Friday, January 09, 2015

What's Going On with Oil Prices? Triads And Consequences


by Gaius Publius

As most people know — certainly everyone with a car — oil prices have plunged in the last six months. Here's what that looks like to an investor:

At the same time, the dollar — by many accounts a "petrocurrency" in two solid senses — has been strong. Normally, when your currency is pegged to something and that something goes down, your currency goes down as well. Yet the dollar is strong, and among the currencies in the tank is the Russian ruble. Are these things connected?

At the other same time, the money-center "too big to fail" (TBTF) banks have gotten Obama, almost all Republicans, and most Democrats to whip for and approve the "Citigroup rider" — an amendment written by Citigroup itself — to put taxpayers back on the hook for that portion of their derivatives "plays" (bets) that the Dodd-Frank bill disallowed. Are these things connected?

What's going on? No one knows for sure, but this certainly gets your attention, doesn't it?

This piece is an attempt to wrangle many of the puzzle parts into some semblance of order. We'll adjust our thinking as events evolve, so stay tuned. For now though, these are the dots I think are currently connected. They are many.

The Saudis Are Engineering Low Oil Prices. Why?

Let's start at the beginning, with oil itself. There's no question the Saudis are engineering or abetting low prices by refusing to cut back production and by their aggressive discounting. As a result, crude oil is now costs 50% of its price six months ago — dropping from roughly $100 per barrel to below $50 per barrel (see chart above; source here).

One theory holds that the Saudis are trying to screw American shale oil and shale gas producers, who have flooded the market with too much supply; in other words, to drive them out of business. This theory is common — for example here, from an interview with oil expert Arthur Berman. (Great thanks to friend and radio host Arnie Arnesen for this link; my emphasis.)
With all the conspiracy theories surrounding OPEC’s November decision not cut production, is it really not just a case of simple economics? The U.S. shale boom has seen huge hype but the numbers speak for themselves and such overflowing optimism may have been unwarranted. When discussing harsh truths in energy, no sector is in greater need of a reality check than renewable energy.

In a third exclusive interview with James Stafford of, energy expert Arthur Berman explores:
• How the oil price situation came about and what was really behind OPEC’s decision
• What the future really holds in store for U.S. shale
• Why the U.S. oil exports debate is nonsensical for many reasons
• What lessons can be learnt from the U.S. shale boom
• Why technology doesn’t have as much of an influence on oil prices as you might think
• How the global energy mix is likely to change but not in the way many might have hoped

OP: The Current Oil Situation - What is your assessment?

Arthur Berman: The current situation with oil price is really very simple. Demand is down because of a high price for too long. Supply is up because of U.S. shale oil and the return of Libya’s production. Decreased demand and increased supply equals low price.

As far as Saudi Arabia and its motives, that is very simple also. The Saudis are good at money and arithmetic. Faced with the painful choice of losing money maintaining current production at $60/barrel or taking 2 million barrels per day off the market and losing much more money—it’s an easy choice: take the path that is less painful. If there are secondary reasons like hurting U.S. tight oil producers or hurting Iran and Russia, that’s great, but it’s really just about the money.

Saudi Arabia met with Russia before the November OPEC meeting and proposed that if Russia cut production, Saudi Arabia would also cut and get Kuwait and the Emirates at least to cut with it. Russia said, “No,” so Saudi Arabia said, “Fine, maybe you will change your mind in six months.” I think that Russia and maybe Iran, Venezuela, Nigeria and Angola will change their minds by the next OPEC meeting in June.
So the Saudis are simply taking advantage of low prices, and the effect on Russian, Iranian, Syrian and U.S. shale producers are secondary considerations. This is one explanation.

Did the U.S. Engineer the Price Drop As an Attack on Russia?

Another theory holds that the Saudi's weren't attacking U.S. producers, but cooperating with U.S. policy-makers in an attack on Russia. For example, from The Guardian (h/t Mike Whitney for the find; my emphasis):
Stakes are high as US plays the oil card against Iran and Russia

Washington is trying to drive down prices by flooding the market with crude but risks collateral damage to its own shale industry

Imagine that at the start of 2014 you were an investor who liked to dabble in the commodity markets. You could sniff something going seriously wrong in Ukraine and you were alarmed by early reports of groups of militants marauding across northern and western Iraq.

