Every week the Partners read articles that spark conversations and reflect their diverse points of view. This week they are discussing, “Why the oil price spike is a risk for markets,” from Yahoo Finance.
The OPEC meeting in Doha came and went without a deal from the organizing countries to agree on output caps. However, I’m far less concerned about the short-term market movements than I am about a small nugget tucked away in the original article. In it, it says that “in the long-term…shale production is here to stay because shale is a technology play…The technology keeps getting better. That’s why it’s unlikely oil will go back to $100. Shale is the great shock absorber for higher oil.”
We saw $40 oil back in 2004 when US shale gas production was .58 trillion cubic feet…total. We saw it again briefly in 2008 when shale production was 1.98 trillion cubic feet. Today we are seeing $40 oil with OPEC dancing the same threatening dance of restricting production while there is a 17 times greater production of US shale from the 2004 levels. From 2004, it took a little over 3.5 years for oil to top $100. From the 2008 lows it took a little over 2 years. Will this recovery be suppressed by increased shale production or just part of a cycle that we’ve already seen before? I’m inclined to believe the latter rather than the former.
I tend to facepalm when I see claims of “spikes” in price when we are still thinking about the $100-$30/barrel world and the price moves $6/barrel. When market analysts report on price spikes and then try to factor in why, it is bizarre to me because the market itself made the determination on whatever evidence to trade up. Prices do not change on their own – they are merely reflections of traders in the market’s beliefs/instincts/sensitivities. Therefore, the majority of oil commodity traders in the U.S. market BELIEVED that the news of Russia and Saudia Arabia production cuts are meaningful, regardless of whether they actually impact a pure supply/demand scenario. When traders become surprised at how commodity prices change, their first move should be to look in a mirror. As a life well-examined is worth living, a trade well-examined is worth making.
A new world order has emerged over the past 10 years in regards to traditional supply/demand economics on oil specifically, and market analysts still tend to work under the paradigm set in the 1970s. Namely, the new paradigm that HAS existed is a function of demand needs shifting from U.S. primacy to being at best split between U.S. (or Western demand) and Chinese (East Asian demand). A movement has occurred that increases supply scenarios from long-standing adversaries to the West to instead supply Chinese demand. Case in point – Sino-Russo pipelines, Chinese port enlargements outside of traditional Bohai Bay (which could be constrained by Strait of Malacca blockades or disruptions), and most recently Iranian oil now freely transported directly to China, ignoring Indian objections and regional territorial disputes.
OPEC has been an operational fiction for the past 2 decades, in that Saudi Arabia is the ONLY country within OPEC member states that has both the geologic ability and government stability to adhere to production limits/quotas/increases/cuts. OPEC member states still want to be seen as important and included in the cartel club to avail themselves of a no-longer potential threat to disrupt global economics. Russia and Saudi Arabia as individual states surely have the ability to threaten others based on production, and it was welcome to read that the actual production areas are singled out.
The common theme among Western pundits that U.S. shale oil production was a threat to Saudi Arabia and therefore Saudi has been keeping production high to “punish” U.S. shale producers is a huge fallacy. Saudi seems to understand that their produced oil and U.S. shale oil are not the same in terms of end-use demand scenarios, and that increased demand in sub-continent, EU anti-Russian options and China still provide global demand for the produced supply. The much more realistic punishment by Saudi with production quotas is to other adversarial members of OPEC: “Yah, Iran, Iraq, Libya – we’re going to tell you that you HAVE to pump as much as you can to meet quotas, and we know you can’t, and you have to sell all your oil and a depressed price under OPEC price decks.” That scenario has been proven to be somewhat useful until the Iran Deal allowed Iranian oil to be exported freely (and make government-to-government deals with China for a mutually agreed-upon price). Now Saudi is back to looking after their own financial interest, in managing low-cost oil at a higher price for maximized margins.
Finally, all this gets us back to “crude oil price” spikes, which tend to be reported almost exclusively in WTI price. When markets react to WTI oil price due to supply disruptions or increases in Brent or Saudi quality (or even Chinese quality, Venezuelan quality, etc), we see a disassociation with actual fundamentals of the oil industry. Hence the move in the article to talk about free cash flow, which is a pure correlation of the quality of individual barrels produced and sold. In my opinion, the mark-to-market move towards multiples of FCF (Free Cash Flow) rather than earnings is long overdue. Given the overt lack of commodity price manipulation with industry operating fundamentals, any price scenario with forward-looking price points must be considered pure fabrication.
While my partner Wade Murphy can speak with eloquence to the variations and price fluctuations that consume not only the oil markets but the world markets themselves, I continue to be concerned with what I see as the unethical collusion of modern financial states in their manipulation of global economies. These state actors have, over time, created, dare I say, criminal syndicates which on their face break the most basic understandings for the moral underpinnings of international law. These states have acted outside personal interest to manipulate markets and avoid free and fair competition. We have now seen multiple American administrations turn away from enforcing economic treaties, or worse, turn a blind eye to off-shore accounts and business practices that put everyone at risk of financial collapse. The time has come to review our role as a world leader in enforcing basic economic and banking laws that stop or produce world turmoil. This can occur by reviewing the laws and rights of these state actors to play fairly in the energy markets where they can assert undue influence with their ill-gotten gains. If we care for our western civilized liberal thought and lifestyle, we need to take more time to prosecute those who reap billions in illegal cartels. This sort of organized crime has been subdued before, so we now need leadership that protects the free and fair trade of energy in order to protect and stabilize our world economy.