Understanding The Oil Price War

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Includes: AGG, HYG, XOM
by: Power Hedge

Summary

The OPEC nations, led primarily by Saudi Arabia, have been actively engaged in an economic war against Russia, Iran, and North America.

This has had a much larger impact on oil prices than the so-called "glut," the existence of which is questionable at best.

The purpose of this war is to weaken the Russian and Iranian economies as both are more dependent on high oil prices than the OPEC nations'.

While the elimination of North America's shale production may or may not be the motivation, it is likely to be a casualty.

The OPEC nations seem to expect that oil prices will surge much higher once a sizable amount of the current oil production is driven out of the market.

By this time, I am certain that everyone reading this is already well aware of the recent collapse in oil prices. Back in June 2014, the spot price for one barrel of WTI reached $105 while the spot price of Brent reached $111. Today, six months later, the spot price of WTI is $56.20 and the spot price of Brent is $60.71. Thus, oil prices have fallen approximately 45.31% in six months. Numerous commentators in the media have discussed the reasons for this violent descent, with the most common reason provided being that the world is greatly oversupplied with oil. While this is true, that oversupply alone cannot explain such a severe decline as the one that we have witnessed, as will be shown in this article. In fact, the full story and reason behind oil's precipitous decline is one that must not only include an analysis of economics and market fundamentals but also geopolitics.

On October 24, 2014, the Wall Street Journal published an article entitled "Global Oil Glut Sends Prices Tumbling." In this article, the Journal states that surging production from areas such as the Williston Basin was responsible for prices falling more than 20% since early June to the time of the article's publication and presumably for the rapid plunge that oil has suffered since then. However, the Wall Street Journal article did not state how oversupplied the global market is. Fortunately, Rex Tillerson, CEO of America's largest oil company, ExxonMobil (NYSE:XOM), did, stating in a CNBC interview that the current oversupply of oil in the global market is approximately 600,000 barrels. This represents approximately 0.7% of the current global demand for oil. That small amount of oversupply should not be enough to cause a price reduction such as the one that oil has seen in isolation. Naturally, one might point out that this surplus will continue to accumulate in inventories day after day with each of the previous days' surpluses. This is also true. However, this has not shown up inside the commercial inventories of the United States. In fact, according to the Energy Information Administration, the inventories of both commercial crude oil and motor gasoline were both consistently lower than in the corresponding week in the previous year throughout the price decline until the week ending December 5, 2014. With that said however, crude oil is a global commodity and the International Energy Agency does report that oil inventories throughout the world have been growing, primarily driven by falling global demand. However, oil inventories remain well under capacity, providing further evidence that the oft-reported "glut" that has been blamed for the rapidly falling price of oil has been somewhat overplayed.

Despite this oversupply of oil, the OPEC nations, led primarily by Saudi Arabia, have been unwilling to cut production. There are a few reasons for this and I believe that these reasons are having as significant of an impact on the price of oil as the oversupply is and perhaps explain why the Saudis are unwilling to cut back their own production to remove this oversupply and prop the price of oil back up.

The first reason is to wage an economic war on Russia. It has been well known for quite some time that the small nation of Qatar has been wanting to construct a natural gas pipeline from its own tremendously large fields to Europe, similar to the pipelines that Russia currently possesses. Unfortunately for Qatar, the Russia-backed Assad regime rejected the idea of a pipeline across the nation of Syria but did allow the construction of a similar pipeline from Iran to Europe. The relationship between Saudi Arabia and Iran can be described as adversarial at best while Saudi Arabia enjoys much friendlier relations Qatar. As both the Iranian and Assad regimes are backed by Russia, this naturally led to some unpleasant feelings towards Russia among the Saudi Royal Family.

Like most oil exporting nations, Russia is highly dependent on its oil revenues to balance its budget. According to Russian sources, the giant Eurasian nation requires a Brent crude price of approximately $105 per barrel in order to balance its federal budget. This is one reason why the Russian Rouble has been plunging against the U.S. Dollar and is currently the worst performing global currency this year (when measured against the U.S. Dollar).

