What determines the price of anything? Is it the demand and supply for it, or is it the cost of production? And can these factors alone lead to a 50% drop in the price of a commodity in a matter of months? With crude oil prices in a free fall, The Dollar Business attempts to answer some of these very important and troubling questions

Shakti Shankar Patra | The Dollar Business

 

From the highs of 2011 to the lows of 2014, international copper prices were down close to 48%. This, more than anything else, was the strongest statement on the health of the global economy, since copper is not called Dr. Copper for nothing. Similarly, the Baltic Dry Index – the best indicator for the health of global trade – is down well over 90% from pre-GFC highs and is currently quoting at levels not seen in the last 30 years! Why then has the recent slump in crude prices – that reconfirmed the bleak global growth picture by crashing well over 50% in the last six months of 2014 – come as a mighty shocker to many?

Collateral Damage

While explaining the reasons for the crash in crude oil prices, the world gets divided into two camps – those who believe it to be a function of market forces and a long overdue correction, and those who believe it be an attempt by the West to pressurize Russia. Let’s deal with these two views one by one.

Although the Federal Reserve’s bond buying programme – Quantitative Easing (QE) III – ended only on October 29, 2014, most asset classes had started getting in sync with the new reality months in advance. The best example of this was the Dollar Index – an index that tracks the greenback’s movement against a basket of six major currencies – that had, after being stuck in a very tight range for well over two years, made a significant bottom at 78.91 in May and then rallied over 10% by October 29, 2014. And this was only logical because with the Fed’s printing press going into hibernation, there would be fewer dollars floating around the world, thereby making them dearer. But the dollar is no ordinary currency. It’s the world’s reserve currency in which all global commodities are denominated in. Hence, the biggest collateral damage of a strengthening dollar was a free fall in commodities.

And the only major commodity that had been holding up strong until then – crude oil – bore the biggest brunt of this. So, while the Dollar Index bottomed out in May and has rallied over 20% since, crude oil prices topped out in June and have dropped more than 50% over the following six months. The obvious question now is if 20% of the drop in crude oil prices can be attributed to the strength in the dollar, what was the reason for the remaining 30%?

Supply Glut

The answer is, probably, two pronged. Firstly, as discussed above, crude oil was one of the only commodities that had been holding steady even during a period of very weak global growth and the primary reason for this was geopolitical risks. With turmoil in several oil producing countries – from Libya, Syria and Iraq to Russia and Venezuela – there was bound to be apprehensions over supplies and this had put a floor on prices. And easing of some of these tensions automatically removed a lot of the bids. Secondly, technological breakthroughs in shale oil technology means that the world’s largest importer of crude oil – USA – is now one of the top producers (some claim it is already the biggest), with domestic production growing by close to 40% between just 2009 and 2013. According to US Energy Information Administration, even some of the traditional producers like Saudi Arabia, Iraq and UAE have seen production rise by anything between 16% and 28% during the same period. And it doesn’t take much to understand what this kind of rise in production can do to prices, if demand fails to keep pace.

Russian Roulette

The other theory, as to what caused the crash in crude oil prices, that’s doing the rounds is that it was all orchestrated by the West and their ally, Saudi Arabia, to punish Russia – the world’s second biggest exporter of crude oil – for its Ukraine adventure. For, unlike what used to be the case in the past, even when prices started spiraling down in the second half of 2014, Saudi Arabia – the world’s top crude oil exporter – just refused to cut production! But won’t lower crude oil prices affect Saudi Arabia as well? It will, but Saudi Arabia’s cost of producing crude oil is one of the lowest in the world, thereby cushioning the effects of lower prices. At the same time, some claim that lower crude oil prices will make production unviable for several of the producers like Russia, forcing them to permanently stop production, which will lead to lower supplies in the future and give Saudi Arabia the kind of pricing power that it always wanted.

New Normal

Whatever be the reasons for the drop in crude oil prices, the impact of it is humongous. Firstly, it’s a boon for net importers. Secondly, it is threatening the very survival of several oil-export dependent economies. Thirdly, it is bound to slow the investment of petro dollars all over the world. Fourthly, it will lead to the shutting down of several high-cost production facilities, leading to debt defaults and job losses. And lastly, a fall in crude oil prices will slow the innovation in a lot of alternative forms of energy because if crude oil is available cheap, why would the world look for anything else?