With hopes that the global economy would continue to strengthen, the smart money would have been on oil prices continuing to climb. That’s what geopolitical tension plus robust demand usually means.

On this occasion, though, the smart money was wrong. After standing at well over $110 a barrel in the summer, the cost of crude has collapsed. Prices are down by a quarter in the past three months. More oil has been pumped at a time when the global recovery has faltered, with traders caught unawares by the slowdown in China and renewed stagnation in the eurozone. ...

Washington is trying to drive down the oil price by flooding an already weak market with crude. As the Russians and the Iranians are heavily dependent on oil exports, the assumption is that they will become easier to deal with. ...

John Kerry, the US Secretary of State, allegedly struck a deal with King Abdullah in September under which the Saudis would sell crude at below the prevailing market price. That would help explain why the price has been falling at a time when, given the turmoil in Iraq and Syria caused by Islamic State, it would normally have been rising.
Are you buying that? It would be a bold move if true. Here's more; Whitney, commenting on the information in the Guardian article:
U.S. powerbrokers have put the country at risk of another financial crisis to intensify their economic war on Moscow and to move ahead with their plan to “pivot to Asia.”

Here’s what’s happening: Washington has persuaded the Saudis to flood the market with oil to push down prices, decimate Russia’s economy, and reduce Moscow’s resistance to further NATO encirclement and the spreading of US military bases across Central Asia. The US-Saudi scheme has slashed oil prices by nearly a half since they hit their peak in June.
Note especially the part about NATO encirclement of Russia. Mikhail Gorbachev had come away from his 1990 talks with the Bush I team — on the unification of Germany, the collapse of the USSR, and the future of NATO — with this as a firm bottom line:
On Feb. 9, 1990, Mr. Baker asked Mr. Gorbachev, “Would you prefer to see a unified Germany outside of NATO, independent and with no U.S. forces or would you prefer a unified Germany to be tied to NATO, with assurances that NATO’s jurisdiction would not shift one inch eastward from its present position?” Mr. Gorbachev, according to Mr. Baker, answered that “any extension of the zone of NATO would be unacceptable.”
And of course, Gorbachev felt betrayed by later U.S. actions:
President George H.W. Bush promised Mikhail Gorbachev that if the Soviets let the Warsaw Pact go, Russia would not have to worry about NATO expansion. The U.S. responded to this deal by immediately taking the former Warsaw Pact states into NATO and then moving into former Soviet territory in the Baltics. Nobody could blame new entrants for wanting NATO entry, given their past of Soviet occupation. But, neither could anyone blame Russians for feeling betrayed by the U.S. breaking its word.
The western press has successfully painted Putin as the devil, perhaps deservedly. But he and all of Russia remember that betrayal, and the whole country sees the current struggles around the Ukraine, Iran and oil price manipulation through that lens. From just a few weeks ago:
A new military doctrine signed by President Vladimir Putin identified NATO as Russia's number one military threat and raised the possibility of a broader use of precision conventional weapons to deter foreign aggression.

The new doctrine was signed on Friday, and it maintains the provisions of the 2010 edition of the military doctrine regarding the use of nuclear weapons.

The doctrine, which came amid tensions over Ukraine, reflected the Kremlin's readiness to take a stronger posture in response to what it sees as US-led efforts to isolate and weaken Russia.

Russia's relations with the West have plummeted to their lowest level since Cold War times, and NATO cut off ties to Moscow after it annexed Ukraine's Crimean Peninsula in March.
Just because we're not watching doesn't mean the Russians are blind. Or unresponsive.

The First Triad — U.S. Interests, Russian Interests, and Saudi Oil Prices

So that sets up our first triad of dots, the international triad. This part of the puzzle involves global geopolitics. The U.S. is either causing or using low oil prices in order to pressure Putin, Russia and its interests in Iran, Syria and Europe.

