow suit, and then Nigeria, and so on. This will fundamentally threaten the petrodollar.
According to a report by the Russian government media, significant progress has been made in promoting bilateral trade in yuan, between the two nations, as the first step towards an even more ambitious plan—using gold to make transactions:
One measure under consideration is the joint organization of trade in gold. In recent years, China and Russia have been the world’s most active buyers of the precious metal.
On a visit to China last year, deputy head of the Russian Central Bank Sergey Shvetsov said that the two countries want to facilitate more transactions in gold between the two countries.
In April, Sberbank expressed interest in financing the direct import of gold to India—also a BRICS member. Make no mistake that a BRICS gold marketplace could be used to bypass the dollar in bilateral trade, and undermine the hegemonic control enjoyed by the US petrodollar as the global reserve currency.
“In 2014 Russia and China signed two mammoth 30-year contracts for Russian gas to China. The contracts specified that the exchange would be done in Renminbi [yuan] and Russian rubles, not in dollars. That was the beginning of an accelerating process of de-dollarization that is underway today.” according to strategic risk consultant F. William Engdahl.
Russia and China are now creating a new paradigm for the world economy and paving the way for a global de-dollarization.
“A Russian-Chinese alternative to the dollar in the form of a gold-backed ruble and gold-backed Renminbi or yuan, could start a snowball exit from the US dollar, and with it, a severe decline in America’s ability to use the reserve dollar role to finance her wars with other peoples’ money,”
Source: The Most Revolutionary Act
We grow up being taught a very specific set of principles.
One plus one equals two. I before E, except after C.
As we grow older, the principles become more complex.
Take economics for example.
The law of supply states that the quantity of a good supplied rises as the market price rises, and falls as the price falls. Conversely, the law of demand states that the quantity of a good demanded falls as the price rises, and vice versa.
These basic laws of supply and demand are the fundamental building blocks of how we arrive at a given price for a given product.
At least, that’s how it’s supposed to work.
But what if I told you that the principles you grew up learning is wrong?
With today’s “creative” financial instruments, much of what you learned no longer applies in the real world.
Especially when it comes to oil.
Long time readers of this Letter will have read many of my blogs regarding commodities manipulation.
With oil, price manipulation couldn’t be more obvious.
For example, from my Letter, “Covert Connection Between Saudi Arabia and Japan“:
“…While agencies have found innovative ways to explain declining oil demand, the world has never consumed more oil.
In 2010, the world consumed a record 87.4 million barrels per day. This year (2014), the world is expected to consume a new record of 92.7 million barrels per day.
Global oil demand is still expected to climb to new highs.
If the price of oil is a true reflection of supply and demand, as the headlines tell us, it should reflect the discrepancy between supply and demand.
Since we know that demand is actually growing, that can’t be the reason for oil’s dramatic drop.
So does that mean it’s a supply issue? Did the world all of a sudden gain 40% more oil? Obviously not.
So no, the reason behind oil’s fall is not the causality of supply and demand.
The reason is manipulation. The question is why.
I go on to talk about the geopolitical reasons of why the price of oil is manipulated.
Here’s one example:
“On September 11, Saudi Arabia finally inked a deal with the U.S. to drop bombs on Syria.
But why?
Saudi Arabia possesses 18 per cent of the world’s proven petroleum reserves and ranks as the largest exporter of petroleum.
Syria is home to a pipeline route that can bring gas from the great Qatar natural gas fields into Europe, making billions of dollars for Saudi Arabia as the gas moves through while removing Russia’s energy stronghold on Europe.
Could the U.S. have persuaded Saudi Arabia, during their September 11 meeting, to lower the price of oil in order to hurt Russia, while stimulating the American economy?
… On October 1, 2014, shortly after the U.S. dropped bombs on Syria on September 26 as part of the September 11 agreement, Saudi Arabia announced it would be slashing prices to Asian nations in order to “compete” for crude market share. It also slashed prices to Europe and the United States.”
Following Saudi Arabia’s announcement, oil prices have plunged to a level not seen in more than five years.
Is it a “coincidence” that shortly after the Saudi Arabia-U.S. meeting on the coincidental date of 9-11, the two nations inked a deal to drop billions of dollars worth of bombs on Syria? Then just a few days later, Saudi Arabia announces a massive price cut to its oil.
Coincidence?
There are many other factors – and conspiracies – in oil price manipulation, such as geopolitical attacks on Russia and Iran, whose economies rely heavily on oil. Saudi Arabia is also flooding the market with oil – and I would suggest that it’s because they are rushing to trade their oil for weapons to lead an attack or beef up their defense against the next major power in the Middle East, Iran.
However, all of the reasons, strategies or theories of oil price manipulation could only make sense if they were allowed by these two major players: the regulators and the Big Banks.
On any given day, if you were to look at the spot price of oil, you’d likely be looking at a quote from the NYMEX in New York or the ICE Futures in London. Together, these two institutions trade most of the oil that creates the global benchmark for oil prices via oil futures contracts on West Texas Intermediate (WTI) and North Sea Brent (Brent).
What you may not see, however, is who is trading this oil, and how it is being traded.
Up until 2006, the price of oil traded within reason. But all of a sudden, we saw these major price movements. Why?
Because the regulators allowed it to happen.
Here’s a review from a 2006 US Senate Permanent Subcommittee on Investigations report:
“Until recently, U.S. energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud.
In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called ”futures look-a likes.”
The only practical difference between futures look-alike contracts and futures contracts is that the look-a likes are traded in unregulated markets whereas futures are traded on regulated exchanges.
The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress.
The impact on market oversight has been substantial.
NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports (LTR), together with daily trading data providing price and volume information, are the CFTC’s primary tools to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation.
…In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight.
In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (”open interest”) at the end of each day.
