E Oil Market: There Will Be Blood

This article is intended to give a general overview of the oil and natural gas markets. In the interest of full disclosure, I am not a commodities expert, but I want to convey my view on the energy markets as I seem to be more bearish going forward than many of the analysts on The Street as well as those who work for large organizations such as the IEA.

For the last few months, many people have appeared on TV saying that they were comfortable seeing WTI Crude trading between 45-55 dollars a barrel. As oil quickly shot up from the lows of $30 a barrel in January of last year, many revised their forecast closer to $60, with some even as bullish as $70 by 2018.

The collapse:

Why did the price of crude (WTI & Brent) crash in the first place? That’s a long and multi-faceted answer. One of the major reasons for the decline was that the dollar has strengthened tremendously over the last few years. For those who don’t know, the price of crude is denominated in US dollars, so when the price of the dollar increases the value of oil relative to the dollar falls. This is why we have generally seen an inverse correlation over time.

There is actually an interesting conspiracy theory contorting that the US toppled Gaddafi because he was planning on creating a new currency backed by gold that all the oil rich nations would adopt to move away from the dollar, which would subsequently make it enormously more expensive for western countries to import oil which is readily apparent. Another huge event was that the US Congress removed the export ban on oil in 2015, which had been in effect for 40 years.

This action allows the US to add more oil supply to the international market making it harder to do business. While demand continues to increase, the rate at which it is increasing is slowing. The Saudi’s saw an opportunity to put US oil companies out of business, so they tried to glut the market by pumping as much oil as they could and steal market share.

What immediately followed was a race to the bottom (in the price of oil). The US shale oil and gas boom made Saudi Arabia nervous and they planned to do whatever it took to ensure they maintained dominant position. While most people think of Saudi Arabia as a wealthy oil kingdom, in reality it is more of a social welfare state. The citizens are almost entirely dependent on the Kingdom for their healthcare, job, education, and infrastructure costs as well as numerous other subsidies they receive. The problem is that the money to support all of these costs comes almost exclusively from oil revenues.

With the price of oil on the decline, they were making a lot less money. To support their welfare programs, Saudi Arabia sold billions of dollars worth of foreign reserves. The strategy was working, leaving oil companies in the US with horrible balance sheets as though they might all be destined for bankruptcy. On a daily basis, talk of widespread bankruptcies continued, citing that the banks may not give companies extensions of their loans. Major well-positioned oil companies would wait for the bankruptcy period so that they could go on an M&A bonanza. But it never happened.There weren’t sweeping bankruptcies, and their wasn’t an M&A frenzy, most likely due to three reasons:the first is that the banks gave generous extensions on company’s short term debt which allowed them to regroup.