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“All Cycle-Bottoms are Different – Tell Me How this One Ends”

Oil rig
by Stephen Arbogast

With oil prices breaking below $30/B, they are close to ‘the sky is falling’ levels promised by Goldman Sachs some months ago.  Clearly the oil markets are at or nearing a cyclical bottom.  Soon the key question will change.  For months the prime interrogatory has been “how far will it fall?”  In short-order it will become “will prices rebound or lay there for years to come?  By looking at the differences between today’s and prior busts, we can discern that the odds favor a quicker recovery this time.  Once prices bottom, the most likely case is a rapid recovery, i.e. +80-100%, after some inflection point is passed in the next 12-24 months.

At moments like this it is customary to revisit prior price collapses.  Oil boasts one of the purest commodity markets.  Its price is transparently set on global exchanges.  By now anyone with an interest in economics or investing knows that oil prices are highly cyclical.  As recently as June 2014, Brent crude oil boasted a $108/b price.  Since then its fallen by more than 70%, and the resulting pain among oil firms and countries is palpable.  Might relief be just over the horizon?  What can prior price cycle bottoms tell us about this oncoming question?

The answer, unfortunately, is less than we think.  Since OPEC seized control of oil markets in the 1970’s, there have been three price cycle bottoms: 1986, 1998, and 2009.  In each case prices fell by more than 50%.  We also forget the absolute bust levels involved – under $10/b in the ’86 and ’98 episodes, and around $35/b in the wake of the Financial Crisis.  The rebounds varied.  After 1986, prices recovered to the $20/b range and then sat there for almost a decade.  The 1997 Asian contagion exhibited a slow recovery; prices stayed in the low $20s/b until 2003, and then began an inexorable rise on the back of China’s take-off.  Prices peaked in the 1<sup>st</sup> half 2008 at $145/b, then collapsed as the Financial Crisis hit.  This time the price recovery was faster and stronger.  Crude prices rose to $100/b by 2011 and stayed around that plateau until the slide began in 2014.  Clearly all cycle bottoms are not the same.  What can we learn from their differences that might inform the present moment?

The 1986 bust was primarily an OPEC cartel internal struggle.  Non-OPEC supplies had grown briskly on the back of high prices and memories of the 1970s shocks.  Starting around 1982, the market began to struggle with surplus supplies.  This posed the supreme test for a cartel – could it ration supply in the face of glut?  OPEC dramatically failed the test.  Countries with high income needs, e.g. Iran, Venezuela, routinely cheated on their quotas.  This forced Saudi Arabia and other Gulf states to compensate by cutting production by more than their allotted reductions.  Here is the astounding fact – by 1985, Saudi exports had dropped below 3 MB/day versus production capacity of around 8 MB/day.  Fed up, the Saudis finally opened the taps.  Prices collapsed in the face of this flood.  More critically, because there was so much spare capacity on the supply side, prices stayed low even after OPEC made a peace of sorts.  When prices recovered to $20/b, all the non-OPEC production was ‘back in the money.’  It kept pumping, leaving the cartel with lots of spare capacity that could be quickly brought on line.  Much of this spare remained in Saudi.  They reasoned the cheaters had been taught a lesson, and it was safe to go back to a revenue maximizing role where the Kingdom supported the oil price.

The 1998 and 2008 busts had something different in common – they were triggered by financial crisis and recession.  Oil demand contracted leaving surplus supplies and plummeting prices.  Once prices had fallen however, the two episodes diverged.  After the 1998 Asian contagion, demand was slow to recover.  After 2008, China launched a fiscal stimulus that was highly energy intensive.  Massive capital projects constructed highways, railroads and apartment blocs.  China’s energy consumption continued to surge, which also sustained energy-intensive growth in the emerging market countries shipping commodities to China.  Consequently, oil prices recovered with surprising rapidity.

From this review it should be clear that each oil price bust is distinctive in some ways.  Oil prices have collapsed both when demand was still growing (1986) and as a result of broad economic recession (1998 &amp; 2008).  Price recoveries have plateaued after an initial bounce back (1986) but also rebounded sharply (after 2008).  Just looking at these episodes provides no easy guidance about the present.  We can however draw out factors that distinguish the current bust from all its predecessors.  This will give us some clues regarding how this new cycle bottom might end.