Source: OANDA

The Russian Central Bank abandoned its currency peg to the United States dollar on November 10 but prior to that had spent approximately $70 billion of its foreign currency reserves defending the Rouble against declines caused by both the precipitous decline in oil prices and the sanctions that have been imposed against it by the Western powers. It should come as no surprise that Saudi Arabia is also dependent on its oil exports to supply a large portion of its government revenues. However, it is somewhat less dependent on high oil prices than Russia is. The nation of Saudi Arabia is believed to require a Brent crude oil price of $90 to balance its budget this year. The Saudi government is expected to announce that it will run a deficit in 2015 but that it will also adjust its budget to attempt to compensate for the lower revenues that it will generate in 2015 due to the lower oil prices.

Thus, one reason why the Saudis are resistant to reducing production and therefore eliminating oversupply is to financially weaken Russia and thus reduce that nation's ability to support both the Assad and Iranian regimes. Further evidence for this comes from the Anadolu Agency. On October 10, 2014, the agency reported that Rashid Abanmy, President of the Riyadh-based Saudi Arabia Oil Policies and Strategic Expectations Center, stated that Saudi Arabia will begin selling oil for $50 to $60 in Asian and North American markets in an effort to reduce revenue for both Russia and Iran. This was well below the spot price for oil at the time and given the quantity of oil that Saudi Arabia exports to these markets, it should not be difficult to see how this would exert strong downward pressure on oil prices.

The second reason why I believe that Saudi Arabia is unwilling to cut its oil production is precisely what the Kingdom has publicly stated - that it wishes to maintain its historic 10.5% share of global oil supply. However, in order to do so, it will need to eliminate much of the new production that has come online in recent years. In particular, the Saudis will need to eliminate U.S. shale production.

The Saudis have a very strong advantage over the U.S. shale producers in this regard. In several recent articles, I have included this chart, which was compiled using data obtained from the International Energy Agency and Morgan Stanley Equity Research, that shows the costs of producing oil in each of the major environments in which oil is produced.

Source: Seadrill, Morgan Stanley Equity Research, International Energy Agency

As this chart shows, it is significantly cheaper to produce oil from the onshore fields of the Middle East, such as most of the ones in Saudi Arabia, than it is to extract oil from the North American shale plays. In addition, the North American shale producers have to contend with other issues, such as exceptionally high decline rates, that the Saudis do not.

There are already indications that the Saudis are having some success at this. In a recent article, I showed that many shale oil producers are essentially being kept afloat due to their ability to easily access the credit markets and issue high yield debt. On December 5, 2014, Zero Hedge reported that these companies are now beginning to have difficulty issuing high yield debt at the interest rates to which they are accustomed. This is most evident by looking at the price action of the largest high yield bond ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG). This chart shows how the price of this ETF compares to a broader investment grade bond ETF, the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG).

Source: Yahoo! Finance

As this chart shows, the high yield bond market as a whole has declined significantly against the broader bond market since the oil price collapse began, with the high yield market declining particularly dramatically within the past month or so. This means that those companies issuing bonds into the high yield markets, including most U.S. shale producers, will have to pay much higher interest rates to do so, if indeed these companies can access these markets at all. Given that tight oil well decline rates can be as high as 70% in the first year of production alone, the ability to access these high yield markets is critical for most of these companies to maintain, let alone increase, production. This reduction in access to the high yield market thus makes it likely that the oil produced by the U.S. shale plays will decline and thus enable the Saudis to maintain their historic 10.5% of the global oil supply.

Further evidence exists that the Saudis are succeeding in their attempt to curtail U.S. shale oil production and thus maintain their share of global oil supply. On December 2, 2014, Reuters reported that the number of drilling permits for new oil wells across the United States declined by 40% month-over-month. In the month of October, the nation's exploration and production companies applied for and were issued permits to drill 7,227 wells. This number dropped to 4,520 in November. The decline in new permit applications were particularly steep among all three of the top producing U.S. oil plays with Permian Basin applications dropping 38%, Eagle Ford Shale applications dropping 28%, and Bakken Shale applications dropping 29%. As would be expected, this reduction in permit applications indicates the intent of the nation's exploration and production companies to reduce their drilling activities going forward. Given the very high decline rates of the Bakken and Eagle Ford Shale plays, there is increased likelihood that the oil output of the United States will decline next year.

The Saudis almost certainly expect oil prices to return to close to their previous levels once the excess supply is removed from the market. Therefore, the Kingdom is likely choosing to wage this price war so that it can continue to capture the revenue from the 600,000 barrels of excess supply that it is currently producing after the North American shale oil producers have been forced out of the market and the price of oil begins to increase again. The Kingdom also likely expects that the breaking of the North American shale producers will induce sufficient fear going forward that the shale production does not return.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.