Oil: Beyond the mirage of low prices

The energy markets have been one of the main forces of the world economy for decades, be it as a locomotive of the economy or dragging it into recession as in 1973. It has been considered an efficient market, more than others, subject to geopolitical instability and conflicts, for obvious reasons. In the last 50 years, with all kinds of scenarios, professional analysts have learned to read certain signs and most of the time they seemed to have got it right.

Indeed, not always. This is a crisis of a magnitude and extension never seen before.

The demand of oil went from flat to negative and recovered slightly in April for June deliveries. Throughout April, the price fluctuated clearly below $20. Prices have been bouncing back all of last week.

The US is trying to strangle Iran and Venezuela. Saudi Arabia is trying to strangle Iran and keep Iraq at bay as it is under Iran’s control.

On May 28,^, these were the prices:  $32.82 for WTI (West Texas Intermediate) or $34.99 (Brent Crude), as per the European standard and the world’s most commonly used benchmark. There was a great deal of short-term hysteria, even higher than the usual panic in circumstances like these.

Prices will experiment a sharper hike the closer we get to the Northern Hemisphere winter purchase orders and especially when lockdown and confinement is eased and even more when they are totally lifted. In general, we have observed that prices have been rather stable throughout the month of May, 2020.

Negative prices were a mirage fueled, what an irony, by panic and uncertainty. Some large traders bought large amounts at very low prices and stocked it. When land storage was full they resorted to idle oil tankers. They will wait until the oil prices go up to the level they believe to be safe, and will make huge profits on these purchases. Most of the largest traders in the world like MERCURIA, VITOL, in-house SHELL and BP Trading Departments or TRAFIGURA, have done this.

The oil war started before COVID-19 struck the world. Low oil prices were part of a war between Saudi Arabia and Russia. It also had other geopolitical reasons behind it.

For instance, the US is trying to strangle Iran and Venezuela. The Kingdom of Saudi Arabia (KSA) is trying to strangle Iran and keep Iraq at bay as it is under Iran’s control.

Road-trips for vacation will become an even more popular means of travel for leisure in many countries, while air travel doesn’t go back to a fully operational level.

In any case, the world’s oil panorama had already changed drastically in the last decade. Back then the world’s largest producer was the KSA, today it’s the USA ($15 million B/d) followed by the KSA and Russia (both near $12 million B/d). Sanctions imposed on Iran and Venezuela keeps two important producers largely out of the market.

The KSA is trying to push fracking, shale gas and bituminous sands out of business. This happened already between 2014-2016, when the KSA was trying to push shale and fracking out of business pushing prices down by overproducing. The difference is that Saudi finances were much stronger back then than they are today.

THERE ARE TWO essential concepts that really count to determine who will come out victorious in this nasty battle.

One, production break-even price: This is what it costs to produce one barrel of oil in each country. In theory, by subtracting cost from the market price, it will give you the net income of an oil-producing nation per barrel.

What really counts is the fiscal break-even price. This is the minimum price that the barrel of oil has to reach so that an oil-producing nation can cover all its budgeted spending needs and still have a balanced budget. Anything below that price — and they will incur budget deficits.

In this oil war this is the concept that will reveal who is better equipped to resist the onslaught of their enemy.

The following is a list of the most recent fiscal break-even prices available in descending order: Iran $195, Algeria $109, the KSA, $85-90 (as per March 2020), UAE $70. Kuwait and Qatar are better suited to withstand this price crisis, especially Qatar at $ 55, (the best in the Gulf by far). It has successfully created financial buffers to absorb the shock. The champion here is Russia at $42.50. It is well-equipped to take as much pressure in this oil war that COVID only worsened.

The oil wars can’t go on forever, and the production cut have been accepted by all the contenders, including the KSA, especially, reportedly, after a very stern phone call from President Donald Trump to Saudi Crown Prince Mohamed bin Salman.

No matter how asymmetric and phased the restart of the biggest economies may be, people will start moving again, going to work and move around their places of residence. The mandatory social distancing and use of masks in public transport, and the fact that it has been proven to be one of the most dangerous spots of infection, will probably cause a very important surge in the use of private cars, which will sharply increase the consumption of gasoline and diesel for private use.

Road-trips for vacation will become an even more popular means of travel for leisure in many countries, while air travel doesn’t go back to a fully operational level. This will spike the consumption of gasoline and diesel for private use. Obviously, the re-start of industrial production will push energy consumption and that again will give oil prices a hike.

It is important to note that according to the OECD, the consumption of oil by sectors is road traffic: 50.11 per cent; petrochemicals: 14.38 per cent; residential/commercial/agriculture 9.09 per cent. Road transportation will sharply increase its consumption for the above-mentioned reasons; the other two won’t decrease. The first three amount to 73.58 per cent of the total consumption. Aviation is only fourth at 7.82 per cent, so even if air travel is affected for longer than expected, its impact on the total consumption is far from critical.

Air travel will restart gradually and with more muscle somewhere in the third quarter of 2020, and slowly grow. It will probably take some time before it reaches the 2019 levels. But, it won’t stay flat.

Even in the world after COVID-19 and all the restrictions and health safety measures, air travel is an essential part of our civilization and it’s not going away, even if airlines have to make investments to increase health safety and slightly reduce their passenger capacity. At the beginning it will be around 85 per cent of normal capacity, including the obligation for crews and passengers to wear facemasks.

Low prices risk instability and war in some of the most volatile regions on the planet, the Middle East and the Gulf, with unpredictable geopolitical consequences.

Also, chartered private jets, fractional ownership of aircraft (NetJets, FlexJet, Flight Options, Plane Sense Executive Air Share etc,) and private air travel, will experience a new surge.

Very low oil prices gravely disrupt the whole economy and will cause serious deflationary problems in many countries, not only among the producers but also among the consumers. Low prices risk instability and war in some of the most volatile regions on the planet, the Middle East and the Gulf, with unpredictable geopolitical consequences.

Oil and gas markets have gradually stabilized and, although they remain low, prices will likely break the $40 barrier as the world economy restarts; despite some ill-informed opinions, this is a positive trend. Indeed, prices will keep climbing but will not go back to the past average in many months to come.