Consequences to us — Increased chance of military conflict with Russia, perhaps directly, certainly via proxies (like the "independent" Ukranian rebellion).

Takeaway — Putin may be the devil, but he plays his cards well. Watch this one. It could be dangerous.

The Second Triad — Shale Oil Producers, Junk Bonds, and Fed-Led Asset Inflation

Now for the fun part, a domestic triad. Shale oil producers are dying in this low-price environment. From the interview with Arthur Berman quoted above:
OP: How do you see the shale landscape changing in the U.S. given the current oil price slump?

Arthur Berman: We’ve read a lot of silly articles since oil prices started falling about how U.S. shale plays can break-even at whatever the latest, lowest price of oil happens to be. Doesn’t anyone realize that the investment banks that do the research behind these articles have a vested interest in making people believe that the companies they’ve put billions of dollars into won’t go broke because prices have fallen? This is total propaganda.

We’ve done real work to determine the EUR (estimated ultimate recovery) of all the wells in the core of the Bakken Shale play, for example. It’s about 450,000 barrels of oil equivalent per well counting gas. When we take the costs and realized oil and gas prices that the companies involved provide to the Securities and Exchange Commission in their 10-Qs, we get a break-even WTI [West Texas Intermediate crude oil, used as a market benchmark] price of $80-85/barrel. Bakken economics are at least as good or better than the Eagle Ford and Permian so this is a fairly representative price range for break-even oil prices.

But smart people don’t invest in things that break-even. I mean, why should I take a risk to make no money on an energy company when I can invest in a variable annuity or a REIT that has almost no risk that will pay me a reasonable margin?

Oil prices need to be around $90 to attract investment capital. So, are companies OK at current oil prices? Hell no! They are dying at these prices. That’s the truth based on real data. The crap that we read that companies are fine at $60/barrel is just that. They get to those prices by excluding important costs like everything except drilling and completion. Why does anyone believe this stuff?

If you somehow don’t believe or understand EURs and 10-Qs, just get on Google Finance and look at third quarter financial data for the companies that say they are doing fine at low oil prices.

Continental Resources is the biggest player in the Bakken. Their free cash flow—cash from operating activities minus capital expenditures—was –$1.1 billion [that's "minus," a negative number] in the third- quarter of 2014. That means that they spent more than $1 billion more than they made. Their debt was 120% of equity. That means that if they sold everything they own, they couldn’t pay off all their debt. That was at $93 oil prices.

... Capital costs, by the way, don’t begin to reflect all of their costs like overhead, debt service, taxes, or operating costs so the true situation is really a lot worse.

So, how do I see the shale landscape changing in the U.S. given the current oil price slump? It was pretty awful before the price slump so it can only get worse. The real question is “when will people stop giving these companies money?” When the drilling slows down and production drops—which won’t happen until at least mid-2016—we will see the truth about the U.S. shale plays. They only work at high oil prices. Period.
As you will read in the rest of the interview, the wheels are coming off of shale oil "plays" (testosterone language for "investments" or "casino bets"). Wells are unproductive financially, producers in a lot of debt, and the shift to natural gas won't happen quickly, according to Berman. The Saudis can sell at low prices because they're cash-rich and carbon-rich. Shale oil producers are cash-poor and debt-strapped and their carbon is expensive to get at. At these prices, shale oil producers can sell into the European market, undercutting Russia, but they can't make a profit doing it.

