The United States, Russia and the Global Oil Market

As my readers may have noticed, in the interest of balance, I quite enjoy posting quotes from the Russian side of the new Cold War since they receive very little coverage in the Western media.  Some recent comments from Vladimir Putin on a wide range of subjects at the Russia Energy Week International Forum provide us with some very interesting insight into Russia's world view, its view on the United States and Donald Trump and its views on the world's energy markets.  In this posting, I wish to look at Mr. Putin's views on the United States and the Trump Administration and its links to the current energy market.

To help keep this posting in perspective, Russia is a very big player in the world's hydrocarbon markets.  According to the Energy Information Administration, Russia is the world's largest producer of crude oil (including condensate) and the second-largest producer of natural gas.  Here is a graphic showing the oil production history for the top five oil producing nations in the world:

In 2017, Russia produced 13 percent of the world's total daily oil production, tied with Saudi Arabia and just ahead of the United States which produced 12 percent of the total.  It is also important to keep in mind that the rapid growth of oil production in the United States since 2010 is a result of the implementation of technology which allows the extraction of oil from previously non-producing reservoirs; unfortunately, given the nature of these reservoirs, production declines are very rapid, requiring massive capital injections to maintain production levels.

Here is a graphic showing the world's largest natural gas producing nations:

In 2017, Russia accounted for nearly one-third of the global increase in natural gas production, propelled by increased domestic and international demand for its product.

  

With that background, let's begin by looking at Mr. Putin's comments on the role that the United States and Russia play in the world's energy markets, particularly the oil market, the balance of supply and demand and oil pricing when asked the following questions by the moderator, Ryan Chilcote, an award-winning journalist with experience at Bloomberg Television and CNN:

1.) Ryan Chilcote: Last year the question was how long is Russia prepared to maintain cuts. Now the question is how much oil is Russia going to give to the market.

Vladimir Putin: As for reducing the production and keeping it at a low level, and so on, these are all instruments. They are not a goal in itself. The goal is to balance the market. When we agreed, with our friends and colleagues from OPEC, to reduce production, this is exactly what we had in mind. The goal was to reduce excessive reserves and balance the market. After all, this matter is not about the income of oil companies or an opportunity to pocket money, it is to do with the health of the industry.

It is necessary to provide resources for investment goals, investment projects. This was the bottom line. If the market is unbalanced this will inevitably lead to a reduction in investment, and eventually create a shortage in the market and trigger a sharp price hike.

Our position has been very responsible. The market had to be balanced and we achieved this goal in cooperation with our OPEC colleagues.

Indeed, we have now met with the Secretary General and spoke about our cooperation in detail. I would like to draw your attention to the fact that probably for the first time in history all participants in the agreements honoured their commitments in full. I believe Russia made a commitment to reduce production by 30,000 barrels, and we did this, just like all other participants in this agreement.

The market is now balanced. The current growth of oil prices is by and large not a result of our efforts but triggered by attendant circumstances, expectations of decisions on Iran – incidentally these decisions are absolutely illegal and harmful to the world economy. The fall in oil production in North Africa (i.e. Libya) is also linked with political circumstances – a civil war and so on. The reduction in Venezuela is also taking place for domestic political reasons and in connection with the restrictions it has introduced. This is what it is all about.

As you said, President Trump considers this price high. I think he is right to some extent but this suits us very well – $65–$70–$75 per barrel. This is quite enough to ensure the effective performance of energy companies and the investment process. But let us be straight – such prices have largely been produced by the activities of the US administration. I am referring to expectations of sanctions against Iran and political problems in Venezuela. Look what is happening in Libya – the state is destroyed. This is the result of irresponsible policy that is directly affecting the world economy. Therefore, we must work closer with each other, not only in the energy industry but also in the political area so as to prevent such setbacks.

As for increasing production – we have already increased it by 400,000 barrels as we agreed with our partners. We can raise it by another 200,000–300,000 barrels per day if need be. (my bolds)

Let's look at how Washington's intervention in both Libya and Iran have impacted oil production from these two states over the past ten years.  Here is a graphic showing how Libya's oil production decreased significantly as the civil war took hold in the post-Qaddafi era:

As Mr. Putin noted, the American-led geopolitical actions to remove Muammar Qaddafi from power in Libya had a significant negative impact on Libya's ability to produce oil.

Here is a graphic showing what happened to Iran's oil production as a result of the implementation of American sanctions in July 2013:

As you can see, in both cases, oil production levels for both Libya and Iran dropped precipitously as a result of Washington's meddling.  Had it not been for increased oil production from U.S. resource plays (i.e. plays that require multi-stage fracking), global oil prices would have been under sustained upward pressure.

2.) Ryan Chilcote: President Putin, is it right for the President of the United States to be so actively trying to manage the price of oil? We’re coming up on elections in the United States, he’s concerned about the price of gas. A gallon of gas in the United States costs almost $3. Traditionally, voters punish the party in power when prices rise ahead of elections. Is he doing the right thing, or actually should he step out of the oil market and let the market dictate what happens?

