Oil, Cartels, and the ECB

OPEC is a cartel but it is a strange species in the sense that it only accounts for about 40% of oil production.  In the past exerted its influence by cutting production, as in 2008, and driving up prices.  Now it faces a different challenge.  New supply has come on the market, which threatens the cartel's position. 

There is only one way to address this challenge.  Drive the price down.  Squeeze rival sources.  This is not just the US, but also Canada, Russia, and alternative energy like solar and wind.   To squeeze rival sources, it must allow the price to fall.  

This will inflict some pain on the high cost producers in OPEC, like Iran and Iraq.    The market has tended to focus on the budget assumptions of oil prices, not the cost of OPEC production itself.  The drop in oil prices in the short-run can be absorbed by cutting some social spending and/or tapping savings (reserves and sovereign wealth funds).     This is the short-term pain.  The promise of long-term gain is that higher cost producers and alternatives are driven out of the market. 

Initially, many observers argued that the Saudi's decision not to cut output was doing the US some sort of favor.   We never accepted this assertion and are even less inclined following the OPEC meeting and comments from the Saudi and UAE oil ministers.  It seems clear that the main impetus is the US shale producers.   OPEC's low cost producers (Saudi Arabia, Kuwait, Qatar, and UAE) are being strategic and seek a larger market share. 

Now some pundits are going in the other extreme.  OPEC is declaring war on US shale producers.  Isn't it the other way around?  More more than 40 years, US President after US President has advocated energy independence.  Through cheap credits in the high yield bond market and environmentally questionable practice (fracking), the US has succeeded in cutting its reliance on foreign energy by the most in a generation.  

The US fracking, and to a lesser extended the tar sands in Canada, have threatened the oil cartel.   It responded in a market-rational way.   It so happens that the high cost producers in the cartel itself, like Venezuela, Iran, and Algeria, will also be squeezed.    Nigeria has been hurt.  Russia, which is not an OPEC member, is also hurt by the drop in oil prices. 

The key to the US fracking may not be the price of oil per se, but the access to cheap credit.  Arguably the cheap credit has led to over-investment, which we have seen in other industries.   This is the life line of the fracking industry. It is one thing to lend to a fracker when oil is $100 a barrel.   It is another after oil prices have fallen more than 30%.  If cheap credits dry up, as anecdotal reports suggest, then this will curtail the expansion of US output, which some industry specialists already see as  subject to over-investment.

The European Central Bank meets Thursday.  Some observers continue to expect a sovereign bond purchases program could be announced as early as this week.  Others argue it is simply a question of time.  We are not as convinced.  In addition to the political and legal hurdles, there are formidable operational issues.  For example, few observers have integrated into their analysis the fact that the Federal Reserve pays 25 bp on excess reserves while the ECB charges 20 bp. 

In any event, the drop in oil prices has become the latest fodder for arguments over sovereign bond purchases.  Many see the decline in inflation expectations as heightening the need for the ECB to respond immediately.  However, the drop in oil prices is also being cited by the Bundesbank's Weidmann to oppose new measures.  

Weidmann wants to look past the deflationary implications of the drop in oil prices and instead wants to focus on the stimulative aspects.  With what he called a "mini-stimulus" Weidmann see some pressure taken off monetary policy.  Germany's representative on the ECB's Executive Board Lautenschlaeger also argued against the urgency that Draghi and Constancio expressed, suggesting that it will take 3-5 months to determine the effectiveness of current efforts. 

The dramatic decline in oil prices is a major surprise this year.  It ranks up there with the decline in US Treasury yields as major stories the consensus failed to see.  Medium term investors need to be particularly wary of dramatic swings in consensus.  Before it was peak oil,and now it is prices will stay low forever.  The race to the bottom is analysts tripping over themselves to see who can project the lowest price.  Another dramatic swing in the consensus view is that sovereign bond purchases have done little good for the real economy even though it boosts equity markets to now it is inevitable that the ECB launches its own program shortly.