If shale oil producers are in trouble, so is their financing. Shale oil production isn't self-financed; it has investors and issues debt (bonds). Trouble for these U.S. producers means trouble for their investors, lots of it. Mike Whitney again:
The problem with falling oil prices is not just mounting deflation or droopy profits; it’s the fact that every part of the industry – exploration, development and production — is propped atop a mountain of red ink (junk bonds). When that debt can no longer be serviced or increased, then the primary lenders (counterparties and financial institutions) sustain heavy losses which domino through the entire system. Take a look at this from Marketwatch:
“There’s ‘no question’ that for energy companies with a riskier debt profile the high-yield debt market “is essentially shut down at this stage,” and there are signs that further pain could hit the sector, ” senior fixed-income strategist at U.S. Bank Wealth Management, Dan Heckman told Marketwatch. “We are getting to the point that it is becoming very concerning.” (Marketwatch)
When energy companies lose access to the market and are unable to borrow at low rates, it’s only a matter of time before they trundle off to extinction.
This brings us to the "giant pool of money" — the trillions sloshing around in hedge funds, sovereign wealth funds, central banks all around the world, and rolling as lint in David Koch's pocket, as a proxy for all lint in all pockets of that ilk. (The link at the start of this paragraph is an excellent listen, by the way, one of the best financial shows ever produced on the 2008 crisis. The equally good follow-up is here. For more information on this concept, search the transcript for the phrase "global pool of money" and start reading.)

And it also brings us to the Fed. The job of the Fed — believe it — is to make sure the giant pool of money has safe places to park and earn a profit; it's why the housing bubble was allowed (created) and, later, why banks and players like AIG were bailed out when it burst. A secondary Fed goal is to make sure U.S. Treasury bonds are the world's one safe haven in times of crisis (goldbugs, you heard that right).

Wolf Richter:
Fed Chairman Ben Bernanke had explained his wealth effect in an editorial in 2010. The Fed’s “strong and creative measures” – as he called QE and ZIRP [zero interest rate policy] – will goose stock prices [where much of modern CEO compensation is stored]. ...

These “strong and creative measures” worked: people who had a lot of money to invest benefited from it. Rising asset prices bailed out banks, TARP, Warren Buffett, GE, and so on. Savers where ritually sacrificed at the altar dedicated to Wall Street. It worked even in economies that continue to be in terrible shape. Not the wealth effect, of course. It never worked anywhere; but asset price inflation.

And oil price inflation? ... Oil was sitting at $107 per barrel in late June this year as QE-3 was being tapered out of existence. There was a self-satisfied calm in the oil markets. Oil was perfectly priced, high enough for mega-profits but not so high that it would strangle the world economy. Junk bonds to fund fracking and off-shore drilling were selling at record low yields. Nothing could go wrong.

[Then] oil crashed. And the crash accelerated with the official end of QE-3 in October.
Mike Whitney puts it succinctly:
The troubles in the oil patch are mainly attributable to the Fed’s easy money policies. By dropping [interest] rates to zero and flooding the markets with liquidity, the Fed made it possible for every Tom, Dick and Harry to borrow in the bond market regardless of the quality of the debt. No one figured that the bottom would drop out leaving an entire sector high and dry. ...

[F]alling oil prices have started to impact the credit markets where investors are ditching debt on anything that looks at all shaky. The signs of contagion are already apparent and likely to get worse. Investors fear that if they don’t hit the “sell” button now, they won’t be able to find a buyer later. In other words, liquidity is drying up fast which is accelerating the rate of decline. Naturally, this has affected US Treasuries which are still seen as “risk free”. As investors increasingly load up on USTs, long-term yields have been pounded into the ground like a tentpeg. As of Friday [December 12, 2014], the benchmark 10-year Treasury checked in at a miniscule 2.08 percent, the kind of reading one would expect in the middle of a Depression.
The second triad of dots, the next three pieces of the oil-price puzzle, involves the effect of oil prices on domestic, over-leveraged shale oil (fracked-oil) producers and the markets that finance them. In the near term, these companies will go out of business, and in a worsening spiral, the cost to stay in business for those remaining will go up with their cost of borrowing.

Consequences to us — The price of gas will likely remain low, since the Saudis et al can't mind seeing the shrinking of U.S. fracked-oil production. This puts pressure on fracking itself, which must be hated everywhere it happens, even among the loyal army of rural tea. But don't look for this effect, this lessening of fracking, immediately. There are a number of reasons for these companies to hold out and drop slowly, one by one.

A second consequence — The Fed's ZIRP (zero interest rate policy) should continue for quite some time. It has to for asset prices to remain high, for money-center banks to remain profitable, and for U.S. Treasuries to remain the global investment of last resort. The average retiree today may never see a decent interest rate for the rest of her life.

