By John Richardson
THERE is a much-broader acceptance today of the recent history of oil markets, which in summary was as follows:
- Oil and other commodities became a great way to make money for speculators at the height of the Fed’s quantitative easing (QE) programme. This was made easy because the financial system was awash with liquidity. Plus, of course, a weak dollar and low interest rates meant that returns elsewhere were paltry –quite often, in fact, negative.
- China’s stimulus package created the illusion of a booming global economy. This was used by speculators as justification for driving oil prices to their levels of 2009-H1 2014.
- But since then, due to the withdrawal of Fed stimulus – and most importantly of all, because of China’s new economic direction – the bottom has fallen out of the oil market. It has become clear that supply is in excess of actual, real demand.
But whilst more and more analysts are agreeing with this kind of historical thinking, I worry that some of these analysts are overlooking the impact of this history on the future – first of all, around the issue of oil industry debts and how they are dealt with.
As a result, they might be at risk of being overly aggressive in their estimates of production cutbacks later this year – and into 2016. Thus, they might end up forecasting a strong recovery in oil prices, when, instead, crude may decline even further.
The argument I have been making since last October – that oil producers will keep production higher than some people think in order to service debts – has now received support from a study by the Bank for International Settlements (BIS).
The BIS writes: Against this background of high debt, a fall in the price of oil weakens the balance sheets of producers and tightens credit conditions, potentially exacerbating the price drop as a result of sales of oil assets (for example, more production is sold forward).
Second, in flow terms, a lower price of oil reduces cash flows and increases the risk of liquidity shortfalls in which firms are unable to meet interest payments.
Debt service requirements may induce continued physical production of oil to maintain cash flows, delaying the reduction in supply in the market.
In the US, as this excellent Business Insider article points out, producers have been released from the burden of debt servicing by “capital flows from Europe and emerging markets on the back of expectation of a Federal Reserve interest rate hike”. Buoyant US stock markets, on all these capital inflows, have thus enabled local producers to retire debt in favour of equity – and by so doing, they have lowered their debt-servicing costs.
So far my coverage has focused pretty much exclusively on US shale production, given its role in driving the supply glut.
But the Business Insider also points out that heavily indebted oil companies in Russia are using current supply to pay off their debts. For example, Rosneft, the Russian state-owned oil company, had to in February “front-load” oil sales in order to meet a $7 billion debt repayment. This involved supplying Trafigura, the oil trader, with 500,000 tonnes of oil in February rather than its usual 150,000-200,000 tonnes.
And there is the extraordinary story of Trinidad and Tobago offering to supply Venezuela with tissue paper, gasoline and machinery parts in return for crude oil.
This raises my second point: That governments of oil-producing countries such as Venezuela – which budgeted for much-higher oil prices in 2015 – will be prepared to take ever-more desperate steps to prevent their economies from imploding.
These measures must surely involve producing more rather than less oil, given oil is the biggest – sometimes the only real asset – of these countries. Again the same argument applies here as with corporate debt: A few dollars over the variable costs of production are better than no dollars at all, even if you end up measuring those dollars in tissue paper.
“Where’s the evidence for this argument?” you might well ask. The answer is recent production trends, which are detailed in the slide at the beginning of this post, again sourced from the same Business Insider article.
The slide shows that:
- A significant proportion of the recent supply surge appeared to occur after the oil price began to drop and global oil demand started to soften.
- Some of this can be explained away as the lag between oil producers noticing prices falling and respond.
- A further explanation is OPEC’s decision, led by Saudi Arabia, not to cut output.
- But the strength of overall production in the chart above – and resilient US production growth in particular – suggests that the factors I have highlighted above are also in play.