At the same time, although this drop is crude oil prices is overall a boon for India’s economy, it is massively negative for India’s top export – High Speed Diesel – $25.5 billion worth of which was exported in FY2014! Why else do you think shares of RIL have dropped over 20% in the last six months, a period during which benchmark indices have rallied over 25%? Similarly, lower oil prices, resulting in economic crises in the Gulf, is bound to slow the repatriation of money from expatriate Indians. It’s also hugely negative for Indian companies involved in oil exploration, in India and overseas.

Pros and cons aside, one can be reasonably sure that the last has not yet been heard about this new normal. If anything, things are just getting warmed up!

 

“The fracking bubble is over. It’s never going to come back again” - Harry S. Dent Jr., Founder, Dent Research

Not your traditional economic forecaster, Harry S. Dent Jr., Founder, Dent Research, expects oil prices to go even lower from here. In a freewheeling interaction with The Dollar Business, Dent spoke about this and why India is the next big thing

Shakti Shankar Patra | The Dollar Business

TDB: What’s your take on the real reason for this 50% crash in crude oil prices in a matter of just six months?

Harry Dent (HD): We have been saying for the last three-four years now that there’s a long-term commodity cycle spanning 30 years, which almost works like a clock – from 1920 to 1950, 1950 to 1980 and from 1980 to 2008-2011. So, our broader view, which we have been talking about for years now, is that commodity prices peak regularly on a 30-year cycle and then go down. This has been going on for almost 200 years. And this time around, a global slowdown and excess capacity have been the reasons for the fall in prices. Now, how did this excess capacity happen? For me, it was a fallout of Quantitative Easing in United States and other countries that allowed fracking companies, who have a different approach to oil production, to borrow money at 5%, instead of 8% or 10%, which should have been the case for such high risk drilling. We also re-stimulated the global economy through central banks, which pushed oil prices higher temporarily.

Oil peaking at $147/bbl before the 2008 slowdown was the first sign that we were in a new era, where things are going to be slower – a winter season, as we call it in long-term cycle studies. But governments stimulated their economies and created this temporary rebound. The fracking bubble – 4-5 million bbl/day just in US – also created excess capacity in a world, where every country but India is slowing.

TDB: Oil is not an investment instrument like stocks or bonds, or even gold. Almost all of it has end-use. How then does a 50% fall in such a commodity impact the top exporters like Saudi Arabia and Russia and the top importers like China and India?

HD: The large exporters – countries like Russia, Iran and Venezuela – are in big trouble. Saudi Arabia, however, being a low-cost producer, likes the situation because it will see competition for it falling. So, it is going to take this downturn well, knowing it will benefit it down the road. On the other hand, for importing countries like India and China, this downturn is a big positive. An exception to this, however, is US and its booming fracking industry, which created a million jobs, saw investments of a trillion dollars and raised $500 billion of debt. This boom is over; it’s never going to come back again! Its booming was the temporary result of artificial stimulus and Quantitative Easing. So, next year, this drop in oil prices is going to badly hurt the US economy, but in the long run it’s a boon for all importers, including US.

TDB: Since you believe the oil price crash is actually going to benefit low cost producers like Saudi Arabia, where do you stand when it comes to theories that claim this has actually been orchestrated by US and its ally Saudi Arabia, in order to punish Russia?

HD: Saudi Arabia not cutting production to prop up prices, as it has done in the past, is a major move. It’s almost as big a move as the Standard Oil episode in the early 1900s. Saudi Arabia is essentially saying that it knows that even if this meltdown causes its oil revenue to drop and its government’s revenue to drop, it will benefit it in the long run as about 10 million bbl/day will never get back to the market in the future. But my problem is that I think, Saudi Arabia doesn’t understand how fragile the global economy is, with unsustainable levels of debt and slowing demographics in almost all the developed countries, which might trigger a major global downturn that will hurt it as well.

