I’m not lying when I say that I find the oil market incredibly fascinating. Many other commodities may be suffering as much if not more than oil, but oil is the global standard for energy and for the entire planet to have mispriced it as bad as we have is truly both amazing and terrifying.
In my last article I discussed my belief that something in the oil market will have to break. Whether it be land storage or high cost high debt producers. The price’s current trajectory and fundamentals all indicate we still have further to go and this is excluding a number of increasingly likely external shocks ie. Yuan devaluation, US recession. If we assume the price falls even further into levels intolerable even by low cost producers, then there will be some very drastic outcomes.
Saudi Arabia is currently doing everything in its power to maintain the Riyal’s peg to the dollar. In my previous article, I argued that Saudi Arabia will do anything and absolutely everything before it is forced to break the Riyal’s peg to the dollar. Since that article, Saudi Arabia has offered to IPO their most prized possession, Aramco, and have now banned currency speculation. How viable are these solutions in the short run? Not very. It will probably take at least a year for the IPO to be launched at the very earliest and banning speculation does little against capital flight. Bets on the currency are much smaller than the flows which are the actual drivers of the currency market.
Notice how each attempt was even more desperate than the next. SA is desperate and with the price of oil headed lower, the Saudi’s will once again dip into their toolkit but find just one rusty, very blunt tool, an engineered market crash. Imagine what another month of oil in the 20s would do to SA’s economy. If oil to were remain at $30, SA would hemorrhage 1/3 of its FX reserves in a year. A large portion of those assets might not even be liquid. Thus the supply of liquid assets SA will burn through will be even greater, leaving the kingdom with even less ammunition to defend its peg.
SA may engineer a bottom in the market through drastic discounts to foreign markets. I’m talking high teens here to put the fear of Allah in the global energy market. The result would be a wave of bankruptcies and cuts in production and the price would rebound from there. It is a risky proposition to say the least, but so is openly pissing off a young uneducated and religious population through a currency devaluation. This is just one example of the extreme consequences of artificially low oil prices. There could be other lurking dangerous possibilities that haven’t been considered and the shocks unanticipated.
It’s important to note that, these oil producing nations don’t hold just a large pile of cash in their FX reserves. They own assets all over the world including equities in developed markets. And when the government needs to raise cash, they sell equities. Specifically US equities, after all they get dollars in return for oil not euros our pounds but dollars. As the price of oil falls, these funds need to sell off more of their liquid assets which draws down equity markets and further depreciates the valley of those assets. The guys at zerohedge have been talking about this since late early 2015. The fall in the price of oil has drained vast amounts of liquidity from the market, and we are starting to see those effects compound with the innate weaknesses and fragility of our dollar reserve currency system.
Sell equity markets. Treasuries still remain an amazing bet and I’m still amazed how many people believed the Fed would be successful in raising rates. That facade has almost faded and long dated US treasury yields should hit all time lows later this year.
Before I go, I want to reiterate my long term bullish stance on oil. The head of the IEA recently said the oil and gas market cut CapEx by a record amount in 2015 and in 2016 they are set to break that record with new cuts to CapEx. So the two biggest cuts in CapEx in the history of the oil and gas business have happened in back to back years. Once again we are setting up for another supply shock, but instead of a glut, there won’t be enough oil.
As of right now, oil futures for Dec 2017 are at $38. Just for a second imagine what the world would be like 2 years from now if oil was still trading in the 30’s. A hellish landscape of forgotten dreams and unimaginable nightmares! The point is, if you are wrong on this bet, then it doesn’t matter, because the world is ending! No but seriously, $38 oil for Dec 2017 sounds incredibly cheap and it may go even lower, but the amount of front loaded supply that’s come to market as a result of this drop in price will force oil prices higher before that December 2017, and those contracts are starting to look like a very nice buying opportunity.