By Chris Sanders of Sanders Research Associates Limited
Oil is down for good reasons
The collapse in the price of oil over the last six months or so is widely misunderstood. Many observers have thought that it is a fall orchestrated by producers – take your pick – to hurt other producers – again, take your pick. There may be something to this, but it’s hard to prove. A far simpler explanation is the one favoured by SRA, which is that oil is simply catching up to global economic reality, which is depression. Oil is tanking because it is becoming increasingly difficult to square the world economic outlook to a bullish energy matrix.
The mainstream continues to talk about a recovering US economy when the US labour market is undergoing a major secular structural shift with millions permanently losing a means of livelihood in the overt, mainstream economy, their jobs replaced by part time employment in sectors that are non-essential. US oil consumption remains weak and does not suggest a robust economic outlook at all, while the production of light tight oil and gas from shale continues because of what amounts to a subsidy from the Fed enabling the E&P players to borrow cheaply today to fill the investment and production cash flow hole that is opening wider beneath the industry. Talk of the US permitting US oil exports is pretty silly really, unless the point is to clear the way to supply the European market for political, not economic ends.
Marshall Plan Redux?
What we are seeing in Europe is an attempt by NATO to replay the post WW2 experience. If history rhymes, this composition is sounding very discordant. The reason is that in a perfect, apolitical world, Europe would quite naturally turn to Russia for its energy needs. No one else is in a position to compete effectively in a free market. The Atlanticist faction in European politics, dominated by the big banks, is not about to walk away from the fight it started, and is displaying a remarkable capacity for dominating the European political contest in spite of the faction’s equally remarkable unpopularity. It is unpopular for the obvious reason that it is causing a recession that is being made worse by increased tensions with Russia.
Discordance arises from the fact that unlike the post-WW2 period, the Red Army does not occupy half the continent. On the contrary, NATO is banging on Russia’s front gate. There is no Red, i.e. communist army exporting revolution. Instead, Russia is, or was, until western sanctions were imposed, open for investment. Unlike the post WW2 period, European labour has been thoroughly cowed, and the cost savings arising from the restructuring of European industry and its retooling to a less coal-centric model aren’t there. A shift at the margins to North American light tight oil and LNG will involve a permanent upward ratchet in energetic and financial costs, and isn’t going to happen overnight in any case, if at all.
The upshot of all this is that when the Russians walked away from the South Stream project in early December, they torpedoed any hope of Europe mitigating the recession consequent to the collapse of the European and North American banking industry. This is why GREXIT is on the table now, and why Greece is unlikely to be the last country to opt for a radical restructuring of its European relations. Russia’s gas deal with Turkey was announced along with the South Stream cancellation, a characteristically brilliant stroke. Whether anything actually comes of it is anyone’s guess. I for one find it hard to see a Turkish gas hub on Greece’s border, but then the Turks do have a long history of involvement in southern Europe. A deal with Russia would utterly transform Turkey’s strategic situation and open the possibility of its ultimate departure from NATO. It’s the possibilities that matter at this time. Now NATO planners must deal with a hitherto non-existent question: is causing Russia problems in Ukraine really worth the disintegration of NATO’s southern flank? Clearly, they seem to think it isn’t going to happen, but then they have been making a lot of mistakes in the last twenty years.
China + Russia = big problem for West
On the other side of the world the Chinese are finding it more difficult to hide a gathering economic slowdown with bogus numbers. This is, obviously, not a “normal” cyclical slowdown because of the huge leverage and what one can only guess is an equally huge iceberg of bad debt ready to hole the Chinese sampan below the waterline. China’s leadership, like everyone else running the industrial world, is addicted to big projects, mega “solutions” to mega problems that simply create even more problems. They don’t have enough water, enough oil, enough coal, enough of anything, really, except overinvestment in capacity that hangs over the global economy like the comet in the sci-fi thriller Lucifer’s Hammer. They are, consequently, in need of the Russians as badly as the Russians need them, a match made in state capitalist heaven. In the last few months they have closed the better part of a trillion dollars worth of energy contracts and a large ruble-yuan swap facility, while the Russians have agreed to supply China with their state-of-the-art S-400 missile defence system. Both are working to develop an electronic payment system as an alternative to SWIFT, the management of which has been at pains to emphasize it wants no part of sanctions. Too late, really, that train has already pulled out of the station. The Anglo-American monopoly on global financial flow management is in the process of becoming history.
None of this should be a surprise
With all this as context, it’s no surprise that world oil prices are falling. This is an inevitable aspect of the increased price volatility that we have forecast resulting from falling world oil production. Make no mistake about it: it is falling. World conventional output peaked in 2005 and continues to slide with a decline rate of c. 6% per annum. The IEA’s production figures are padded with anything that flows and burns to arrive at its “all liquids” number that includes a lot that simply isn’t oil and therefore does not represent a perfect, or indeed in some cases any substitute.
Another prediction we and others have made is that the energy sector would rapidly pre-empt investment in more discretionary sectors of the world economy as the EROI of marginal production falls. According to the Perryman Group in Texas employment growth in the energy E&P sector has accounted for the creation of 9.3 million “permanent” (not part-time) jobs nationwide.1 The whole economy didn’t create this many jobs since the recession employment trough in December 2009.2 The US energy sector accounts for over 18% of US high yield bond issuance.3 Most of this growth is coming from the shale industry. The sector is caught in a vice between the oil price and the need to drill to replace rapidly declining legacy production. The industry’s problem is evident. It is also quite clear that higher policy rates would quickly make the industry untenable, and that if oil prices stay below $50 for very long there are going to be capacity closures.
The US dollar has risen 28% off its 2011 lows on a trade-weighted basis and is challenging the highs last made in 2006. An extension of this run is by no means impossible, especially if Japan continues with its national monetary self-immolation and Europe continues to disintegrate, either or both of which would provide fundamental fuel for the rally. Doubling the current move would take the dollar back into the neighbourhood of its turn of the century highs, implying a euro at or below parity. None of this would alter the fundamentally dollar negative developments in the energy markets. The threat is structural and largely self-inflicted.
Things are much changed since the end of the last century. On the energy front, the supergiant fields in the North Sea, Alaska and the Gulf of Mexico have all peaked. The US is attempting to replace them with low EROI resources such as tar sands, shale and deep water reservoirs, but this is proving to be impossible even in volumetric terms, never mind in energy equivalent units. Those economists thinking that low oil prices will give a boost to demand ought to be careful what they wish for. At current prices the North American shale “miracle” is going to disappear PDQ, and along with it the Canadian tar sands “bonanza” unless prices rebound soon. That is highly unlikely.
Financially, it’s a different world. The “rescue” of the financial system has been accomplished, at least temporarily, by mobilising national finances across the OECD to plug the holes in the sector’s balance sheet. Ultimately this can only be validated by a return to real growth. With the energy sector in this kind of disarray, don’t bet on it.