Brief Notes on an Oil War

What the Saudis and Russians are doing and why your 401k hates it.

By Eric,

Now that my travel plans are shot, I thought I'd do a bit more writing - but where to begin? I don't feel like I have a handle on the Coronavirus, and frankly writing anything coherent about politics in this moment would take more space than my poor raspberry pi has to offer. I woke up today to the markets crashing, though not for any of the reasons I'd have expected - instead, it's just a good old bit of straight line geopolitics. That, THAT I can get a handle on.

Oh, and obvious note that I'm not an expert. Don't invest based on my musings.

You may have noticed there was a bit of a kerfuffle in the markets this morning. While stocks have taken some hits over the last couple weeks already, it turns out this wasn't a pricing adjustment related to the globe-spanning pandemic or the less-than-confidence-inspiring briefings from the White House. The cause today was the Saudis declaring they would stop supporting the price of oil, in effect declaring a pricing war with Russia.

I want to cover a couple things in this post - first, some background on how we got here; second, why a Saudi/Russia pissing match is ruining your 401k; and finally, what I expect going forward.

Background

As you probably know, global oil prices are generally managed by OPEC, headed by Saudi Arabia, along with a couple other players, including Russia. In normal times, these countries work together to set production quotas to assure a high price of oil. The impact of the Coronavirus outbreak on the global economy has been to suppress demand, and thus the price, for oil, both through reducing Chinese factory output and reducing people's willingness to travel. The Russians refused to cut production to boost prices again, which led to the Saudi decision to boost production and cut their prices. The overall impact was to cut effective oil prices by almost 25% overnight.

The foundation of the rift lies in differences between the Saudi and Russian oil markets and how those countries have structured their economies. The Saudis have the second-largest proven oil reserves in the world, and until recently were the largest producers of oil in the world (the US recently passed them, although most US oil is for domestic consumption). They also have the lowest cost of oil production in the world, with estimates ranging between $5 and $10 per barrel. However, the Saudis have an extremely concentrated oil industry, with one company, Saudi Aramco, effectively accounting for the entire Saudi output. The Saudi economy is strongly leveraged on oil, and estimates are that oil prices need to be above $75-85 per barrel to balance the Saudi state budget. The Saudis have enormous cash reserves - on the order of $500Bn or so - to pad the budget, but effectively oil prices below the $75 mark mean the Saudi government is running a deficit.

The Russians, on the other hand, have both smaller reserves and smaller output, but not by much - they're the third largest producers of oil in the world. The economics for them are different, though. Cost estimates per barrel range between $20 and $30. The Russian economy is heavily dependent on oil as well, but the oil industry is both less concentrated and more independent - both Gazprom and Rosneft are around 50% government owned, and Rosneft, the largest producer, is only around 40% of production. Finally, the Russians only need oil prices around $50 to balance the state budget, and the country has similar reserves to Saudi Arabia.

All of this adds up to different incentives for the two countries: Saudi Arabia needs high oil prices and has the leverage to enforce production cuts at its only oil company. Russia can live with lower oil prices, but it faces domestic pressures from its oil industry to keep production up and the money flowing in. However, Saudi Arabia can profitably produce at prices as low as $20 a barrel, while Russia probably needs prices north of $30. The result is a pricing war: Saudi Arabia is trying to drive prices down low enough that the Russians blink and decide to come back into the fold and cut production. The Russians are looking at this as an opportunity to reshape the oil producing market by breaking the Saudis ability to drive prices.

The Market Reaction

What's strange about all of this is that the markets have reacted to lower oil prices the way they normally react to crisis news - things like national defaults or large company collapses. Normally, lower oil prices effectively act as a stimulus for the economy - since oil is both an input into industrial processes and a cost item for consumers (as gasoline), lowering oil prices both lowers costs of production and stimulates consumer demand. That we've seen stock prices go down in reaction to an oil price change is unusual. I think there are four potential reasons:

1. Bad Heuristics

In normal times - hell, as of last week - a drop in oil prices indicates a drop in demand for oil. Drops in oil demand are usually indicators of slowdowns in economic activity, and so a falling oil price can be an indicator of problems in the overall economy. Indeed, that's what we were seeing leading up to this price war - the Coronavirus's effects on economic output were leading to lower demand for oil, reflecting a slowdown in the overall economy. However, the current fall in oil prices has nothing to do with demand - it's an increase in supply, not a demand restriction, causing the price to fall. So if this doesn't reflect anything in the underlying economy, what gives with the pricing?