I have written a number of articles about India. I think India is the next big thing. It’s not just about PM Modi, but starting to turn around the bureaucracy is in itself a huge thing. So, India should take this oil price crash as an advantage, since unlike most emerging markets, India doesn’t depend on commodity exports. In fact, India is a net importer of both oil and gold. 

TDB: Since you believe the Federal Reserve’s policies was the main reason behind the oil bubble as it funded the fracking industry, would you say the strengthening of the dollar, after the end of QE, has played a major role in bursting the oil bubble?

HD: We have also been, for years, forecasting that the dollar is going to go up in this era. People don’t realise that the dollar went down by 58% between 1985 and early 2008. Ever since, it is going up. In the world of currencies, I see the US dollar going up against almost all currencies, especially against the yen, the euro, the won and the renminbi and this is another reason why commodity prices will continue to head lower.

TDB: Let’s talk about your forecasts. Where do you see oil prices in the next 5-10 years?

HD: Firstly, I see oil prices going down to $30/bbl this year. It is bouncing now. I think it will bounce closer to $60/bbl and then turnaround to hit new lows and that’s when global markets, the US markets in particular, will have to accept that the fracking industry is dead. We will see major debt defaults and major job losses and I think the next fall in oil prices will see all that.

TDB: Do you think if the Federal Reserve starts another round of Quantitative Easing (QE), oil prices can again head up to $100/bbl?

HD: I think US economy will be weaker than they expect by the third quarter, when they are expected to raise interest rates. So, there is a possibility that the Fed will do QE IV. But the question is will people support it? If we have had this unprecedented stimulus in not just US, but by Japan, China, the Swiss National Bank and even the Bank of England, and still the economies turn down – my calculation suggests around $11 trillion of QE around the world – who would think that it could work the next time? I think QE IV, if it happens, will be too late and will fail.

TDB: If you were an adviser to Prime Minister Narendra Modi, would you dissuade him from building strategic oil reserves given that you think oil prices are headed even lower?

HD: I would not be investing in oil or energy infrastructure for a while, since I would be able to import it cheap. In fact, I think there will be de-investing or deleveraging in the energy industry all around the world. But five to eight years from now, I think we will see the start of another commodity cycle and that boom would be dominated by countries like India, which have demographics on their side, unlike the West.

“Fed abandoning its tightening rhetoric will push oil prices back up” - Peter Schiff, Chairman, Euro Pacific Bank

One of the biggest Fed critics in the US, Peter Schiff, Chairman, Euro Pacific Bank, thinks the drop in oil prices are a temporary phenomenon and a crash in the US dollar will see them heading back up

Shakti Shankar Patra | The Dollar Business

TDB: Is it just free market forces of demand and supply that caused this recent, sudden and huge fall in crude oil prices? Or is it something which doesn’t meet the eye?

Peter Schiff (PS): Obviously, it is supply and demand, be it in the real world or in the futures market, which have brought about this price decline. But, I don’t think this represents a permanent decline in oil prices. I don’t think oil prices will continue at $40/bbl or $30/bbl or even $50/bbl. Some are calling for prices to drop even into the 20s, but I wonder where all these people were a year back. If supply and demand balances were that bad, they should have been apparent back then. I think, we have a lot of people jumping into these conclusions, after the fact.

This decline had more to do with speculative positions, in anticipation of a tighter Fed and a consequent stronger dollar. Remember, the dollar has appreciated substantially against a lot of currencies, which means oil prices in Australia or Canada or Europe are quite a bit higher in local currencies. So, a lot of it is not just a function of the dollar being strong, but the anticipation that it will gain even more in strength in the future, based on a tighter Fed. This, because I think, one of the main reasons why oil prices went as high as they had, was because of the Fed’s lose monetary policy. But I think those who have jumped to this conclusion are wrong. I don’t believe we are in a new era of a strong dollar. I think the dollar strength is based on a wrong thesis that the US recovery is genuine and that the Fed is going to tighten. I think the US economy is already slipping back into a recession and I think the Fed is going to abandon its tightening rhetoric in favour of QE IV, which I think will push the dollar lower and the price of oil back up.

TDB: What’s your take on the theories doing the rounds as to how this price decline is just a function of the friction between Russia and US?

