Financial Review

The Brute Economic Power of Oil

Financial Review

DOW – 61 = 16,987
SPX – 11 = 1985
NAS – 24 = 4567
10 YR YLD + .08 = 2.61%
OIL – .58 = 92.25
GOLD – 11.90 = 1229.30
SILV – .06 = 18.71

For the week, the Dow was down 0.9%, the S&P 500 was down 1.1% and the Nasdaq was down 0.3%.

Let’s start with the economic data: Business inventories rose 0.4 percent in July vs a 0.8% rise in business sales that keeps the stock-to-sales ratio unchanged at a healthy and lean 1.29. In a separate report, retail sales and consumer sentiment pointed at an improving economy. The preliminary September reading on the University of Michigan/Thomson Reuters consumer-sentiment index rose to the highest level since July 2013 and topped consensus expectations. Sales at US retailers rose in August by the largest amount since April, sales were up 0.6%; raising confidence in the economic outlook for the second half of the year. Retail sales would have been higher, but the price of gas dropped; after excluding gasoline, spending rose 0.7% in August.

Of course, one of the reasons Americans spent more money going out and eating and shopping is because the price of gasoline has been low. Spending at gas stations declined an estimated 0.8% in August. That followed a flat July and another 0.8% drop in June. A separate report from the Labor Department on Friday showed that prices of fuel imports fell 4.6% in August, the largest monthly drop in more than two years. If you can save $10 or $20 at the gas station, you’re more likely to spend that money at the mall or a restaurant.

So, in a very strange twist, the volatile situation in Ukraine and the Middle East has actually been a good thing for American consumers as we go to the gas pump. And in another strange twist, the International Energy Agency noted another reason for the lower prices: demand is remarkably low, and falling; and this is due to the weak economic prospects, especially for Europe and China. The Financial Times concluded:
The world’s appetite for crude oil slowed at a “remarkable” pace during the second quarter because of weak economic growth in Europe and China, prompting the International Energy Agency to revise lower its demand forecasts for 2014 and 2015. In its widely followed monthly report, the west’s energy watchdog said that global oil demand growth had slowed to below 500,000 barrels a day in the three months to June – the first time it has reached this level in two-and-a-half years. Slowing demand and plentiful supplies have together pushed down the price.

The United States has imposed new sanctions on Russia’s largest bank, and a major arms maker; also there will be sanctions on arctic, deepwater and shale exploration by its biggest oil companies.

Energy stocks were pressured after the Treasury department announced the new sanctions, designed to punish the country for its intervention in Ukraine. The S&P oil sector fell 1.4% today, continuing a downtrend that has taken the group down 3.6% this week.

The sanctions target companies including Sberbank, Russia’s largest bank by assets, and Rostec, a conglomerate that makes everything from Kalashnikovs to cars, by limiting their ability to access the US debt markets. They also bar US companies from selling goods or services to five Russian energy companies to conduct deepwater, Arctic offshore and shale projects. The Russian firms affected are Gazprom, Gazprom Neft, Lukoil, Surgutneftegas and Rosneft.

The energy sanctions are not designed to curb Russia’s current oil production but to hit future production by depriving Russian firms of the expertise of companies such as Exxon Mobil and BP. Exxon has a $3.2 billion deal with Rosneft to develop Arctic oil fields. BP owns 18% of Rosneft and has signed a deal to explore oil shale fields in the Volga and Urals.

The Euro-union has also imposed new sanctions restricting financing for 15 Russian owned companies, plus asset freezes against 24 Russians, mainly politicians. The combined US and EU sanctions effectively shut Russian banks out of the capital markets of the US and Europe for everything except short-term debt.

The United States stressed that the sanctions could be removed if Russia took a series of steps including the withdrawal of all of its forces from Ukraine. Russia denies sending troops into eastern Ukraine and arming the separatists. Russian President Putin called the new economic penalties “strange,” given his backing of peace efforts in eastern Ukraine, and Russia’s Foreign Ministry said it would respond quickly with retaliatory measures against what it criticized as another “hostile step.”

