Basically there are a couple of theories and I’m personally guessing its a combination of the two. Just keep in mind back in July of 2008, oil was at $147 a barrel. By December of 2008 it was down to around $32 per barrel…a drop of over -75%. In other words, prices may still have further to tumble.
Increased Production and Less Demand – Chinese demand has somewhat slowed, while U.S. oil supplies have risen from five million barrels per day to around 9.3 million barrels per day in the past five years. Also keep in mind we are using more bio-fuels and vehicles are getting much better gas milage. You also have to recognize the Saudis have brought more rigs online.
Geopolitical Maneuvering – The Saudis are making their move for political reasons. They clearly want to send a message to Russia as they fear the implications of a well funded Iran and ISIS [the Islamic State] military movement. Bottom-line, this is a very viable way to break Iran’s economy. the theory is that Saudi Arabia has nearly $750 billion in reserves and can withstand low oil prices for several months, perhaps even a year or more. My point is, the Saudis clearly have a game plan and they will want to see their goals achieved before they change or shift their policy. The next OPEC meeting is in June and I highly doubt the Saudi’s veer from their current positioning.
As we constantly try and avoid the “unpredictable,” I thought I would throw out a few ideas and thoughts I’ve been hearing talked about in my travels. Obviously I have no idea if anything will come from the events, but they are certainly worth thinking about. As you know, I constantly talk about the “what ifs” pertaining to geopolitical risk, but these trends are more concerning in regard to weather and natural events.
El Niño – I can’t stress enough how much “weather” is impacted by El Niño patterns. As of this writing there’s still a 45% to 65% chance that a full-blown El Nino weather pattern will appear in 2015. To put it simply, this warm band of water in Pacific ocean could help push the global thermometer up further in many locations. The effects could mean many different things, most of which are highly unpredictable. The biggest fear would be a massive drought in Asia couple with intense rainfall and flooding in South America.
Blocking Deserts in China – I don’t know if you’ve seen this yet, but workers in China are busy planting the “Great Green Wall,” a massive belt of man-made forest that eventually will stretch nearly 2,800 miles across China, in an effort to block the growth of the Gobi and Taklamakan deserts and stem the massive dust storms they create. If the trees survive and do the job as envisioned, a similar green belt might be planted in Africa. How this so called “changing of the landscape” effects longer-term weather is still up to debate. Just understand there are some dramatic man-made changes to the landscape taking place. This sounds great in theory, but generally never works out so well in practical application.
- Ocean Acidification – The oceans are absorbing carbon dioxide and it’s causing the pH levels to change. In a just published study by British Canadian and Swedish researchers they conclude that shrimp aren’t going to taste so good to humans in the near future. There’s also been recent evidence that mussel shells are becoming more brittle because of rising acidity. There is no question that our oceans are changing. The more important question is how close are we to the “tipping point”?
- Water Shortages – We have discussed water shortages for the past several years and this year is no different. Expected water scarcity and problems with allocation will pose significant challenges to governments in the Middle East, Sub-Saharan Africa, South Asia and northern China. I continue to believe we will see increased civil and political tensions in regions where water supplies are limited.
Earthquakes – To start with, lets make certain everyone understands I am a huge proponent of “fracking” and the benefits associated with US energy production and self-reliance. But at the same time we have to acknowledge some additional risk-factors that are being talked about in association. Study after study is showing an increasing risk of earthquakes along various fault lines. It’s not necessarily the fracking itself causing the concern, but rather the disposal of the millions of gallons of waste water being pumped into injection wells or disposal wells. The oil and gas industry has been grappling with the disposal piece of the puzzle for years. Several states are now starting to jump on the bandwagon and propose legislation that bans fracking in certain areas because of what they are seeing as increase earthquake risk. Regardless of if you agree or disagree this could eventually turn into more substantial headwinds for the energy industry.
Q. Kevin, what’s your thoughts on Crude Oil?
A. Crude oil prices have now plunged by almost 40%, the bulk of which has occurred in just the past three months. As most of you know, energy price declines of this size and magnitude are most often associated with large declines in global economic growth. There have however been two specific periods of time in recent history where energy prices saw similar type setbacks and they were not associated with a global recessions. Those setbacks occurred in 1986 and again in 1997. Keep in mind both of those time-frames were followed by stronger than expected nearby global growth. Meaning, despite the fears of the world slowing down, this might actually be the shot in the arm that is needed as the Fed exits Quantitative Easing??? Here at home, I hear most of the existing wells could hang in there and still be profitable if crude oil prices pull all the way back to $40. Its the NEW wells and exploration that are in danger of being stopped or halted. Everybody had leveraged up and the cost to finance a new well has dramatically increased in the past few years. In other words it might be the businesses that have leveraged up along with the oil companies that get hit the hardest on a major drop in crude i.e some of those who rapidly expanded in rail, those in the business of building new tankers, new railcars, drilling equipment, frack sand, drilling pipe, etc… Make sure your connecting all the dots and understanding how the drop in crude could negatively impact some of your other investments. Before you liquidate, just make certain you aren’t throwing the baby out with the bathwater. There are some great energy stocks that are now being offered at some good discounts (talk with your advisor about specifics). On the positive side, I’m hearing some larger traders say they suspect the billions consumers are saving (over $1,000 per household) will go to more money being spent on travel, entertainment and at restaurants. These might also be something to consider if in fact energy prices are going to stay low for an extended period of time.
Oil seems to be all the talk inside the trade as it’s down almost 30% since early-summer: AAA is saying this is leaving US consumers with an extra $250 million a day in their pocket when compared to mid-June price levels. The question is how long can oil producers afford to hang on? Keep in mind, several nations and private oil explorations companies are already being forced to digest prices below their cost of production. Below is a great map from Reuters and Deutsche Bank that has been floating around the trade. As you can see, oil prices below $80 could spell disaster for countries like Iran, Nigeria, Russia, and Venezuela… maybe there’s a “bigger picture” item being put into play by some of the global powers? I’ve already heard rumblings from inside Russia that they may soon need to make massive government spending cuts. With Russia already being considered a “high risk” creditor it might be next to impossible for them to borrow money. We’ll see how popular Putin is inside Russia once their government is forced to make massive cuts in public spending? Let’s also not forget that a nuclear Iran is a huge thorn in the side for Saudi Arabia. Bottom-line, the North American shale boom has flattened the supply curve and OPEC is no longer the only price determining player in the game. Maybe the Saudis realize this and are trying to run some of the other players out of the game? Maybe there is more global political jockeying here than we care to realize? In any regard it appears the Saudis are serious about shaking up the world of energy production as we know it. I’m afraid this is just the beginning of a long process with many uncertainties associated. Be careful swimming out too far into the “energy” space…
The good folks at JP Morgan recently released their Q2 Guide To The Markets. Inside was a map that shows in detail the % of the world’s liquid fuel being produced and transported through specific areas in the Middle East. Before everyone hits the panic button, just keep in mind the bulk of Iraq’s oil production and export facilities are in largely Shi’ite areas in the Southern part of the country, where al Qaeda-inspired groups enjoy little sympathy. Those facilities generally ship about 2.6 million barrels per day and seem (for the time being) to be extremely safe… Also keep in mind, the most recent data shows we imported about 341,000 barrels of oil per day from Iraq, which is just under 4% of our total crude oil imports.