The CFTC’s ability to monitor the U.S. energy commodity markets was further eroded when, in January of this year (2006), the CFTC permitted the Intercontinental Exchange (ICE), the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of U.S. crude oil futures on the ICE futures exchange in London-called ”ICE Futures.”
Previously, the ICE Futures exchange in London had traded only in European energy commodities-Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICE Futures exchange is regulated solely by the United Kingdom Financial Services rooority. In 1999, the London exchange obtained the CFTC’s permission to install computer terminals in the United States to permit traders here to trade European energy commodities through that exchange.
Then, in January of this year, ICE Futures in London began trading a futures contract for West Texas Intermediate (WTI) crude oil, a type of crude oil that is produced and delivered in the United States. ICE Futures also notified the CFTC that it would be permitting traders in the United States to use ICE terminals in the United States to trade its new WTI contract on the ICE Futures London exchange.
Beginning in April, ICE Futures similarly allowed traders in the United States to trade U.S. gasoline and heating oil futures on the ICE Futures exchange in London. Despite the use by U.S. traders of trading terminals within the United States to trade U.S. oil, gasoline, and heating oil futures contracts, the CFTC has not asserted any jurisdiction over the trading of these contracts.
Persons within the United States seeking to trade key U.S. energy commodities-U.S. crude oil, gasoline, and heating oil futures-now can avoid all U.S. market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.
As an increasing number of U.S. energy trades occurs on unregulated, OTC electronic exchanges or through foreign exchanges, the CFTC’s large trading reporting system becomes less and less accurate, the trading data becomes less and less useful, and its market oversight program becomes less comprehensive.
The absence of large trader information from the electronic exchanges makes it more difficult for the CFTC to monitor speculative activity and to detect and prevent price manipulation. The absence of this information not only obscures the CFTC’s view of that portion of the energy commodity markets, but it also degrades the quality of information that is reported.
A trader may take a position on an unregulated electronic exchange or on a foreign exchange that is either in addition to or opposite from the positions the trader has taken on the NYMEX, and thereby avoid and distort the large trader reporting system.
Not only can the CFTC be misled by these trading practices, but these trading practices could render the CFTC weekly publication of energy market trading data, intended to be used by the public, as incomplete and misleading.”
Simply put, any one can now speculate and avoid being tagged with illegal price. The more speculative trading that occurs, the less “real” price discovery via true supply and demand become.
With that in mind, you can now see how the big banks have gained control and cornered the oil market.
Continued from the Report:
“…Over the past few years, large financial institutions, hedge funds, pension funds, and other investment funds have been pouring billions of dollars into the energy commodities markets…to try to take advantage of price changes or to hedge against them.
Because much of this additional investment has come from financial institutions and investment funds that do not use the commodity as part of their business, it is defined as ”speculation” by the Commodity Futures Trading Commission (CFTC).
…Reports indicate that, in the past couple of years, some speculators have made tens and perhaps hundreds of millions of dollars in profits trading in energy commodities.
This speculative trading has occurred both on the regulated New York Mercantile Exchange (NYMEX) and on the over-the-counter (OTC) markets.
The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil to be delivered in the future in the same manner that additional demand for the immediate delivery of a physical barrel of oil drives up the price on the spot market.
As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.
Although it is difficult to quantify the effect of speculation on prices, there is substantial evidence that the large amount of speculation in the current market has significantly increased prices.
Several analysts have estimated that speculative purchases of oil futures have added as much as $20-$25 per barrel to the current price of crude oil, thereby pushing up the price of oil from $50 to approximately $70 per barrel.”
The biggest banks in the world, such as Goldman Sachs, Morgan Stanley, Citigroup, JP Morgan, are now also the biggest energy traders; together, they not only participate in oil trades, but also fund numerous hedge funds that trade in oil.
Knowing how easy it is to force the price of oil upwards, the same strategies can be done in reverse to force the price of oil down.
All it takes is for some media-conjured “report” to tell us that Saudi Arabia is flooding the market with oil, OPEC is lowering prices, or that China is slowing, for oil to collapse.
Traders would then go short oil, kicking algo-traders into high gear, and immediately sending oil down further. The fact that oil consumption is actually growing really doesn’t matter anymore.
In reality, oil price isn’t dictated by supply and demand – or OPEC, or Russia, or China – it is dictated by the Western financial institutions that trade it.
Via my past Letter, “Secrets of Bank Involvement in Oil Revealed“:
“For years, I have been talking about how the banks have taken control of our civilization.
…With oil prices are falling, economies around the world are beginning to feel the pain causing a huge wave of panic throughout the financial industry. That’s because the last time oil dropped like this – more than US$40 in less than six months – was during the financial crisis of 2008.
…Let’s look at the energy market to gain a better perspective.
The energy sector represents around 17-18 percent of the high-yield bond market valued at around $2 trillion.
Over the last few years, energy producers have raised more than a whopping half a trillion dollars in new bonds and loans with next to zero borrowing costs – courtesy of the Fed.
This low-borrowing cost environment, along with deregulation, has been the goose that laid the golden egg for every single energy producer. Because of this easy money, however, energy producers have become more leveraged than ever; leveraging themselves at much higher oil prices.
But with oil suddenly dropping so sharply, many of these energy producers are now at serious risk of going under.
In a recent report by Goldman Sachs, nearly $1 trillion of investments in future oil projects are at risk.
…It’s no wonder the costs of borrowing for energy producers have skyrocketed over the last six months.
…many of the companies are already on the brink of default, and unable to make even the interest payments on their loans.
…If oil continues in this low price environment, many producers will have a hard time meeting their debt obligations – meaning many of them could default on their loans. This alone will cause a wave of financial and corporate destruction. Not to mention the loss of hundreds of thousands of jobs across North America.”
You may be thinking, “if oil’s fall is causing a wave of financial disaster, why would the banks push the price of oil down? Wouldn’t they also suffer from the loss?”