So, today, oil prices continued moving lower to the lowest levels in 2 years, but that might not be the case if the sanctions are extended. Russia’s ruble currency has already fallen to a historic low against the dollar as its economy is hit by sanctions. That increases the price Russians must pay for many imports, from vegetables to luxury goods. And the price of oil might be an even bigger economic weapon than sanctions.

Russia is heavily reliant on oil sales and faces budget shortages at current price levels. It is estimated that the cost of production combined with what the Russian government siphons off to prop up its budget, results in a breakeven price for Russian oil at about $110 to $117 a barrel. Russia may have designs on Ukraine but if they are locked out of the financial markets and if they can’t turn a profit in the global oil market, they will find it difficult to finance their ambitions.

Daily oil production in the United States has risen sharply in the past 5 years. In 2010 the country still imported half of the crude it consumed, but the US Energy Information Administration forecasts that will fall to little more than 20% next year. Increased production of oil in the US combined with weakening demand, has pushed prices closer to $90 a barrel than $100, and prices could drop a bit more.

While US oil output has been rising fast, part of the big jump in supplies has come from countries that remain at risk of supply disruptions, including Libya and Nigeria; and don’t forget Iraq and Iran. Meanwhile, Saudi Arabia and the rest of OPEC is expected to continue to supply oil as needed, at least as long as the price stays above $85 a barrel. The Saudis have long said that they like the price around $100. Meanwhile, US oil companies working the shale fields claim they need $100 a barrel oil to make it worth their while, but a friend in the oil business tells me their real breakeven is closer to $80. For other US oil producers, like those working the established fields in Texas, the breakeven is closer to $30.

Where will prices settle? Well, they won’t. Oil prices constantly fluctuate. In early 2008, speculators jacked up the price to $147 and a year later, after the financial crisis, prices dropped under $40. Oil prices always move and always have an economic impact. If we look back to the 1980s we can see how this played out in the collapse of the Soviet Union.

From 1973 to 1980, when the West went through huge economic problems due to oil price shocks, the Soviet Union did not appear to have any concerns and their economy was fairly strong. In the mid-1980, the Saudis stopped protecting oil prices, and instead increased production fourfold, which resulted in a drop in oil prices by about the same amount in real terms. The Saudis still got the same amount of payment, they just delivered four times as much oil. The price declines hit the Soviet Union hard, resulting in loses of more than $20 billion a year, which was big money back then – not just the price of a startup tech company that makes one stupid little app.

So, the Soviets had a choice; they could cut back food imports, which would have resulted in food rationing and an angry populace; they could stop the highly subsidized oil trade among the Soviet bloc countries and risk dissolution of the Union; they could make radical cuts to the military-industrial complex; or they could go into debt, big time. Like politicians everywhere, they chose the path of least resistance, and started borrowing money from abroad, and avoided actual reforms. They managed to borrow very heavily until about 1989, when the price of oil dropped into the low teens and Soviet oil production dropped by 30%, and the Soviet economy came to a grinding halt. And the international creditors demanded payment, and cut off the credit lines.

The only way that the Soviet Union could have possibly survived such an oil production decline crisis, not to mention a complete loss of oil export revenue for hard currency, as well as cut its internal consumption, and cut off Eastern European exports, would be to shift to a market economy. The Soviet Union did exactly that. First, the Soviet’s cut off Eastern Europe from receiving cheap Soviet oil and forced them to pay in hard currency prices. Then when that was not enough the Soviets themselves had to allow internal oil prices to rise. This forced the Soviets to follow the same transition that Eastern Europe did. Indeed, Soviet and post-Soviet oil consumption declined a staggering 50% from 1985 to 1995.

In November 1989, the Berlin Wall fell. The pictures on television and in the history books imply that the breakdown of the Communist system in 1989 was a result of the peoples’ longing for freedom and democracy, and certainly that is true. The Soviet Union was both corrupt and brutal, the military defeat in Afghanistan had been costly and demoralizing, and don’t forget Chernobyl, the Communists could not compete effectively in new technology. It wasn’t just one thing; but President Reagan’s call to “tear down that wall” would not have had the impact if oil prices had not been torn down first. The transition was not by choice but by brute economic force.

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