Here's What Happens When Oil Geo-Policy and Market Reality Collide

Here’s What Happens When Oil Geo-Policy and Market Reality Collide

by | published August 25th, 2015

Over 220 years ago, a Scottish writer by the name of Thomas Carlyle provided a personal account of what Paris was like during the French Revolution. The three-volume work (which at one point I suggested in an academic article was two volumes longer than necessary) is full of personal anecdotes. One of them is particularly relevant these days.

On a hot afternoon, Carlyle was sitting in a coffeehouse with a supposed high fellow of the revolution. Suddenly a shouting crowd with raised pitchforks rushed by. The revolutionary jumped to his feet, apologized to Carlyle, and said: “Those are my people. I am their leader. I must follow them.”

Cut to yesterday.

The last two trading sessions have prompted a frantic rush among investors to find whatever safe haven from a global market implosion may be available. Yet, in my circles, there is an even more interesting development afoot, one that brings back Carlyle’s 1790 conversation.

Here’s what’s really going on in the oil markets right now… 

OPEC’s Backfiring Plan

What had begun as a calculated move by OPEC producers to protect market share has morphed into a crushing decline in crude oil prices. The downward spiral in the oil market now has a life of its own. And in the process, its creators are panting to catch up.

Like a snowball racing down the mountain, those who set it in motion no longer control where it is heading.

Beginning last November (on Thanksgiving, no less) OPEC started the policy assault by deciding to keep production constant. By doing so, it telegraphed an intention to protect its international market share rather than the price.

What followed was the first of two significant pricing slides.

In the process, it became clear that not all cartel members were in the same boat. While all members were experiencing shortfalls in revenue – requiring deficit financing for central budgets – only Saudi Arabia, Kuwait, and the United Arab Emirates (UAE) could afford to carry the policy along without serious financial problems.

Other OPEC members, such as Venezuela, Libya, Algeria, Nigeria, Iran, and even Ecuador (the smallest producer and exporter in the group), require triple-digit crude prices to have any hope of balancing already suspect budgetary outlooks.

The Saudis Target Russia and the U.S.

That translated into a rising desperation among the also-rans to produce and export well above their monthly quotas. The receipt shortage was demanding that they sell additional amounts of oil into an already oversupplied market. That drove prices down further.

No longer able to control the situation, the Saudis decided to continue appearances as the “leader” of OPEC and increase their own production and sales. That way, the overproduction could be portrayed as a cartel-wide decision. Of course, prices went down in consequence.

There were two targets for these machinations. The first is the Russians. Moscow has a completed ESPO (Eastern Siberia-Pacific Ocean) pipeline with a crude oil grade better than Saudi exports destined for the Asian market.

The Saudis needed to offset that competition in what is becoming the principal worldwide energy market. By cutting prices significantly, Riyadh is requiring that Moscow move oil to Asia at a loss. Recent strong statements from state giant Gazprom that the trade will continue despite Saudi moves are actually a recognition that the OPEC policy is working in limiting Russian exports to the energy-thirsty region.

The second target is the one getting all the media attention. U.S. shale and tight oil production had been accelerating, with the traditional “call on OPEC” being replaced by the “call on shale” in setting prices.

Now the American impact remains indirect, since the vast bulk of domestic production cannot legally be exported. Yet OPEC knows that more than 80% of the world’s extractable shale and tight oil is not located in North America.

That means the contest with the American oil patch is the “test case” for a problem they will be increasingly facing as other countries turn to developing local unconventional volume.

The Chinese Stock Market Implosion Changes the Game

And then the other shoe fell. Two of them, actually, and both Chinese.

First, Beijing began importing more African oil, especially from other OPEC members Angola and Nigeria. The prospect has required Saudi Arabia to lower its own export prices and to enter into an intra-OPEC competition.

Left in the wake as well is Iran, which has relied on China as its primary trading partner throughout the period of Western sanctions.

Normally, lowering prices to one region would result in raising export prices to others, especially in this already reduced pricing environment. But then the second shoe fell.

The Chinese stock market implosion hit. Not only has this introduced concerns (largely overblown, in my estimation) of an impending major decline in Chinese energy needs. The market collapses in Shanghai and Sichuan have ushered in a global market meltdown.

This dual whammy from the Orient has slashed crude oil prices well below where OPEC wanted them. The policy they had introduced to maintain their market share in the face of competitors is now under the direction of forces beyond their control.

As I write this, it is 1 a.m. U.S. Eastern Time. Shanghai is down another 4%. OPEC will need to reassess its strategy shortly.

Carlyle must be smiling in his grave. Déjà vu is like that.

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  1. August 25th, 2015 at 15:49 | #1

    …and well below where Russia wanted them. That is interesting. I went to school with some Saudi Princes. This seems as if this is more like an unintended economic sanction against our former allies the Russians. I suspect the price of oil will remain not too high, not too low, but just right. I used to study maxima and minima.

  2. Laurel W
    August 26th, 2015 at 19:22 | #2

    Interesting Dan

  3. Captjohn
    August 26th, 2015 at 19:48 | #3

    So – with the ‘crash’ of prices comes a lack of reinvestment and development of resources… Eventually falling crude stocks and production – leading to higher prices?
    Maybe next year?

  4. Manfred Kruger
    August 26th, 2015 at 20:15 | #4

    The Saudis would have been much smarter if they had invited Russia to join OPEC and the Russians would be much smarter to join. The two largest oil producers could then rule the oil market and adjust production to meet their economic needs.

  5. August 29th, 2015 at 09:31 | #5

    All these conflagrations on the periphery of the USA show that the USA is still the ‘center of the universe’ economically, maybe all this talk about China over-taking this & that is just that, talk.
    It seems that where market forces are just convenient veneer, that’s where central planning causes the market lurching of a disorientated drunk.
    The only reason the USA is now less effective in stabilizing markets is because it itself has fallen to the siren call of a command economy but as always in a free economy (somewhat) the potential exists to right the ship during this election cycle.

  6. raman india
    August 29th, 2015 at 23:41 | #6

    Sir, We here in India are fed up of this oil-gas-war politics. Ultimately technology like shale oil/gas is what worries OPEC. Today china has invested billions of dollars to promote Electric vehicles. Of course they are also investing in LNG/nat gas trucks/buses. Even here in india we are promoting solar energy/wind farms in a big way. For example in the state of Tamilnadu we have massive wind farms which sell electricity to the TNEB grid. This way we can reduce our dependence on Coal or heating oil(kerosene).
    Losers in this game of chicken is Venezuela, iran, libya.
    Libyia was a great cuontry for indian Teachers/professors they were very safe there until Gadhaffi was killed. now it is another syria. very sad.

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