Oil Price Crash

If there’s one resource that makes the modern world go round it’s oil. Pick a major financial crisis or military conflict of the past 60 years and there’s a pretty good chance oil was involved in it somewhere. It’s not just the fuel that drives our cars, trucks, ships, airplanes and a lot of our power stations; it’s also an essential raw material for the plastics and chemical industries. When oil supplies are threatened we see panic buying of fuel, rocketing prices, sometimes even public disorder. Even routine cuts or caps on OPEC output can have a dramatic effect, pushing prices up and placing a brake on the whole economy as everything costs more to power, manufacture and transport. A large part of the USA’s foreign policy since 1945 has been aimed at ensuring a reliable, affordable supply of oil.

But what happens when the usual oil shocks are reversed? What if the market is glutted with cheap oil as supply outstrips demand? Right now we’re finding out. In June a barrel of standard crude cost over $100. The lighter, sweeter Brent and West Texas Intermediate – both in high demand for making gasoline, kerosene and diesel – were selling for more than $125. That was good news for the economies of the Middle East and Russia, the axis of the world energy market. But it also opened up options for the USA. New domestic oil sources like shale have a higher extraction cost than traditional drilling, but at $100 a barrel it was still profitable to extract it. That helped power the boom in production that’s made the USA almost independent of foreign oil for the first time in decades.

Then, in late summer and fall, it started to change. The increase in supply had a downward pressure on prices anyway but not enough to cause any real difficulties. Then a deliberate fall was arranged to hurt the Russian economy; Putin’s budget plans depended on prices of at least $100 a barrel and the break-even point is around $80. With the price dropping through that price in early November Russia has now been losing money for six weeks and struggling since late summer. The idea was to punish Russia for invading Ukraine, but it has potential to backfire.

Usually when oil gets cheap OPEC restricts supply to drive the price back up again. This time they haven’t. Obviously that helps keep Russia poor but the Saudis and their Emirati allies look like they’re aiming more at the USA. The growth of shale oil has threatened their profits, with US demand for imports slumping and the still-recovering economies of Europe and Asia not ready to take up the slack. Now, with prices already low, the Saudis are taking a shot at restoring the balance. Shale oil, with its higher extraction cost, is more vulnerable than Gulf crude; by holding supply up, and prices down, they’re hoping to run the US industry at a loss for long enough that production falls. If they can do that OPEC will regain some of their lost bargaining power – and right now, with the situation in the Middle East, that’s not a good thing.

Ironically, while Russia’s definitely struggling and their economy has shrunk by around 8 percent, they might be better placed to survive. Their actual production costs are among the world’s lowest and that gives them a bit more slack. US shale runs on much smaller margins though, and it’s already making a loss. Higher oil prices bump up costs right across the economy, but right now that might be a price worth paying to ensure energy independence. But with the Saudis now saying they’re prepared to let it fall to $20 a barrel it could be a while before we manage that.

China Rate Cut

Despite continued doubts about underlying employment figures the US economy is looking fairly healthy at the moment and seems to be recovering from the financial crisis, but many analysts are worried by the situation in Europe. With disappointing growth figures from all the major Eurozone nations there’s anxiety about what that could mean for Euro stocks, and the potential for a knock-on effect on the USA. However developments on Friday helped ease fears for the moment, and may have bought the Eurozone some more time to resolve its issues.
The main news was an unexpected interest rate cut by the Chinese central bank. This move, announced before markets opened Friday, took most analysts by surprise but makes perfect sense in the circumstances. While the Chinese economy is one of the most spectacular examples of growth over the past few years there have been recent signs that this might be slowing, and easier access to money should help stimulate it. The cut takes the central bank’s deposit rate 0.4 percent to 5.6 percent. As well as making credit easier for startups it should also encourage investors to opt for equities over bank deposits. The new rates kicked in Saturday morning, so the markets will be watching carefully to see where equities go over the coming weeks.
The other welcome news was a speech by European Central Bank president Mario Draghi, delivered to German economists in Frankfurt. Draghi signaled that the ECB, which has been cautious this year, is moving towards implementing a new round of full-on quantitative easing to inject some life into the continent’s sclerotic economies and raise inflation to meet planned levels. The UK has managed to stimulate growth by reducing spending and tax takes, but the Eurozone has been less successful; the revelation that Draghi is considering a more interventionist line boosted optimism and pushed all the main stock markets up sharply. London’s FTSE 100 saw a 2.3 percent rise over the week, and 1.3 percent of that came on Friday afternoon. France’s CAC and the German DAX also saw rises of over 2 percent as traders bought in to the promise of higher profits and corporate growth.
Europe has been struggling this year, against a toxic cocktail of low growth and low inflation. Even Germany, long regarded as the powerhouse of the continent, seems to have run out of steam of late. The situation in France is far worse, and the Mediterranean fringe is still reeling from the disaster of the debt crisis. Anything that helps rebuild confidence among businesses and investors is very welcome news, and with the EU being one of the USA’s largest markets it’s good news for US businesses too. A renewed recession in Europe is going to hurt demand for American products and services, which would drive down share prices on the New York exchanges. Hopefully by adopting quantitative easing, even as the Federal Reserve is backing away from the policy following recent announcements, that danger will be averted long enough for the Eurozone to turn the corner.

July Thoughts on Iraq

If anybody needed any evidence of why Iraq needed to be sorted out in 2003 the last couple of weeks should have provided more than enough. The ISIS insurgency that’s rolled over the north of the country with such stunning speed isn’t anything new – it’s the result of sectarian tensions brewed up by the despotic regime of Saddam Hussein and left unresolved in the time since he was removed by Operation Iraqi Freedom eleven years ago.

Islam is dominated by the Sunni sect, but there are two countries where the smaller Shia strain is in the majority. The best known is Iran. The other is Iraq. Nearly two-thirds of Iraqis are Shia muslims, and most of the rest are Sunni (about three percent are other religions, mostly Christian). However from 1958 to 2003 the country was dominated by Sunni dictators, most infamously Saddam. The Shia were second class citizens and not surprisingly that caused huge resentment. The Sunni also suffered under Saddam’s regime though; the only people who benefited were his own al-Tikriti tribe. Sunni Iraqis had grievances of their own and ISIS is their latest way of venting them.

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