I'd expect the impact is by two paths - first, traders are used to seeing the correlation between low oil and low output, and are likely blindly trading based on that (if anyone ever tells you the markets are rational, they haven't met traders). Second, I'm guessing the "oil drop => demand drop" relationship is baked into about a gazillion trading and pricing algorithms, none of which can actually read the news. The market's a self-fulfilling beast: if the prices go down, the prices are going down, to hell with the reasons.

In other words, in part, I think the market reaction is the tail wagging the dog: normally, X is caused by Y, so when we see X, we act on Y. In this case, we've got exogenous X, but we're still acting on Y.

2. Chaos is bad for markets.

Another driver of price drops is perceived market risk, and perceived risk is largely driven by perceived stability in the broader world. Overall, markets and the economy at large perform best when the geopolitical situation is stable - when supply lines aren't getting interrupted, when companies know what the next couple years look like from, and when consumers feel relatively secure. The collapse of OPEC negotiations and Saudi Arabia and Russia getting into a pricing war may not be directly bad for the economy, but it increases the number of possible surprises in the world economy, and that makes everyone nervous. Nervousness depresses investment, and depressed investment costs both the markets and the broader economy. In other words, to channel Keynes, the Animal Spirits are Spooked.

3. Adverse Impacts on Oil Producers

This is the most direct-line negative effect I can see between lower oil prices and the broader economy: for a number of oil producers, there's a floor beneath which they're no longer profitable. If it costs a company $40 per barrel to extract oil, and global oil prices drop below that, the company has to shut down operations. This causes layoffs, bankruptcies, and other negative economic effects. I don't think there's enough potential economic impact to account for a 7% drop in the overall market, but this is the only direct (short term) negative impact I could see from lower oil prices.

4. The Market prices Assets, not Output

I think the other basic driver here is that the markets don't actually price economic activity, they price assets. If you hold oil, the price of oil going down is bad for you. If you hold oil companies, the price of oil going down is bad for you. Overall, as a person who owns assets, the cost of oil going down is likely to be directly bad for you. It doesn't really matter what happens in the rest of the economy - if you were to own the patent on the cure for the common cold, breaking that patent would likely raise global economic output by several percent, but would tank your portfolio. The market is not the economy, the market is the market.

Back in the real world

Ok, so what's the likely impact on the economy day-to-day? Once again, lower oil is effectively a stimulus to the economy. That's actually pretty valuable right now, as the rest of the economy is in pretty rough shape thanks to the impacts of the Coronavirus. The net impact is going to depend on whether the stimulus effects of lower prices offsets the panic effects caused by whatever the bajeezus the market's doing right now. I think there are some really strong structural forces that are going to resist any type of stimulus, though - the drop in oil demand is being driven by quarantines in China and travel restrictions & reductions due to Coronavirus fears, and all of that's pretty insensitive to price. Consumers are spooked, and a decrease in gas prices isn't going to have that strong of a marginal effect on travel right now. It could help keep airlines and shipping companies afloat, though, by lowering their costs.

Long Term

I don't know which way this falls in the long term. Both the Saudis and the Russians have enough money in the bank to keep this going for a while. My instinct is the Saudis blink first - Russia's simply got less to lose here. The Russians have shown they're willing to take risks to reshape the global order, and I think forcing the Saudis to admit they can't control the oil markets anymore is a big enough prize that they'll hold out for longer than the Saudis are expecting. The chaos in Saudi leadership over the last year or so doesn't inspire confidence that they're properly evaluating risks on that side - Saudi leadership has always been a collection of the worst assholes in the world, but previously they were generally risk-averse assholes. Since taking power, Mohammad bin Salman has started a disastrous war in Yemen, killed a Washington Post journalist in a ludicrously public fashion, and is seemingly engaged in a continuous set of purges and power struggles against his family and anyone else who might know what they're doing. Still, my baseline instincts are that things basically stay close to the same in the long run - my guess is the overall outcome is pricing power shifts fractionally towards the Russians, with an impact of long-term prices being around ~10-20% lower than they'd otherwise be.

Normally I'd argue this was a bad outcome from a Climate Change perspective, but at this point, it's pretty clear the market's not going to solve the climate for us. Oil prices have made some impact on arguments about the economics of decarbonizing the economy, but I think increasingly weather pattern changes are going to take over that role. Between the fires in Australia and California, the increased storms and flooding, and the changing seasons' effects on crop viability, I think we'll have plenty of economic drivers to push climate policy for the next few years. If we could pump political will out of the ground, that'd be nice, but absent that, I don't think this has an impact much one way or the other.

Discussion

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