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Cheap oil is welcome but more instability not

The bumpy yet persistent slide in the price of crude carries the potential to cause severe disruptions in major financial markets. Ironically, the very development that brought the price down, is now also threatened by a barrel price that may go too low.
As an outside observer to the oil industry and a citizen of a country where oil still has to be found in commercially viable volumes, it is rather a stimulating analytical exercise to try and fathom who is responsible for what.

For more than a month, crude futures traded at a barrel price in the upper-seventy US dollar range. Seemingly, the US$70 level was seen by many analysts as a key technical threshold and I received many what-if reports, were the price to go below this level. Then, earlier this week, fresh US statistics indicated their crude stockpiles are much higher than expected, and crude really took a beating. By Wednesday it was touching US$60 per barrel for so-called West Texas Intermediate, or more popularly known as light sweet crude. Late on Thursday saw some upward movement settling at just above US61 per barrel.
The intrigues in the oil industry interest me no end, but the spill-over to financial markets was far more severe than I anticipated. All the world’s major bourses took a hammering in the first half of the week, only grabbing back some of the lost territory on Thursday. Throughout, oil was cited as the main culprit, but why?
When the Saudis announced a few weeks ago, they will not reduce their production volumes, I was perplexed. This went so contrary to the conventional OPEC modus operandi. Typically, if the price of crude goes below certain anticipated levels, OPEC members would exercise their cartel power, and curb production to support the price. Not this time.
It is common knowledge that the explosion in shale oil production in the United States has brought this oil glutton to a stockpile level where many analysts predicted the end of imported oil into the US. But this was foreseen as a gradual process, possibly taking many years to make the US oil independent again. It was also widely seen as very positive for new investment in the industry, in both technology and capacity. There was however one snag – shale oil is considerably more expensive than free-flowing oil. For most of the shale plays, break-even is cited around US$110 per barrel but this rough figure is not confirmed, nor supported by the breakdown of input costs, for one very simple reason, Massive amounts of capital has been raised in the capital market to finance the extraction of this abundant, but reclusive energy source, and those bonds, many of them junk, enjoyed a sterling uptake by financial managers hunting desperately for yield. This fact massively distorted the real cost of pumping shale oil.
I suspect the Saudis also cottoned onto this fundamental fact. Below a certain barrel price, America and Canada’s shale plays simply do not make economic sense. They are too expensive. And with ample artificially induced liquidity in the US capital market, it was no wonder investors were so eager to pump dollars into pumping oil. But the Saudis hold the trump card, and they know it. So, the next thing you know, the Saudis made all sorts of noises, eventually convincing all other OPEC members that the only solution to sink the over-production, is to flood it further. The oil market, being a futures market, quickly saw which way things are going and the formerly eager investors started dumping shale bonds by the billions of dollars.
Suddenly, these bonds are worth ten cents on a dollar, shale operators are in a cash flow crunch, and many are issuing even more junk, just to be able to honour their immediate obligations. Of course, the Saudis are very reticent, saying it is not they but all the OPEC members together that determine the future of crude.
To me there is a lot of conspiracy in the unprecedented oil volatility. I do not for one moment believe the Saudis’ decision was not intended to keep driving the price down. As a consumer nation, and one exposed directly to the vagaries of the South African Rand, it provides a welcome respite to pay less for fuel at the pump. But I am afraid, again it is a case of the tail wagging the dog, and once enough shale plays have been put out of business, OPEC will revert to a more rational level of production.
The cheap oil party will then end as abruptly and as unexpectedly as it started earlier this year. That is bad news for consumers, but I also believe OPEC has no qualms to ensure that somewhere in the future, oil trades at a value they want to determine, and not let it be decided by such ordinary, mundane factors as supply, and over-supply. In the meantime, the potential risks to financial markets remain enormous, and we may be surprised in the new year, just how severe this contagion can become.

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