A little crude?

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The economy is picking up. Maybe even to a level that will truly change the situation for the Middle Class. But, no matter what any politician says, one of the biggest reasons The US economy is picking up is because the price of oil is tanking. (Don’t you just love that metaphor?)

The price of oil has fallen from some $ 140 a barrel (for “Brent crude”- the primary benchmark “oil” from which all oil prices emanate) to about $ 60. That means the price of oil has decreased some 50% since June- an amazing drop in 6 months. This change in oil prices (albeit a drop) is almost as amazing as the dramatic increase in oil prices that occurred under President Carter. Moreover, this means that almost every prognosticator not just miscalculated the price of crude- but was dead wrong.

One of the big reasons for this dramatic shift in price of crude is the boom in tar sands and shale oil production. The other primary reason is the refusal of Saudi Arabia to stop pumping out oil. (Saudi Arabia provides about 1/3 of all the OPEC-produced oil in the world.)

I’ll get to the second reason shortly- but the ability of a firm to almost immediately begin extracting shale oil is a dramatic factor in the world’s supply of oil. Instead of years of planning and preparation before an oil well is producing oil (or offshore oil is found and extracted), shale oil production only awaits a few months before it’s a reality. (This may be the only sector of the economy that has an “easy money” pathway with the banks. Most of this shale production is “capitalized” with debt financing.)

What this new-found supply really means is that there is a glut of oil on the market. And, one of the biggest importers of oil (the US) is no longer importing all that oil. (China is the other country that imports a ton of fuel.)

Oil production- and pricing requirements around the world

This price drop in crude also means that Iran, Russia, and Venezuela are hurting beyond belief. As you can see from the chart, these countries need oil prices to exceed $ 100 or more to sustain their economies. And, while Saudi Arabia isn’t obtaining the cash flow it needs, the House of Saud is sitting on a pile of cash and feels it can ride this storm out for a few years.

Don’t think the US is immune to this price drop.  Oh, as a country- we will do fine.  But, Alaska is kind of like Russia.  A drop in oil prices destroys their state’s economy.  And, their budget is about to be slashed.  As is true in Louisiana.  (Texas is being hurt [home sales are way down, Houston’s jobs are being decimated].  But, the state overall may survive this onslaught, because it has slowly diversified from oil to biotechnology and computers.)  I doubt Wyoming and North Dakota will be able to continue with their budget largesse.

But, there’s another cause of this oil glut, as I mentioned above. Countries like Saudi Arabia don’t really trust the other OPEC nations to cut their production- and that really includes Russia and Mexico, who aren’t OPEC members. The Saudis (among others) fear these other countries would swoop up their market share, should they cut production (which also means at least one country is not cutting its output).

This concept is basic ‘game theory’. While it may be in the collective interests of everyone to cut oil production which will raise oil prices, the interest of any given country is quite the opposite. The “game” dictates that one needs only wait for a competing country to make the change upon which the other can capitalize.

Couple this issue with the fact that the Saudi-American relationship is changing. Decades ago, the Saudis provided a steady flow of oil to the US (except during the embargo) in return for US support against internal and external threats to the House of Saud. Now that the US is using much less Saudi oil, this quid-pro-quo is devolving.

Since 2009, Saudi Arabia has been pumping out oil, in part to force Iran to cease and desist from its nuclear efforts. Because Saudi Arabia, the UAE (United Arab Emirates) and Kuwait have been picking up the slack for those countries that are complying with the Iran oil embargo. (This embargo has cut Iran’s oil exports in 1/2, which hurts their economy- and that doesn’t reflect the complications of the oil price drop.)

This oil situation also helps enforce the Russian embargo. Since other countries don’t have to rely on Russian petro-exports, foreign currency in Russia is drying up- as is the value of the ruble.

Oh, and the other fact? The Saudis ‘know’ that the allure of alternative energy sources is also a function of the price of oil. The belief is that cheap fuel renders the desire of the world’s nations to switch to wind or solar is not just attenuated, but decimated, when the price of oil is in the basement. They further believe that the American and Canadian companies won’t be able to sustain their shale or tar sands production with these lower oil prices.

But, that last belief is as credible as the one about Santa Claus. As I have repeatedly stated (an example), most American shale oil (and even coal gasification) production makes economic sense when the price of oil is in the high 40’s  or low 50’s- but is clearly profitable with the price ranging in the 60’s.

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