PS: I think it did factor into this decline, but it’s not something which can take the price of oil down by 50%. Obviously, in term of the rouble, the price of oil didn’t go down at all. In fact, it probably went up. So, the currency impact is probably a big factor, but I think, it was more a case of a lot of longs in the market getting hit. And now, we have a lot of speculative shorts, which is going to be problematic, because I think we have seen a lot of selling into this recent bounce. Almost everyone is bearish on this bounce. Everyone is expecting new lows. But I think, maybe, we have already seen the lows and a lot many will be trapped short if WTI futures push back above $60/bbl.

TDB: Would you agree to the theory that crude oil prices have factored in a massive global slowdown and this decline has taken place pre-empting that?

PS: I think price of oil has come down on the belief that the dollar is going to rise because the Fed is going to tighten. It’s interesting that if the Fed is actually going to tighten, oil prices are not the only thing that are going to go down – stock prices are going to come down, real estate prices are going to come down, in fact, all of the assets that were impacted by cheap money are going to come down in price. But if the Fed gives up on this talk and market perceives that the next move by the Fed is not higher rates, but QE IV, then oil will stop going down. 

TDB: When the global economy is not doing very well, crude oil prices will not fetch a lot of premium and will settle slightly above the cost of production. What’s your take on this theory?

PS: One of the drivers of crude oil prices will continue to be continuous currency debasement around the world. You can’t continue to print money and not expect the price of oil to rise. I do think we are going to see commodity prices rising because of the global monetary policy. And I think, if we ever, and I think we will see the de-pegging of the Chinese renminbi, the demand for oil from China will absolutely explode.

TDB: Do you think it’s possible to have an era wherein the global economy is doing well, but oil prices are either flat or trending lower?

PS: It all depends on how much oil we produce. If we can increase production dramatically, then price doesn’t have to rise even if the global economy is doing well. At the same time, rising oil prices don’t really lead to economic growth. It’s actually the other way round. If you have a lot of demand and can’t increase supply, you will end up with high oil prices. 

TDB: Since you expect the dollar to collapse and oil prices to head back up, you would advise importers like India to build reserves, wouldn’t you?

PS: Yes. What India should also do though is allow the rupee to appreciate and use its dollar reserves to buy more gold. India needs more gold reserves, not dollars, to back its currency. What it needs to do is sell dollars and buy gold! This will do several things. Firstly, it will strengthen the position of its central bank, because it will have a higher concentration of gold reserves. Secondly, by selling dollars, it will increase the value of its currency and that currency would be now backed by a higher quantity of gold reserves. This will not only raise the purchasing power of Indians and help India’s balance of trade, but also keep the price of oil down. Remember, it is much easier to stockpile gold. If you have gold, you can always buy oil! 

“Geo-political risks had artificially kept oil prices high” - Rohit Srivastava, Fund Manager, Sharekhan

A keen student of long-term economic cycles, Rohit Srivastava, Fund Manager, Sharekhan, thinks oil prices will go through a long basing period, before eventually breaking out higher

Interview by Shakti Shankar Patra | The Dollar Business

TDB: What do you think was the main reason for the big crash in crude oil prices in the second half of last year?

Rohit Srivastava (RS): One of the obvious reasons was that a lot of production came online at the same time. Although it was known that this was going to be the case, prices had remained elevated, essentially because of various geo-political risks. But as soon as the supply became visible, the market stopped looking at those risks and priced-in actual demand and supply. The second reason was that there were a lot of trade positions. By the end of June-July, we had two data points – an extreme in sentiment and an extreme in speculative long positions. These two data points indicate that we, probably, had reached an extreme top. Hence, once the selling started, it just didn’t stop.

Even now, when I look at position data, I get a sense that all positions have not unwound yet, particularly if one compares today’s scenario with that during previous bottoms. So, the sense is that we haven’t really hit the lows. We might be seeing some short-term bounce. At the same time, I should mention that the entire range might have changed for oil. We are no longer in the $70/bbl – $100/bbl range, because the kind of sell-off we have seen indicates a structural change. So, I expect to see prices in a much lower range for a prolonged period.

TDB: Unlike stocks, bonds or even gold, crude oil is ultimately something that has end-use. What does it crashing by over 50% in a few months, tell us about the real demand for it?

