Tuesday, December 2, 2014

Oil price, elasticity winners and losers!

Sunday night I began writing on the astounding drop in the oil sector, at the time (Tokyo time 9am Monday) the price of oil was on its way to $64/bbl down from $105 in January -- this is a 39% drop in price -- a singularly important component of the world economy, just became much cheaper. Since then oil prices have risen back to the $67/68 range, so crisis averted...

The retracement in the oil market is natural, a function of properly working financial market.  My guess was that at $64.55/bbl we were looking at a massive natural barrier to further drops, there's a futures market out there, and for the players there are "natural" inflection points.  Now these are usually technical (rules of thumb) issues, but it remains that they are real for the market.  What is happening is "consolidation", the market overshot and now its finding a new (maybe temporary) equilibrium.  Oil prices are not independent, they are a transfer of wealth between the user and the supplier.  Lower oil prices means that the users retain more of their wealth, and the supplier have less to spend.

The big losers:  Countries such as Saudi Arabia that have variable costs of maybe $10/bbl are still doing well, although I understand that to justify the country's "living expenses" $70/90 per barrel is really much more comfortable.  Watch this year -- Saudi Arabia's government will have a sizeable deficit.

The big winners are massive consumers:  China, most of South America, the US (they still import) and Europe.  the big losers:  Russia, Canada, Middle East -- Far East (Malaysia & Indonesia).  So there are winners and there are losers too.

Capital markets will probably not be very happy.  A substantial portion of the junk bond market has financed oil and gas project -- some of these are fine, others not so much.  The real problem is that with the hedge fund industry all bets are off, what in the past would have been a technical default with a covenant renegotiation can become a drawn-out battle for control.  Those who have a small position can easily be crushed by these big players -- logic has little to do with these instruments.

We have witnessed a major shift in the oil&gas segment.  At this stage it is unclear where all this is going; there is no doubt that at $105/bbl there was lots of money hunting new finds.  At $60/70 per bbl there will be less money hunting for new oil finds.  Already certain Canadian oil sands projects are hitting the wall -- at $55/bbl (heavy crude is discounted against the WTI) the economics are just not there anymore.  projects that are already up and running (when the heavy Capex has already occurred) continue to operate, at least as long as the variable covered.

Canada is one of the losers (well Alberta and Saskatchewan the big producers) are hurting, budgets will have to be revised, since the province (where there is no provincial income taxes) lives of the royalties from its oil and gas finds -- very little of Alberta's oil revenues have been saved for a rainy day, mainly because the size of the oil sands (a few hundred years).

So what's the big takeaway here:  First the 35% drop in oil price has transferred wealth from some parts of the world to others -- China, as a massive oil importer, just saw its production costs drop, Russia is not finding this very amusing -- although its production costs are low, but the size of the transfer just dropped.

Green energy solutions were kicked in the teeth, at $105 solar pannels are nearly competitive -- and once you take into account the fixe/variable cost analysis -- solar energy was basically on par with oil.  Now they are 40% more expensive.  This price drop is almost certain to reduce the attractiveness of all green energy projects.

The concern by economist is that everyone has been cooking the books -- just a little; the problem is not the rise in supply but the fall in demand (we now know that Europe's growth last summer was virtually inexistent) we are talking 0.1%.  Although the ECB has targeted inflation rates of 2% -- the numbers are far low (and now with a massive drop in the cost of energy) inflation numbers could go negative -- deflation could be here.

Japan is a mess, China may see some hope out of the lower oil price but as a massive exporter of goods and where its markets (Japan, Europe and the US) are either in recession, near a recession or suffering from low growth -- despite very stimulative policies it may be that its not only the supply side that is a problem, but more fundamentally the demand side of the equation...


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