Vladimir Putin: I have already said this and want to repeat it again: we had a very good meeting with the President of the United States in Helsinki. But if we had talked about the issue we are discussing now, I would have told him: Donald, if you want to find out who is guilty for the increase in prices, you should look in the mirror. That’s the truth.

We have just spoken about the geopolitical factors behind the price hikes. They exist and really play a role in the market. It is better not to interfere in these market processes, not to try and get some competitive advantage by using political instruments and not to try to regulate prices as the Soviet Union did. This does not end well. After all, when talking about our negotiated actions with OPEC we do not use non-market instruments. We are merely matching supply and demand in the market, no more than that. Everything else today has to do with geopolitical factors that influence prices....

What is happening in the United States? The United States is one of the world’s biggest producers of both oil and gas. We know everything about new technology  (i.e. horizontal drilling and multi-stage fracking) that is being countered by environmentalists. I agree with them, this production is often carried out using barbarous methods we do not use. 

3.) Ryan Chilcote: Let’s return to energy, or at least more directly to energy, President Putin, and talk about Nord Stream 2. That’s the pipeline that Gazprom wants to build between Russia and Germany. Again, the President of the United States has said his opinion about this. He says that Germany is effectively a hostage already of Russia, because it depends on Russia for so much of its energy and gas supplies, and that it’s vulnerable to “extortion and intimidation” from Russia. What do you make of that?

Vladimir Putin: My response is very simple. Donald and I talked about this very briefly in Helsinki. In any sale, including the sale of our gas to Europe, we are traditionally the supplier, of pipeline gas I mean. We have been doing this since the 1960s. We are known for doing it in a highly responsible and professional manner, and at competitive prices for the European market. In general, if you look at the characteristics of the entire gas market, the price depends on the quantity and on sales volumes. The distance between Russia and Europe is such that pipeline gas is optimal. And the price will always be competitive, always. This is something all experts understand.

We have a lot of people here in this room, in the first row, who could easily be seated next to me, and I would gladly listen to them, because each one is an expert, so each of them can tell you that. And so Nord Stream 2 is a purely commercial project, I want to emphasise this, warranted by rising energy consumption, including in Europe, and falling domestic production in European countries. They have to get it from somewhere.

Russian gas accounts for around 34 percent of the European market. Is this a lot or a little? It is not insubstantial, but not a monopoly either. Europe certainly can and does actually buy gas from other suppliers, but American liquefied gas is about 30 percent more expensive than our pipeline gas on the European market. If you were buying products of the same quality and you were offered the same product for 30 percent more , what would you choose? So, what are we talking about?

If Europe starts buying American gas for 30 percent more than ours, the entire economy of Germany, in this case, would quickly become dramatically less competitive. Everyone understands this; it is an obvious fact.

But business is business, and we are ready to work with all partners. As you know, our German partners have already begun offshore construction. We are ready to begin as well. We have no problems with obtaining any permits. Finland agreed, and so did Sweden, Germany, and the Russian Federation. This is quite enough for us. The project will be implemented.

Now, let's look at what Mr. Putin had to say about the United States in a more general sense.  When asked about the European Unions initiative to protect European corporations from the sanctions that Washington has imposed on Iran because of its alleged breach of the JCPOA nuclear deal, here is his response:

"This is why Europe is thinking about some new opportunities in connection with these circumstances, for instance about dollar-free settlements that incidentally will undermine the dollar. In this context – I have said this many times but would like to repeat it again – I believe that our American partners are committing a huge strategic mistake and undermining confidence in the dollar as today’s only reserve currency. They are undermining confidence in it as a universal instrument and are really biting the hand that feeds.

This is strange, even surprising, but I think this is a typical mistake made by any empire when people believe nothing will happen, that everything is so powerful, so strong and stable that there will be no negative consequences. But no, they will come sooner or later." (my bold)

Mr. Putin also states the following:

"Please do not involve me in domestic political processes and squabbles in the United States. It is for you to figure out or else we will be accused again of meddling in the domestic political life of the US."

In the interest of balance, it is always an interesting exercise to look at how the other side of the new Cold War looks at the global geopolitical environment, particularly as it relates to the energy sector since it forms such an important part of the global economy and is a key part of the economies of both Russia and the United States.  It is also interesting to note that Russia's president rarely seems to use a confrontational tone when referring to the United States, a sharp contrast to how Washington treats what is rapidly becoming its global archenemy.

The Consequences of Overheating in the Energy Bond Market

Updated February 3, 2015

A speech by Jeremy Stein, former Governor of the Federal Reserve Bank of St. Louis looks positively prescient, particularly as interest rates appear to be heading up and the price of oil has fallen substantially.