RS: I don’t think the demand scenario has changed. The world GDP has continued to grow. There hasn’t really been any negative growth. But as oil price remained elevated for a prolonged period, it lured a lot many to set up capacities, because they thought prices were there to stay and also since at the elevated prices, their production was viable. However, eventually, as these new supplies came in, there was a lot of over-supply.

TDB: What’s your view on the theory that speculation in the futures market plays a big part in jacking up oil prices and that the prices we see are nowhere close to the cost of production?

RS: I haven’t really looked at this aspect in detail but there is one argument that if there is enough demand for oil, then why should prices fall close to the cost of production? Producers should have a control over the price, isn’t it? But since the size of the market, in terms of the trading that goes on, is so big that it has actually, in itself, become a major force in determining market prices. In its own way, this plays a spoilsport for the producers. This is one of the reasons why some sections of the commodity market – for example, the steel market – have, for long, avoided trading in the open market.

Having said that, I don’t think the speculative trade in oil will go away, because the whole industry has evolved around trading. There are a lot of funds dedicated to the sector. There are ETFs at work, which was not necessarily the case in the past. So, it’s very unlikely that the size of trading will reduce and prices will remain near the cost of production. There will be over-valuation and under-valuation from time to time.

TDB: I am sure you are aware of the various theories that are floating around as to what caused the crash. Do you think other than market forces of demand and supply, any of these ‘other’ factors triggered the meltdown?

RS: Not really. I think the biggest ‘other’ force has been a rising dollar, which is a market force. I won’t call it a non-market force. We have seen one of the strongest ever dollar rallies in the last few months. Not that it developed over night. It has been building for the last couple of years. If you see, most currencies have been depreciating against the US dollar for the last many months. And I am not just talking about the Dollar Index currencies like the yen or the euro. I think a strengthening dollar is one of the reasons why oil, along with many other commodities, have taken a beating. In fact, if you look at the commodity basket as a whole, you will find that oil was holding out much better than most other commodities, primarily because of geo-political risks. And this had led to excess capacity buildup. 

TDB: Since you are someone who also looks at the larger cycles, tell us where you see crude oil prices in the future.

RS: There was a thought when prices got really elevated in the last decade that alternate forms of energy would come-in and the importance of oil would go away. But those technologies are still developing. And now that crude oil prices have come down, those alternative forms of energy have become further unviable. Secondly, if global economic growth slows down yet again, there wouldn’t be enough reason for crude oil prices to bounce back immediately. So, I think what is likely to happen, particularly since this is not just an oil cycle, but an entire commodity cycle, we will go through a long basing period. Maybe, we will see a bounce till $60/bbl, then break below $40 and then establish a $20-30 range between $30/bbl and $60/bbl. Probably, we will spend several years in this range, which will see a lot of capacities shutting down. Eventually, I expect prices to break out, but that will take several years, at least four to five years.

TDB: There are two camps – one, which believes lower oil prices are good and will leave more money in the hands of the consumers, thereby fostering growth, while the other camp believes lower oil prices will dry up petro-dollars and lead to a slowdown. Which camp do you belong to?

RS: I think the consumption theme is pretty immediate. Gasoline prices in several countries are marked to oil prices and hence, there have been immediate benefits for the consumer. For countries like India that are net importers of crude oil, there are several positives like the CAD coming down. The negative impact, on the other hand, is only on countries that are highly dependent on the export of oil. So, as a whole, I think the positives outweigh the negatives. 

TDB: Let’s talk about India. Why do you think the government hasn’t entirely passed on the benefits to the consumers?

RS: I think the government is trying help oil marketing companies (OMCs) recoup the bleeding that they have taken for years. But India faces a separate problem, which is that it is trying to contain its fiscal deficit. And in the current financial year, the government has been falling behind its targets. So, oil was an immediate target because the drop in oil prices created an immediate surplus, particularly since there hasn’t really been a lot of complaints about the drop in prices not being entirely passed on. The government used the opportunity to raise taxes on oil. So, although the OMCs should be allowed to use this drop in prices to recoup past losses, so far, the government has itself taken those funds.