Takeaway — The world of the Bigs is roiling. ZIRP is propping up the Dow and other assets in the bubble, but oil prices threatening part of the game. What does that mean for investors caught in the oil asset bubble, and the economic system itself? Read on; there's one more triad. 

The Third Triad — TBTF Banks, Oil-Based Derivatives & the CR-Omnibus "Citigroup Rider"

Which leads us to the final set of dots. Money-center (TBTF) banks like Citigroup and Goldman Sachs are once more big in derivatives, as you may know. Many of those derivatives are already held in bank subsidiaries that don't put taxpayers on the hook for losses, or are tied up in true hedges. But a portion of them are hooked to the oil bubble.

Let's look at some numbers. Dealbook on the overall size of this market:
American banks have nearly $280 trillion of derivatives on their books, and they earn some of their biggest profits from trading in them.
As you'll see below, that's about 20 times the U.S. national debt. Most of these derivatives are already exempt from the Dodd-Frank limitation (called the "Lincoln Amendment"), the one that was recently repealed. Forbes in June 2012:
Dodd-Frank's Derivatives Curbs Won't Be A Problem For Big Banks, Fitch Says

The biggest U.S. banks are likely to see little impact from a portion of the Dodd-Frank Act that seeks to constrain derivatives activity.

In a report Tuesday, Fitch Ratings argues that the “swaps push-out rule,” known as the Lincoln Amendment to Dodd-Frank, is unlikely to have much of an impact on the major U.S. banks.

The rule prohibits federal assistance – including FDIC insurance and access to the Federal Reserve’s discount window – for banks that deal in certain derivatives, but has loopholes you could drive an 18-wheeler through.

For instance, Fitch notes that “interest rate, currency, gold/silver, credit derivatives referencing investment-grade securities, and hedges are permissible activities within an insured depositary institution.” ...

For Goldman Sachs and Morgan Stanley, the rule is almost a non-event, as they already conduct derivatives activity outside of their bank subsidiaries. ...

The impact on Bank of America, Citigroup, JPMorgan Chase, and to a lesser extent, Wells Fargo, would be greater, but still rather middling, as the size and scope of the restricted activities is but a fraction of these firms' overall derivative operations.
But a "fraction" can still be a rather large number. From the same piece:
Fitch estimates that the total notional value of derivatives at the four banks stood at $193 trillion at the end of 2011, about 95% of which will be unaffected and able to remain under banking units without risking loss of access to federal assistance.
Let's take the Dealbook total-market number as more recent. As pointed out here, 5% of $280 trillion is $14 trillion, roughly the size of the U.S. federal debt. And according to Reuters, almost $4 trillion of that is in commodities "plays":
Last year, the top ten regional banks active in the space together held an average of $23 billion in commodity derivatives contracts on their books, up nearly 50 percent from their holdings in 2009, according to a Reuters analysis of quarterly regulatory data from Thomson Reuters Bank Insight.

This is still miniscule relative to the $3.9 trillion in commodity derivatives that the top six Wall Street banks still controlled, according to the data, though that sum has barely risen over four years.
I've seen estimates that much of these commodity derivatives are in oil. For example:
It has been estimated that the six largest “too big to fail” banks control $3.9 trillion in commodity derivatives contracts.  And a very large chunk of that amount is made up of oil derivatives.

By the middle of next year [2015], we could be facing a situation where many of these oil producers have locked in a price of 90 or 100 dollars a barrel on their oil but the price has fallen to about 50 dollars a barrel.

In such a case, the losses for those on the wrong end of the derivatives contracts would be astronomical.
The consequences are made clear here:
Among the banks' most important commodities bets are oil derivatives. An oil derivative typically involves an oil producer who wants to lock in the price at a future date, and a counterparty -- typically a bank -- willing to pay that price in exchange for the opportunity to earn additional profits if the price goes above the contract rate. The downside is that the bank has to make up the loss if the price drops.