Great question. But the banks never lose. Continued from my letter:
“If you control the world’s reserve currency, but slowly losing that status as a result of devaluation and competition from other nations (see When Nations Unite Against the West: The BRICS Development Bank), what would you do to protect yourself?
You buy assets. Because real hard assets protect you from monetary inflation.
With the banks now holding record amounts of highly leveraged paper from the Fed, why would they not use that paper to buy hard assets?
Bankers may be greedy, but they’re not stupid.
The price of hard physical assets is the true representation of inflation.
Therefore, if you control these hard assets in large quantities, you could also control their price.
This, in turn, means you can maintain control of your currency against monetary inflation.
And that is exactly what the banks have done.
Last month, the U.S. Senate’s Permanent Subcommittee on Investigations published a 403-page report on how Wall Street’s biggest banks, such as Goldman Sachs, Morgan Stanley, and JP Morgan, have gained ownership of a massive amount of commodities, food, and energy resources.
The report stated that “the current level of bank involvement with critical raw materials, power generation, and the food supply appears to be unprecedented in U.S. history.”
For example:
“…Until recently, Morgan Stanley controlled over 55 million barrels of oil storage capacity, 100 oil tankers, and 6,000 miles of pipeline. JPMorgan built a copper inventory that peaked at $2.7 billion, and, at one point, included at least 213,000 metric tons of copper, comprising nearly 60% of the available physical copper on the world’s premier copper trading exchange, the LME.
In 2012, Goldman owned 1.5 million metric tons of aluminum worth $3 billion, about 25% of the entire U.S. annual consumption. Goldman also owned warehouses which, in 2014, controlled 85% of the LME aluminum storage business in the United States.” – Wall Street Bank Involvement with Physical Commodities, United States Senate Permanent Subcommittee on Investigations
From pipelines to power plants, from agriculture to jet fuel, these too-big-to-fail banks have amassed – and may have manipulated the prices – of some of the world’s most important resources.
The above examples clearly show just how much influence the Big Banks have over our commodities through a “wide range of risky physical commodity activities which included, at times, producing, transporting, storing, processing, supplying, or trading energy, industrial metals, or agricultural commodities.”
With practically an unlimited supply of cheap capital from the Federal Reserve, the Big Banks have turned into much more than lenders and facilitators. They have become direct commerce competitors with an unfair monetary advantage: free money from the Fed.
Of course, that’s not their only advantage.
According to the report, the Big Banks are engaging in risky activities (such as ownership in power plants and coal mining), mixing banking and commerce, affecting prices, and gaining significant trading advantages.
Just think about how easily it would be for JP Morgan to manipulate the price of copper when they – at one point – controlled 60% of the available physical copper on the world’s premier copper trading exchange, the LME.
How easy would it be for Goldman to control the price of aluminum when they owned warehouses – at one point – that controlled 85% of the LME aluminum storage business in the United States?
And if they could so easily control such vast quantities of hard assets, how easy would it be for them to profit from going either short or long on these commodities?
But if, for some reason, the bankers’ bets didn’t work out, they still wouldn’t lose.
That’s because these banks are holders of trillions of dollars in FDIC insured deposits.
In other words, if any of the banks’ pipelines rupture, power plants explode, oil tankers spill, or coal mines collapse, taxpayers may once again be on the hook for yet another too-big-to-fail bailout.
If you think that there’s no way that the government or the Fed would allow this to happen again after 2008, think again.
Via the Guardian:
“In a small provision in the budget bill, Congress agreed to allow banks to house their trading of swaps and derivatives alongside customer deposits, which are insured by the federal government against losses.
The budget move repeals a portion of the Dodd-Frank financial reform act and, some say, lays the groundwork for future bailouts of banks who make irresponsibly risky trades.”
Recall from my past letters where I said that the Fed wants to engulf you in their dollars. If yet another bailout is required, then the Fed would once again be the lender of last resort, and Americans will pile on the debt it owes to the Fed.
It’s no wonder that in the report, it actually notes that the Fed was the facilitator of this sprawl by the banks:
“Without the complementary orders and letters issued by the Federal Reserve, many of those physical commodity activities would not otherwise have been permissible ‘financial’ activities under federal banking law. By issuing those complementary orders, the Federal Reserve directly facilitated the expansion of financial holding companies into new physical commodity activities.”
The Big Banks have risked tons of cash lending and facilitating in oil business. But in reality they haven’t risked anything. They get free money from the Fed, and since they aren’t supposed to be directly involved in natural resources, they obtain control in other ways.
Remember, the big banks – and ultimately the Fed who controls them – are the ones who truly control the world. Their monetary actions are the cause of many of the world’s issues and have been used for many years to maintain control of other nations and the world’s resources.
But they can’t simply go into a country, put troops on the ground and take over. No, that would be inhumane.
So what do they do?
Via my past Letter, The Real Reason for War in Syria:
“Currency manipulation allows developed countries to print and lend to other developing countries at will.
A rich nation might go into a developing nation and lend them millions of dollars to build bridges, schools, housing, and expand their military efforts. The rich nation convinces the developing nation that by borrowing money, their nation will grow and prosper.
However, these deals are often negotiated at a very specific and hefty cost; the lending nation might demand resources or military and political access. Of course, developing nations often take the loans, but never really have the chance to pay it back.
When the developing nations realize they can’t pay back the loans, they’re at the mercy of the lending nations.
The trick here is that the lending nations can print as much money as they want, and in turn, control the resources of developing nations. In other words, the loans come at a hefty cost to the borrower, but at no cost to the lender.”
This brings us back to oil.
We know that oil’s crash has put a heavy burden on many debt facilities that are associated with oil. We also know that the big banks are all heavily leveraged within the sector.
If that is the case, why are the big banks so calm?
