We all woke up to a crisis in the oil markets yesterday. It was a 31% drop within seconds. The second highest drop since January 1991 when the Gulf War had broken out. Most of the millennials will not remember that. I remember it like it was yesterday.
Sitting on my desk on Wall Street, not even 16 months into my career, looking at all the market monitors and watching the havoc unfold. I thought it was the end of my career as I thought that it was the end of the financial markets around the world. Looking back today, I smile. How naïve could one be? The answer is, as naïve as I was.
That time came and left and gave me a thick skin to deal with all such future events. So thick that nothing affects anymore except an analytical switch turns on which helps in looking at the whole scenario with a bird’s eye view being completely detached from it. Being detached is what is needed to analyze a situation correctly.
Tens of situations like 1991 came and went in the past 30 years. From capital markets crashes to commodities crashes to wars and debt market chaos. At the end, it all worked out fine, as it always does.
The Current Oil Chaos:
Is this something new? Yes. Slightly. The only factor new in this whole scenario is the Corona Virus. We will come to that later. But let us examine what happened and who will blink first, the Shaikh (Saudis) or The Czar (Russians), because the Shale (Americans) guys are absolutely sitting ducks, them blinking or not makes no difference at all.
Saudi Arabia has been trying to coerce Russia into cutting production by 1.5 million barrels a day. Russia is not an OPEC member so nobody can muscle them into obedience. One can only negotiate with them. And if the negotiations fail then it is a war. And in a war, may it be financial or conventional, there are no winners.
In Vienna, the Saudi Oil Minister met with his Russian counterpart with a clear message from Putin. We will not be strong armed into cutting production, and that message was probably delivered to the Saudis back home and instead of negotiating further, the Saudis announced that they would increase the production, instead of decreasing it, by 400,000 barrels per day, taking it above 10 million barrels a day. In other words, declaring an absolute production war by flooding the markets assuming or calculating that it would reduce the oil prices drastically and hurt the Russians and force them into obedience. But that was not the right move by the Saudis, in my humble opinion, and based on numbers my opinion gets stronger.
Let’s do some calculations as to who loses this oil war.
Nobody can extract oil cheaper than the Saudis. This fact is half true because extraction and fiscal breakeven are completely two different matters. Saudis can extract oil from their existing fields at just $2.80 a barrel. Russian Rosneft, can do the same thing but at $20 dollars a barrel. Exxon Mobile does it at $16 a barrel.
And this is where the confusion for a common man steps in. They think that $2.80 is the final cost and you can sell it at the market price. Absolutely no.
Overhead costs, calculations by the IMF show an absolutely different story when it comes to final or fiscal cost per barrel which include all overheads. Keep in mind that ARAMCO is one of the largest corporations in the world, along with EXXON or ROSNEFT or others. So the overheads pile up.
The IMS says:
The cost for UAE, for example, per barrel including Fiscal breakeven is $70 per barrel. Iraq is $60.3 per barrel. Kuwait is $54.7 per barrel. Delaware Basin is $44.3 and U.S. Midland Basin is $44 per barrel.
So far so good ? Not really. Let’s see what the breakeven costs are for the two giants fighting with each other, Russia and the Saudis.
The breakeven cost per barrel for Russians is $42.40 and the Saudis is $83.60
Saudi has been losing money since 5 years to begin with because we haven’t seen those price levels since then. Saudi probably thought that they could do the same thing that they did back in 1985 when the flooded the markets as well and few years later it caused the collapse of The USSR.
Another factor that comes into play is the corporate debt that these behemoth corporations have on their books. Energy companies borrow heavily to finance their operations. The yield on Saudi bonds maturing in 2030 come out to be about 2.38% and Russian bonds at 2.56%, but the Shale producers are the losers here with yields on their junk debt crossing 10.6%.
Russia does not have a huge economic development program like the Saudis do. Vision 2030 planned by MBS, The Crown Prince. Reforms are the key to succession in the case of MBS. Russia does not face such a pressure. A prolonged price war will spill over into the bond markets and repayments being affected by profitability will reign havoc for the producers.
So in the end, my conclusion is that if Corona Virus is controlled then we might see either Russia or the Saudis softening their stance towards each other because they cannot continue to fight. In the second scenario, Corona, if not contained immediately, will wipe out the demand in proportions never witnessed by this world in recent history. No air travel. No summer vacations in cars. No ships sailing, pleasure or trade. Corona can create a disaster in the oil markets that would look like this Russia and Saudi tussle like two kids pinching each other.
This is a wait and see game. So let’s wait and let’s see.
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