As Snyder observes, the recent drop in the price of oil by over $50 a barrel -- a drop of nearly 50 percent since June -- was completely unanticipated and outside the predictions covered by the banks' computer models. The drop could cost the big banks trillions of dollars in losses. And with the repeal of the Lincoln Amendment, taxpayers could be picking up the bill.
Let's say $3 trillion in oil-related derivatives goes bad. That's "trillion." Despite being just a "fraction" of the $280 trillion in derivatives, it's a lot of money. The 2014 U.S. deficit was just under $500 billion (half a trillion), down from a Bush II–era high of just under $1.5 trillion (2009; source). In contrast, TARP was "just" $700 billion, though the true cost of the 2008 bailout was much higher.

Still a $3 trillion dent will leave a lasting impression, if only on the willingness of people, red and blue, to tolerate another giveaway. Ultimately this is political as well as financial. Ordinary Americans "win" at the pump, but lose at the payroll window. All while the global tribe, the billionaires drink deep and often of the wealth generated by others. At some point, this will be made to stop. The only question is the trigger.

The Senators Who Cared Enough to Filibuster the Next Bailout

We started with oil prices and ended with the repeal of the Dodd-Frank "Lincoln Amendment" which Citigroup stuck into the CR-Omnibus bill. Let's stop just a moment to notice that only six Democratic senators opposed the bill enough to support the filibuster. Those six again:
  • Elizabeth Warren
  • Sherrod Brown
  • Al Franken
  • Bernie Sanders
  • Claire McCaskill (for reasons of her own)
  • Joe Manchin (for reasons of his own)
Every name not on that list helped break the filibuster and pass the bill. It's a side note here, but we have our work cut out for us, as do they.

Three Triads, Three Potential Consequences

For the larger point, were back where we started, with three sets of pieces to this puzzle, and three sets of consequences. The Russian ruble has dropped more than 50% in the past year, from about $0.03 to about $0.015. The Russians are getting killed on the import side — everything they buy abroad is twice as expensive. On the oil export side the Saudis are killing them also, with heavily discounted oil. If Obama, Kerry and the Russia-hating foreign policy establishment engineered this, they succeeded.

But there's a cost, a set of consequences, associated with each of the three triads discussed above:

First Triad — Increased international tension and a seriously annoyed Vladimir Putin, fully supported by an embattled and NATO-surrounded Russia. We don't see the Bush I betrayal because we, and our press, choose to pretend it didn't happen. Russia sees that betrayal every day as NATO approaches closer and closer.

Second Triad — The near-certain failure of highly leveraged shale oil producers who failed to lock in January and June high prices with derivatives contracts. The climate folks may cheer this outcome, though it won't happen fast enough to be helpful. Energy investors, however, are being hurt badly.

Third Triad — Trillions in losses waiting in the wings for any money-center (TBTF) bank that acted as a counter-party to oil producers who did lock in high prices with derivatives. Also, losses for money-center banks who simply bought into an oil "play" thinking prices couldn't fall because world tension means pricier oil. (In other words, the housing market error made twice.)

And thanks to the CR Omnibus bill, which Obama and almost the whole of the Democratic leadership desperately wanted (h/t CorrenteWire) ...
"I think we got hurt when Jamie Dimon and the president started to whip," [Rep. Maxine] Waters told reporters after the [CR-Omnibus] vote. "That's when I think we lost some votes." ...

When asked if she thought that Obama had sold out to Wall Street, Waters replied: "That's not for me to determine. I know that the president was whipping. I know that Jamie Dimon was whipping and calling directly into members' offices. And that's odd. That's an odd combination."
... the American taxpayer may get to bail out casino-dwelling billionaires again — that's twice in ten years — with money that the bigs will turn, again, into reasons for even more austerity at home. That didn't go down well the first time; it may go down less well the second. At some point people just might find they've had enough.

Unless there's a game on, of course.

Sorry, wrong game. This one:

Which means one more dot to connect — American propaganda.


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At 10:22 AM, Anonymous Anonymous said...

Really fine analysis!


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