The answer is simple.
Most of the loans associated with oil are done through asset-backed loans, or reserve-based financing.
It means that the loans are backed by the underlying asset itself: the oil reserves.
So if the loans go south, guess who ends up with the oil?
According to Reuters, JP Morgan is the number one U.S. bank by assets. And despite its energy exposure assumed at only 1.6 percent of total loans, the bank could own reserves of up to $750 million!
Via Reuters:
“If oil reaches $30 a barrel – and here we are – and stayed there for, call it, 18 months, you could expect to see (JPMorgan’s) reserve builds of up to $750 million.”
No wonder the banks aren’t worried about a oil financial contagion – especially not Jamie Dimon, JP Morgan’s Chairman, CEO and President:
“…Remember, these are asset-backed loans, so a bankruptcy doesn’t necessarily mean your loan is bad.” – Jamie Dimon
As oil collapses and defaults arise, the banks have not only traded dollars for assets on the cheap, but gained massive oil reserves for pennies on the dollar to back the underlying contracts of the oil that they so heavily trade.
The argument to this would be that many emerging markets have laws in place that prevent their national resources from being turned over to foreign entities in the case of corporate defaults.
Which, of course, the U.S. and its banks have already prepared for.
Via my Letter, How to Seize Assets Without War:
“…If the Fed raises interest rates, many emerging market economies will suffer the consequence of debt defaults. Which, historically means that asset fire sales – often commodity-based assets such as oil and gas – are next.
Historically, if you wanted to seize the assets of another country, you would have to go to war and fight for territory. But today, there are other less bloody ways to do that.
Take, for example, Petrobras – a semi-public Brazilian multinational energy corporation.
…Brazil is in one of the worst debt positions in the world with much of its debt denominated in US dollars.
Earlier this year (2015), Petrobras announced that it is attempting to sell $58 billion of assets – an unprecedented number in the oil industry.
Guess who will likely be leading the sale of Petrobras assets? Yup, American banks.
Via Reuters:
“…JPMorgan would be tasked with wooing the largest number of bidders possible for the assets and then structure the sales.”
As history has shown, emerging market fire sales due to debt defaults are often won by the US or its allies. Thus far, it appears the Petrobras fire sale may be headed that way.
Via WSJ:
‘Brazilian state-run oil company Petróleo Brasileiro SA said Tuesday (September 22, 2015) it is closing a deal to sell natural-gas distribution assets to a local subsidiary of Japan’s Mitsui & Co.’
The combination of monetary policy and commodities manipulation allows Western banks and allies to accumulate hard assets at the expense of emerging markets. And this has been exactly the plan since day one.
As the Fed hints of raising rates, financial risks among emerging markets will continue to build. This will trigger a reappraisal of sovereign and corporate risks leading to big swings in capital flows.”
Not only are many of the big banks’ practices protected by government and Fed policies, but they’re also protected by the underlying asset itself. If things go south, the bank could end up owning a lot of oil reserves.
No wonder they’re not worried.
And since the banks ultimately control the price of oil anyway, it could easily bring the price back up when they’re ready.
Controlling the price of oil gives U.S. and its banks many advantages.
For example, the U.S. could tell the Iranians, the Saudis, or other OPEC nations, whose economies heavily rely on oil, “Hey, if you want higher oil prices, we can make that happen. But first, you have to do this…”
You see how much control the U.S., and its big banks, actually have?
At least, for now anyway.
Don’t think for one second that nations around the world don’t understand this.
Just ask Venezuela, and many of the other countries that have succumbed to the power of the U.S. Many of these countries are now turning to China because they feel they have been screwed.
The diversification away from the U.S. dollar is the first step in the uprising against the U.S. by other nations.
As the power of the U.S. dollar diminishes, through international currency swaps and loans, other trading platforms that control the price of commodities (such as the new Shanghai Oil Exchange) will become more prominent in global trade; thus, bringing some price equilibrium back to the market.
And this is happening much faster than you expect.
Via Xinhuanet:
Chinese President Xi Jinping returned home Sunday after wrapping up a historic trip to Saudi Arabia, Egypt, and Iran with a broad consensus and 52 cooperation agreements set to deepen Beijing’s constructive engagement with the struggling yet promising region.
During Xi’s trip, China upgraded its relationship with both Saudi Arabia and Iran to a comprehensive strategic partnership and vowed to work together with Egypt to add more values to their comprehensive strategic partnership.
Regional organizations, including the Organization of Islamic Cooperation (OIC), the Cooperation Council for the Arab States of the Gulf (GCC) and the Arab League (AL), also applauded Xi’s visit and voiced their readiness to cement mutual trust and broaden win-win cooperation with China.
AL Secretary General Nabil al-Arabi said China has always stood with the developing world, adding that the Arab world is willing to work closely with China in political, economic as well as other sectors for mutual benefit.
The Belt and Road Initiative, an ambitious vision Xi put forward in 2013 to boost inter-connectivity and common development along the ancient land and maritime Silk Roads, has gained more support and popularity during Xi’s trip.
…Xi and leaders of the three nations agreed to align their countries’ development blueprints and pursue mutually beneficial cooperation under the framework of the Belt and Road Initiative, which comprises the Silk Road Economic Belt and the 21st Century Maritime Silk Road.
The initiative, reiterated the Chinese president, is by no means China’s solo, but a symphony of all countries along the routes, including half of the OIC members.
During Xi’s stay in Saudi Arabia, China, and the GCC resumed their free trade talks and “substantively concluded in principle the negotiations on trade in goods.” A comprehensive deal will be made within this year.”
In other words, the big power players in the Middle East – who produce the majority of the world’s oil – are now moving closer to cooperation with China, and away from the U.S.
As this progresses, it means the role of the U.S. dollar, and its value in world trade, will diminish.