To begin, the current bust is not rooted in recession.  Oil demand is still growing.  Currently the world is consuming more than 92 MB/day, up from 89 MB/day in 2010.  We can therefore throw out the recession-driven narratives.  What can be said on the demand side is this – it’s not growing as fast as supply-side investors thought.  Prior to 2008, oil demand zoomed higher, driven by China’s build-out.  China has since lost its export dynamism, and its dramatic fiscal stimulus which kept commodities afloat from 2009-14 has run out.  Since then, global oil demand has not flat lined, but it hasn’t compounded rapidly either.  Global demand has added 1.5 MB/d since 2013 and continues to grow.

We can also throw out the idea that this bust is about OPEC quotas and discipline.  The Saudis have shown remarkably little interest in talking to their OPEC ‘partners.’  There have been no emergency cartel meetings.  Indeed, the Saudi Oil Minister went on record favoring fewer regular meetings.  There have been no headlines about ‘who is cheating.’  It seems instead that the Saudis just assume everyone produces full out and they are doing so too. The idea of revenue maximization seems to be lost.  There is little discussion of an equilibrium target price against which the cartel should distribute supply cuts.  The pain from Caracas to Lagos must be unbelievable, yet OPEC shows zero sign of responding.  Something more than punishing cheaters must be driving Saudi policy.

Make no mistake, it is Saudi policy which has galvanized fundamentals into a full-blown oil price bust.  In 2008 the world economy was on its knees and prices only fell to $35/b.  On January 15, 2016 they fell below $30/b.  What explains this anomaly?  The answer is an artificially induced supply side glut. Current Saudi oil production is over 10 MB/day and exports are around 8 MB/d.  The Saudis have manufactured this glut by assuming all OPEC states will produce full out and then doing the same thing. The oil market surplus is only 1-2 MB/d.  If the Saudis and their Persian Gulf partners withdrew 1.5 MB/d, prices would be above $50/b within a week.  What is driving Saudi policy?  If it isn’t cartel politics, what is it?

This brings us to the unique feature of this bust, a complex geopolitical overlay.  The Saudi state feels threatened on all sides.  It is threatened by ISL, a radical Sunni jihadism that depicts the House of Saud as apostate sell-outs.  It is also threatened by Iran, its longtime foe across the Persian Gulf.  Iran has militant proxies operating in Lebanon, Syria and Yemen.  The Shiite government in Baghdad is heavily influenced by Tehran.  A majority Shiite population in eastern Saudi Arabia and Bahrain is a constant source of suspicion and worry. All of this gives the Saudis the feeling of hostile encirclement.  On top of this, the U.S.-Iranian nuclear deal promises to remove sanctions that have crippled Iran’s economy for more than a decade.  The deal also signals a radical downgrading of U.S. priority towards protecting the Saudi state.  The Obama Administration has taken a bet that this agreement and internal Iranian dynamics will lead to Iran voluntarily foregoing nuclearization.  If they are wrong, the Saudis know the bill will be presented on their doorstep.

These are existential threats of the first order.  Only issues of this magnitude can explain the Saudis’ seeming indifference to cartel politics and revenue management.  This becomes clearer when we examine how rock-bottom oil prices serve Saudi security interests.

For starters, rock bottom prices blunt the benefits Iran reaps from its U.S. nuclear deal.  Much has been written about Iran’s $100 billion in blocked cash soon to be released.  Much also has been written about the 500 kb/d of additional oil Iran can soon put on the market.  Little has been written about the fiscal hole Iran has fallen into since 2013.  What must Iranian government accounts look like as the state oil firm (NIOC) saw its export prices fall by 75%?  What physical conditions currently characterize Iran’s oil fields, pipelines and refineries?  It is a reasonable bet that the $100 billion will be swiftly swallowed up just repairing the shortfalls of the last two years, not to mention the longer sanctions period.  As for its opportunity to ramp up oil sales, the Iranians are painfully aware that this could even be <strong><em>“revenue negative.”  </em></strong>The oil price structure is so fragile at the moment that plus sales could result in price declines affecting all Iranian exports such that little or no net revenue gain results.  This is the reality behind recent Iranian talk about executing “barter sales.”

Wielding the oil price weapon also gives the Saudis ‘leverage’ in critical events soon to unfold.  It gives the Saudis leverage on Iran’s execution of the nuclear deal.  Tehran knows there will be little hope of OPEC returning to price supporting quotas if Riyadh sees it cheating on the nuclear deal’s provisions.  Only in the wake of what the world sees as a ‘successful’ deal implementation will there be an environment conducive to hammering out a new OPEC deal in Vienna.  Low prices also punish ISL by depressing the value of its smuggled oil sales; these have been key to financing the self-proclaimed caliphate, but are now worth half of their value from one year ago.  Finally, the Saudi induced price bust reminds the U.S. of the Kingdom’s ability to shape events apart from its American patron.  For now Saudi policy is enormously helpful to the Obama Administration’s risky bet.  The implied message to Washington – don’t take us for granted; our interests might not always converge so conveniently.