In his speech, "Overheating in Credit Markets: Origins, Measurement and Policy Responses", Mr. Stein examines the factors that lead to "overheating" (think bubble formation) in credit markets and why there are credit booms and busts.

He notes that there are three factors that can contribute to "overheating" as follows:

1.) Financial innovation: While financial innovation has provided benefits to the economy, it can lead to the creation of new financial products that do not fall under any sort of regulation since the regulators tend to act well behind the changes in industry.  A prime example of this is the existence of second-generation securities like the subprime CDOs that came into existence during the housing boom.  As we all know, it was the collapse in the value of these imaginative new derivatives that nearly caused the world's economy to implode.  The financial industry is guilty of making decisions on their own behalf that maximize their profits and compensation and, in the competitive nature of Wall Street, these decisions are made solely to attract new money and increase the assets that are under management.

2.) Regulation: As new regulations are implemented, they tend to open new regulatory loopholes which spur the development of new products, once again, in an attempt to maximize profits and compensation.

3.) Change in Economic Conditions: I'm going to quote directly from Mr. Stein's speech for this one:

"The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to "reach for yield."  An insurance company that has offered guaranteed minimum rates of return on some of its products might find its solvency threatened by a long stretch of low rates and feel compelled to take on added risk.  A similar logic applies to a bank whose net interest margins are under pressure because low rates erode the profitability of its deposit-taking franchise. "

Hold your thoughts on that one for a moment.

Mr. Stein goes on to note that all three of these factors can interact with each other and gives the example of a low interest rate environment that increases the demand for the financial industry to engage in "below-the-radar forms of risk-taking".  He notes that the high demand for high-yield (i.e. junk bonds) is part of investors "reaching-for-yield" in this low interest rate environment, an issue that could result in significant losses to junk bond investors.

In Thomson Reuters latest Debt Capital Markets Review, they note that global high-yield corporate debt issuance fell over the last two quarters but was still just below the record of $442.5 billion set in 2013 at $441.5 billion as shown on this bar graph:

Nonetheless, as the graph shows, since 2009, the issuance of corporate junk bonds has mushroomed since the end of the Great Recession, particularly when we compare the total dollar value issued between 2009 and 2014 to the value issued in 2006 and 2007.  This is thanks to two factors:

1.) companies that are less creditworthy are able to raise funds at relatively low rates compared to the past because of the global low interest rate environment as shown on this graph:

You'll note that the drop off in junk bond issuance pretty much parallels the increase in interest rates from below 8 percent in June 2014 to the current rate of 11.46 percent.  You will also observe that the spread between junk bonds and Treasuries was at a multi-year low in mid-2014 as shown on this graph:

  

2.) investors are "reaching-for-yield" because of the prolonged period of near-zero interest rates on Treasuries and other fixed income investments.

Fortunately, for those of us that are non-professional investors, FINRA provides a bond market pricing and yield tool.  From their website, we can see what has happened to the price of high yield bonds over the past year (and I apologize for the quality of the screen capture in advance):

Now, let's put the recent collapse of the price of oil into this equation and see what has happened to the price and yield of some oil sector bonds, including a sample of bonds issued by smaller oil shale players, over the past year, noting that the current yield is well above the coupon interest rate:

1.) Rex Energy: 8.875 percent maturing December 1, 2020 - rated B-

a.) Price:

b.) Yield:

2.) Goodrich Petroleum: 5 percent maturing October 1, 2029 - rated CCC

Price:

Yield: currently trading at $52 resulting in a yield of 12.021 percent.

3.) Halcon: 9.75 percent maturing July 15, 2020 - rated CCC+

Price:

Yield:

Switching gears for a minute, let's look at one world's largest oil well drilling companies:

4.) Transocean: 7.5 percent maturing April 15, 2031 - rated BBB-

a.) Price:

b.) Yield:

I think that's enough information to give you a general idea of the problem.  The debt of smaller oil companies exploiting shale oil reserves in North America and those that are viewed as weaker players is getting hammered.  Not only will it be difficult for these companies to raise money at these high interest rates, their low share prices will make it difficult to issue additional equity to fund their ongoing operations.

According to Citi Research, the energy sector accounts for 17.4 percent of the high-yield bond market, up from 12 percent in 2002.  Smaller oil companies involved in the high-cost high-decline fracking plays rely on debt to fund their operations, however, in this low price environment, it will be increasingly difficult for them to rely on cash flow to fund further operations because of low prices and high production decline rates and an inability to raise additional capital through the issuance of new debt unless they are willing to pay bondholders substantially higher interest rates.

When we combine what is currently happening in the world's oil market, the high-yield energy bond market and Mr. Stein's observations about "overheating in the credit market", it is apparent that the Federal Reserve's prolonged policy of near-zero interest rates is coming apart at the seams.  Unfortunately, as was the case in 2008 - 2009, it is the small retail investor that will pay the biggest price for the Fed's mistake.