And the big banks, which hold trillions of dollars in U.S. assets, aren’t concerned.
They’d much rather own the underlying assets.
Seek the truth,
by Ivan Lo for The Equedia Letter
As the strategy of Saudi Arabia becomes clearer, along with the response of shale producers to low oil prices, the question now has to be asked as to whether or not the big oil companies support the decision by Saudi Arabia to crush frackers until they have to offer their various plays at fire sale prices.
With the emergence of frackers came a significant number of new competitors in the market that didn’t have an interest in playing nice with OPEC and Saudi Arabia, as major oil companies have in the past. This was a real threat as other OPEC members and shale companies started to take share away from Saudi Arabia.
The general consensus is Saudi Arabia isn’t interested in crushing any particular competitor, rather it’ll keep production at high levels until the weakest producers capitulate. I have thought that as well until recently.
What changed my thinking was analyzing who was the biggest threat to OPEC and Saudi Arabia, and in fact it is the shale industry in the U.S. The reason I draw that conclusion is the energy industry had its traditional competitors in place for many years, and other than occasional moves to impact the price of oil using production levels as the weapon, it has been a relatively stable industry. Shale changed all that.
I think what bothered Saudi Arabia in particular was it didn’t have a working relationship with many of these new competitors, who have been very aggressive with expanding production capacity over the last few years. They were in fact real competitors who were working to take market share away from existing players. And with Saudi Arabia being the low-cost producer with the highest reserves in the world, it was without a doubt a direct assault on its authority and leverage it historically has had on the oil market. Its response to frackers is obvious: it isn’t willing to give up share for any reason.
Where the challenge for Saudi Arabia now is it has started to have to draw on its own reserves and issue bonds to make up for budget shortfalls. It has plenty of reserves, but it appears we now have a clear picture on when it would really come under pressure, which is within a four to five year period. That’s the time it has to devastate its shale competitors.
The other problem for the country is it could take down some members of OPEC in the process, where there are already significant problems they’re facing, which could lead to unrest.
From a pure oil perspective, it seems to be an easy read. Saudi Arabia can outlast the small shale producers with no problem. I think that’s its goal. But it is putting enormous pressure on other countries as well, and there will be increasing pressure for them to slow production in order to support oil prices.
This even extends to Russia, which produces more oil than any other country.
My belief is Saudi Arabia is attempting to force consolidation in the shale industry, so it can resume its dealings with big oil players it has worked with for many years. I believe it’s also what big oil players want. All they have to do is sit back and experience some temporary pain and wait for some of the attractive plays to come onto the market at low prices.
So far the price is still high in the U.S., but as time goes on, the smaller companies will be forced to sell, one way or another. That’s the big opportunity for investors. Identifying those companies with the resources and desire to acquire these properties is the key. That and evaluating the plays with the most potential for those buying them up.
There are analysts predicting oil price levels that are all over the board. I’ve seen those that believe it’s going to shoot up to over $100 per barrel again, and those that have estimated it could fall to as low as $15 per barrel.
The best way to analyze this is to consider what Saudi Arabia can handle over the longest period of time without destroying its own economy and industry, meaning at what price it can remain fairly healthy and outlast its competitors.
Looking at the price movement of oil and the range it’s now settled into, I think it’s close to what the Saudi have been looking for.
Most smaller shale producers will struggle to make it, if the price of oil remains under $60 per barrel, which it will probably do until Saudi Arabia cuts back on production. There will be occasional moves above that, and probably below $50 per barrel again as well, but I think we can now look to somewhere in the $50 per barrel area as the target being sought. We’ll probably see this be the price range oil will move in for the next couple of years, with $50 being the desired low and $60 being the desired high.
I don’t mean by this Saudi Arabia can absolutely control the price of oil, but it can influence the range it operates in, and I think that’s where we are now.
For that reason oil investors should be safe in investing under these assumptions, understanding there will be occasional price moves outside of that range because of usual trading momentum.
Some may question why the price of oil got slammed not too long ago, falling below $40 per barrel, if the probable price range for oil is about $10 to $20 per barrel higher.
As mentioned above, some of that was simply from trading momentum. It didn’t take long for it to rebound soon afterward.
The other element was the response by shale companies to the new price of oil, which threatened their ability to pay interest on loans that were due.
Frackers weren’t boosting production because they believed they could outlast Saudi Arabia; they kept production levels high because they had to continue to sell even into that low-price environment or default on their payments. This was a major factor in why prices dropped so far over the short term.
With the bulk of the over $5 trillion spent on shale exploration and development coming from companies operating in the U.S., that is also where the bulk of the risk is.
Much of the efficiencies have been wrung out of operations, and moving to higher producing wells that are less costly to operate can only last so long. I believe efficiencies will position some in the industry to survive the current competitive environment, but they will also have to have enough reserves to tap into in order to do so.
Top producing shale wells are at their highest level of productivity in the first 6 months it goes into operation. It gradually fades after that.
Larger players like EOG Resources (NYSE:EOG) have continued to drill, but they are stopping short of production, with approximately 320 DUC wells ready to bring online when the price of oil reaches desired levels. Its smaller competitors don’t have the resources to wait out existing production levels, which is what will again offer the opportunity for patient investors.
In other words, most of what can be done has been or is currently being done, and from now on it’s simply a waiting game to see how long the Saudis are willing to keep the oil flowing.
Most shale producers believed the lowest oil prices would sustainably fall and would be about $70 per barrel. Decisions were made based upon that assumption.
Saudi Arabia and big international energy companies have had close relationships a long time via Saudi Aramco, the state-owned firm.
Those relationships, while competitive, still operated within parameters most agreed upon. Shale producers weren’t playing that game, as they invested trillions and aggressively went after market share. If Saudi Arabia wanted to maintain market share, it had to respond.