It is a measure of these existential threats that the Saudis have announced far reaching fiscal reforms.  Higher gasoline and electricity prices, an IPO for Saudi Aramco, major budget cuts, these are just some of the measures signaled by the new generation of Saudi leadership in a recent Economist interview.  These announcements signal the Kingdom digging in for an extended price war.  Whether they follow through on implementing everything is beside the point.  What matters now is the signal.  The message is – ‘yes we know we’re burning ~$100 in fiscal reserves annually, but that alone is not going to cause us to turn.  We’re prepared to withdraw some of the subsidy from our coddled populace in order to stare down our more vulnerable opponents.’

Much has been written about Saudi policy punishing frackers and bad actors like Russia and Venezuela.  These are collateral benefits but not the root cause driving policy.  The Saudis are astute oil market observers.  They know that fracking, unlike deep water or tar sands, can be turned back on fairly quickly.  Moreover, to Saudi eyes fracking has the side benefit of chilling momentum towards renewables.  The Kingdom probably understands that frackers will be the marginal supply source going forward, and has made its peace with that happening in a long term $60-70/b world.  Its budget measures can be seen as a step towards aligning with that long term reality.  As for Venezuela or Russia, neither poses anything like the existential threats of Iran and ISL.  Neither concern could drive Saudi policy to this extent.

If a very different Saudi policy is the distinguishing feature of this oil bust, what does that say about how things might end?  For starters, it means this fact – the OPEC cartel is almost out of spare capacity.  Sure there is always some spare sprinkled around the producers for various reasons: less marketable grades, new fields coming on, etc.  Still, the key here is this – once Iran and some plus Iraqi supply is in the market, OPEC will have very little capacity to meet higher demand.

This means demand growth will be one key to figuring out when and how much oil prices will recover.  Right now China’s slowdown and the commodity bust are suppressing demand growth in the most energy-intensive markets.  At some point the combination of economies stabilizing and low energy prices will reverse that trend.  Meanwhile, demand growth has already resumed in the U.S. and Europe.  Prior forecasts that U.S. gasoline demand would never exceed 2008 have already gone out the window.

So, the first end-scenario is that demand growth gathers steam, soaks up supplies and oil prices recover in a spike to $60-70/b.  When might this happen?  That is a guessing game but late 2016 into 2017 is not an unreasonable bet.

A second scenario is derived from the first.  In this outlook, the Saudis see demand growth beginning to gather, see that Iranian implementation has met requirements, and decide the time is ripe to make a deal.  They would do this because they perceive the alternative to be the first scenario – in which case Saudi Arabia loses its leverage.  The Kingdom would be left producing all-out, have no influence over price, and the frackers would be back.  Better to make a deal that restores Saudi spare capacity and leverage while taking the fiscal pressure off and suppresses demand recovery than be rendered impotent by the market.  Possible timing would be towards the front end of the range mooted above.

Of course there is the scenario markets are currently pricing – that demand lags, nobody knows how bad China’s economy is, and new supplies from Iran/Iraq crater a fragile price structure.  Almost all of this risk is known; it is also front-end loaded, and probably reflected in current prices.  The unknown is whether a complete bust up is possible in China.  That would extend the time horizon for the above scenarios out many years.  However, such an event is unlikely for two reasons.  First, the Chinese government has no hesitation when it comes to intervening in its economy.  It doesn’t worry about moral hazard or animal spirits.  Second, that government is petrified of losing control and sees economic recession as its existential threat.  This means it will do whatever it takes to keep the economy functioning.  If that requires bailing out zombie banks and companies, it will do so.  That may not be a recipe for long term growth, but it likely will forestall the kind of financial meltdown that leads to deep recession or depression.

Thus, oil market eyes should turn back to the Saudis.  The distinguishing features of this bust concern them: 1) that the oil weapon has been deployed to lower rather than raise prices; 2) that revenue maximization seems a secondary concern; and 3) that current slow demand growth gives the Saudis a context in which their supply capabilities can determine price.  The Saudis have deployed their weapon in this different fashion because of non-economic, existential concerns.  They will revert to more conventional policies when either those concerns are ameliorated and/or they decide to sheath their weapon before demand renders it impotent.