If the smaller shale producers thought their strategy though, they must have underestimated the will of Saudi Arabia to fight back against them. Either that or they became overly optimistic and started to believe their own press about the shale revolution.
It’s a revolution for sure, but the majority of those that helped launch it won’t be finishing it.
My point is big oil, in my opinion, doesn’t mind quietly standing on the sidelines as their somewhat friendly competitors destroys their competition and prepares the way for them to acquire shale properties at extremely attractive prices.
I’ve said for some time the shale revolution will go on. The oil isn’t going anywhere. What is changing is who the players will end up being, and what properties they’ll end up acquiring.
With EOG, the strongest shale player, it said the prices of those plays now for sale are still too high; that means the smaller players still think they have some leverage.
My only thought is they are hoping for the large players to enter a bidding war and they can at least recoup some of their capital. I think they’re going to wait until they’re desperate and have no more options.
Sure, some big players may lose out on a desirable property or two, but everyone will get a piece of the action. It appears once the prices move down to levels they’re looking for, at that time they’ll swoop in and make their bids. At that time it’s going to be a buyer’s market.
Big oil companies are the preferable players Saudi Arabia wants to do business with and compete against. They will play the game with them, and there won’t be a lot of surprises.
Some of the larger companies that have already filed for bankruptcy this year include Hercules Offshore (NASDAQ:HERO), Sabine Oil & Gas (SOGC) and Quicksilver Resources (OTCPK:KWKAQ).
Companies known to have hired advisers for that purpose are Swift Energy (NYSE:SFY) and Energy XXI Ltd. (NASDAQ:EXXI).
Some under heavy pressure include Halcón Resources Corporation (NYSE:HK), SandRidge Energy, Inc. (NYSE:SD) and Rex Energy Corporation (NASDAQ:REXX).
There are more in each category, but I included only those that had at least a decent market cap, with the exception of those that already declared bankruptcy.
Here are a couple of other companies to look at going forward, which can be used for the purpose of analyzing ongoing low prices.
Stone Energy’s credit facility of $500 million is reaffirmed, but may not be liquid enough to endure the next couple of years, even though in the short term it does have decent liquidity. If Saudi Arabia keeps up the pressure, it’s doubtful it will be able to survive on its own. There are quite a few companies falling under these parameters, including Laredo (NYSE:LPI). The basic practice of all of them was to limit the amount of leverage they have in place in order not to have paying off interest as the priority use of their capital, while maintaining a strong credit facility.
I’m not saying these companies will survive, but they will survive if the price of oil stays low, but it will take a lot more to root them up than their highly leveraged peers.
Clayton Williams (NYSE:CWEI) recently put itself up for sale because it can’t afford to continue operating at these prices. It has approximately 340,000 acres under its control, and two of the most productive shale basins in the U.S.
Once it announced it was open to selling, the share price skyrocketed, but since it’s struggling to afford extracting the oil, it’s puzzling as to why some believe it’s going to attract a premium price. It’s possible because of the quality of assets, but it would make more sense for larger companies to wait.
This will be a good test on how big oil companies are going to respond. It’s possible they may be willing to pay for the higher quality shale plays, but under these conditions shareholders would resist paying a significant premium.
If Clayton Williams does go for a premium, it doesn’t in any way mean that’s how it’ll work out for most of the shale companies.
There would have to be a significant reason they would pay such a high price. In the case of CWEI, the catalyst would be high production.
All of this sounds neatly packaged, and if all things proceed as planned, this is how it will play out.
Where there could be some risk is if the Middle East explodes and oil production is interrupted. That would change this entire scenario, and if it were to happen soon, shale companies still in operation would not only survive, but thrive.
Barring that level of disruption, which would have to be something huge, this is how it will play out. After all, with everything going on there now, it hasn’t done anything to disrupt Middle East oil. It would take a big event or a series of events to bring it about. That’s definitely a possibility, but it’s one that is unlikely.
Once all of this plays out, there is no doubt in my mind the bigger oil companies will be much stronger and able to produce a lot more oil.
What we’ll probably see happen is for them to cut back on production to levels where everyone is happy, including the Saudi.
That’s what this war is all about, because shale oil deposits remain in the ground. While some companies can quickly resume production because of the nature of shale oil, which can ramp up production fast, it depends on the will and determination of Saudi Arabia and whether or not the geopolitical situation remains under control.
I don’t care too much about the number of rig counts in shale plays because production can be resumed or initiated quick. The risk is how leveraged the shale companies are, and whether or not they have to continue production at a loss in order to pay off their interest on loans in hopes the price of oil will rise.
What I’m looking for with existing plays is for companies like EOG Resources, which continues to develop wells, but does so without the idea of completing them and bringing them into production until the price of oil rebounds.
Shale oil in the U.S. is alive and well, but those companies overextended and few resources are going to be forced to sell at bargain prices. That will produce a lot of added value to the big oil companies waiting on the sidelines watching it all unfold.
By Kyle Spencer
Investors are slowly waking up to the fact that Saudi Arabia is willing to take OPEC hostage to defend its market share, with Oil Minister Ali Al-Naimi declaring that –
In a situation like this, it is difficult, if not impossible, that the kingdom or OPEC would carry out any action that may result in a reduction of its share in market and an increase of others’ shares.
Alas, rather than embrace the cheap petroleum paradigm that has dominated most of the 20th century, many investors continue to cling to old shibboleths. Case in point: Brian Hicks, a portfolio manager at US Global Investors, recently noted that –
The theme going into 2015 is mean reversion. Oil prices are below where they should be (emphasis mine), and hopefully they will start gravitating back to the equilibrium price of between $US80 and $US85 a barrel.
I emphasize the words “below where they should be” because the notion that oil (NYSEARCA:USO) prices belong somewhere – and it’s always higher, somehow – is the linchpin of the bullish thesis. But the question of why a high price regime should prevail over a low price regime is never satisfactorily explained.
Higher extraction costs? A sizable chunk of those costs are sunk costs that can simply be ignored in production decisions and lowering the effective breakeven price. A tighter focus on already drilled wells in areas with mature infrastructure could lower costs even further. Moreover, service sector costs fall as rigs are idled. Depleted reserves? Most resource-producing basins are experiencing an increasing yield over time despite the rapid depletion of individual wells. A lot of that is due to extraction efficiency, which is increasing at a phenomenal rate; in fact, one rig today brings on four times the amount of gas in the Barnett Shale than it did in 2006. Drill times in the Bakken are also falling, while new well production per rig is steadily rising since 2011.
(SOURCE: ITG Research)
Technically oversold? Good luck catching that knife. Traders have been pounding the table on “oversold conditions” since $80. Proponents of the Oversold Hypothesis who like to point historical examples of oil’s extreme short-term volatility for validation are conveniently ignoring the vast number of counter-examples like this TIME Magazine headline from June, 1981, which almost reads as if it could have been written yesterday:
(Source: TIME Archives)
1981 is an intriguing date for another reason: It marked the first time in over a decade that Non-OPEC nations countries outproduced OPEC. Despite repeated cuts by OPEC, it took five years for capitulation to set in. Nor are lower prices guaranteed to lead to cuts. Indeed, when oil prices plummeted from $4/bbl to 35 cents in 1862, the Cleveland wildcatters didn’t idle their pumps; they pumped faster to pay the interest on their debt.
Don’t Iran and Venezuela require higher oil prices in order to balance their budgets and head off domestic upheaval? Please. The Saudis don’t care about Iran’s budget problems. Venezuela is a non-entity despite it’s immense reserves. In fact, Venezuela’s hell-in-a-handbasket status was one of the major reasons for Cuba’s recent defection to the US.
Asian stimulus? The only reason that Japanese consumers know that oil prices are lower is from Western news headlines. The share of a day’s wages to buy a single gallon of gas in Japan is 5.59% vs. 2.45% in the US. Nevertheless, the Japanese are riding high compared to the BRICS: In Brazil, it’s 17.62%; in Russia, 7.95%; in India it’s 114.92%; in China it’s 23.54%. Not the most fertile ground for a demand-side revolution; especially since oil is priced in dollars rather than yen, reals, rubles, or rupees.
What about the US? Won’t lower prices lead to higher consumption? Despite what you read about our “insatiable thirst” for oil, Americans don’t actually drink the stuff. Our machines do, and those machines are becoming more and more efficient due to CAFE standards and new transportation technologies, especially NGVs. Demographic changes are also leading a secular decline in consumption. Fig. 2 below highlights the steady march down for miles traveled per capita as the Baby Boomers retire to slower paced lives.
(Source: Citigroup, Census, CIRA)
The reality is that there’s little that an uptick in demand can do to offset oil’s continuing price collapse if the Saudis aren’t prepared to cut to the bone. The wildcatters certainly aren’t going to; on the contrary, they have every incentive (and no real alternative at this point) to pump like crazy to pay down debt and break OPEC’s back. Most doom and gloom prognostications for North American shale use full-cycle breakeven estimates like the ones presented in Figure 2.
Unfortunately for the bulls, all-in sustaining cost (full-cycle capex) is a totally irrelevant metric for establishing a floor on commodity prices. Commodities prices are based on the marginal cost of production of the most prolific producers, not the full-cycle costs of marginal, high cost producers lopped in with the market leaders. As Seth Kleinman’s group at Citi has pointed out –
…what counts at this stage is half-cycle costs, which are in the significantly lower band of $37 to $45 a barrel. This means that the floor is falling and may not be nearly as firm as the Saudi view assume(s).
Oil rig in North Dakota. Increased US drilling is a factor in the current decline in prices. This article by Wolf Richter
The global oil glut, as some call it, is caused by the toxic mix of soaring production in the US and lackluster demand from struggling economies around the world. Since June, crude oil prices have plunged 30%. It drove oil producers in the US into bouts of hand wringing behind the scenes, though they desperately tried to maintain brittle smiles and optimistic verbiage in public.
But everyone in the industry – particularly junk bondholders that have funded the shale revolution in the US – were hoping that OPEC, and not the US, would come to its senses and cut production.
So the oil ministers from OPEC members just got through with what must have been a tempestuous five-hour meeting in Vienna, and it was not pretty for high-cost US producers: the oil production target would remain unchanged at 30 million barrels per day.
“It was a great decision,” Saudi Oil Minister Ali al-Naimi said with a big smile after the meeting.
Saudi Arabia and other Gulf states were thus overriding the concerns from struggling countries such as Venezuela which, at these prices – and they’re plunging as I’m writing this – will head straight into default, or get bailed out by China, at a price, whatever the case may be.
Venezuelan Foreign Minister Rafael Ramirez emerged from the meeting, visibly steaming, and refused to comment.
The US benchmark crude oil grade, West Texas Intermediate, plunged instantly. Even before the decision, it was down 30% from its recent high in June. As I’m writing this, it crashed through the $70-mark without even hesitating. It currently trades for $68.51. Chopped down by a full third from the peak in June.
This is what that Thanksgiving plunge looks like:
Nigerian Oil Minister said OPEC and Non-OPEC producers should share responsibility to stabilize the markets. I don’t know what he was thinking; maybe some intervention by central banks around the world, such as the coordinated announcement of “QE crude infinity” perhaps?
Ecuadorian Oil Minister called the decision a rollover. However, the Iranian Oil Minister, whose country must have a higher price, kept a positive face, saying, “I’m not angry.”
The next OPEC meeting will be held in June, 2015. So this is going to last a while. And there is no deus ex machina on the horizon.
It seems OPEC, or rather Saudi Arabia and some of the Gulf States, decided for now to live with the circumstances, to let the markets sort it out. High-cost producers around the world will spill red ink. Governments might topple. Junk bondholders and shareholders of oil-and-gas IPOs that have blindly funded the miraculous shale revolution in the US, lured by ever increasing hype, will watch more of their money go up in thick smoke.
And the bloodletting in the US fracking revolution will go on until the money finally dries up.
Prisoner’s Dilemma Unfolding. The oil producing cartel will be 55 years old next year. It is not clear, but it may be experiencing an existential crisis. It’s share of the world oil production has fallen with the rise of non-OPEC sources, like Russia, Norway, the UK, Canada, and significantly in recent years, increasingly the US.
In addition to the external threat, OPEC faces internal challenges, There is a divergence of perceptions of national interest by the political elite. Indeed, Middle East politics is arguably incomprehensible without appreciating the tension between Saudi Arabia and Iran.
Generally speaking, OPEC countries have tended to fall into one of two groups. The first has greater oil reserves relative to population. Saudi Arabia and Kuwait are the obvious examples. The second have relatively less oil and more people. Iran and Iraq are examples. This has often created conflicting strategies. The former wants to protect the value of their reserves by discouraging alternatives, which means relatively low prices. The latter want to maximize their current value.
OPEC, like all cartels, have governance or enforcement challenges. It long faced difficulty ensuring that the production agreements and quotas are respected. By OPEC’s own reckoning, there is often production in excess of the prevailing agreement. Last month, while oil prices were falling, OPEC says that it produced 30.25 mln barrels a day, which is 250k barrels a day over the production agreement. This may under-estimate OPEC’s production. Iran, for example, appears to be selling greater amounts of (condensate) oil than the sanctions allow.
The prisoner’s dilemma is both within OPEC and without. For the Saudis to continue to act as the swing producer, it would mean the surrender of revenue and market share to its rival Iran. Iran would very likely use the proceeds for purposes that would frustrate Saudi Arabia’s strategic interest. In a similar vein, a substantial cut in OPEC output, even if it could be agreed up, would benefit non-OPEC producers and only encourage the expansion of US shale development.
Putin with Igor Sechin (right)
Contrary to the some conspiracy theorists who claim Saudi Arabia is doing US bidding by allowing the price of oil to fall to squeeze Russia, it has its own reasons not to want do Russia favors. Putin’s support for Assad in Syria and the Iranian regime puts Russia in opposition to Saudi Arabia. If the Saudis pick up the mantle again as the swing producer, Russia would a beneficiary. A recovery in oil prices would allow Putin to replenish his coffers, which would make its foreign assistance program even more challenging.
Moreover, and this is a key point, given OPEC’s reduced leverage in the oil market, a large cut in the Middle East production of mostly heavy sour crude might not be sufficient to support prices. It could lead to a loss of both revenue and market share. It could also lead to new widening of the spread between Brent, the international benchmark, and WTI, the US benchmark.
The significant drop in oil prices over the last several months has not deterred the expansion of US output. In the week ending November 7, the US produced nine mln barrels a day, which was the most in more than two decades. Output slipped in the week through November 14 by less than 60k barrels a day, but we would not read much into that.
Industry estimates suggest that more than three-quarters of the new light oil production next year is expected to be profitable between $50 and $69 a barrel. The press reports that rather than be deterred by the decline in prices, some companies, like Encana (NYSE:ECA) plan to dramatically increase the number of wells in the US Permian Basin (Texas) next year.
Reports do suggest that parts of nearly 20 fields are no longer profitable at $75 a barrel. There has been a very modest reduction of oil rigs. However, this has been largely offset by the rise in productivity of the existing wells. For example, in the North Dakota Bakken area, the output per well has risen to a record. In addition, industry reports suggest that the costs of shale and horizontal drilling is falling.
Although the price of oil has fallen below budget levels for many oil producing countries, the situation is not particularly urgent. Seasonally this is a high demand period. Most countries have ample reserves to cover the shortfall in the coming months. Around March, the seasonal factors shift and demand typically eases. That is when some key decisions will have to be made. It may not sound like a significant tell, but when the next OPEC meeting is scheduled may be indicative of a sense of urgency. A meeting in the February-March period may indicate higher anxiety than say a meeting in the middle of next year.
One study by Bloomberg found that only two OPEC quota cuts have been for less than one million barrels. A Bloomberg’s survey found that the respondents were evenly split between expecting a cut and not, few seem to be actually anticipating a significant cut. This suggests the scope for disappointment may be limited. That said, there is gap risk on the US oil futures contract come Friday, when they re-open after Thursday’s holiday.
As a consequence of lower oil prices, some oil producers may have to draw down their financial reserves to close the funding gap. Some will assume this will translate into liquidation of US Treasuries. However, it is not as easy as that. According to US Treasury data, in the first nine months of this year, OPEC increased its holdings of US Treasuries by $41 bln. In some period last year, it had sold about $17 bln of Treasuries. Could OPEC countries also be unwinding the diversification of reserves into euros, with yields so low and officials explicitly seeking devaluation (something not seen in the US since Robert Rubin first articulated a “strong dollar” policy almost two decades ago).
There may be political fallout from a continued decline in oil prices. An agreement between Baghdad and Kurds may be more difficult. Pressure in Libya and Nigeria is bound to increase, for example.
Back in 2009 when some observers began warning that higher food prices were the result of the extremely easy and unorthodox monetary policy. We argued that the shock was more on the supply side than the demand side and that commercial farmers would respond to the price signal by boosting output. Oil is similar but opposite. Oil prices will bottom after producers respond to the price signal by cutting production because they have to, not because they want to. Fear not greed will be the driver. It does not look like this can happen until Brent falls below $70 a barrel and WTI is nearer $60-$65.
Easy Money 