We dissect the crisis in Russia and the global impact of low oil prices
The last several weeks have seen a remarkable drop in oil prices and this has had a wide impact on the world. Brent at $58.5 and WTI as low as $55 were multi-year lows and caught the attention not only of traders, but also the general public. At the same time the Russian currency is dropping like a stone, losing more than 50% against the U.S. dollar.
So why is this happening? Or rather, why is it happening so fast.
There are two main reasons: First comes the increased production of shale oil in the U.S. that dramatically turned the largest economy in the world from an importer, to an exporter of what is essentially the lifeblood of commerce and trade.
Shale oil has made the fundamental reason for price changes – supply and demand – shift by providing more oil in the markets and lowering the price on the international markets. This should in theory help the economy by letting consumers spend more on something else beside transportation and companies on other business needs.
The second reason is the clearly visible geopolitical confrontation between Western countries and Russia over the conflict in Ukraine. Despite the ceasefire there are still outbursts of violence and tensions haven’t subsided.
The West has chosen not to intervene with a strong military response in what is considered to be Russia’s backyard, but their response, slow by many accounts, has come to fruition with the help of the aforementioned boost in the change of oil production.
Russian GDP is extremely dependant on the income generated from oil, despite it being an exporter of substantial amounts of natural gas and aluminium. Like any country they plan their budget expenses ahead for the coming years, with a projected average and range for oil’s price. It’s clear that those boundaries have been breached.
This is forcing the Russian central bank to intervene on the forex market, pumping its currency reserves (accrued mainly from said oil production) into the market in an attempt to stop the drop and thwart sellers. It seems like a case of someone going against the markets and possibly even throwing money in the wind. Time will tell if it was worthwhile.
There are several other aspects to the whole conundrum. The main one is Saudi Arabia and OPEC (the Organisation of Petroleum Exporting Countries) by proxy. The former’s role as the 2nd country with the largest reserves of black gold (after Venezuela) is vital. From their perspective, they see a quick win from keeping oil prices lower.
Several weeks back they decided not to decrease their output, pushing prices down. Their motivation for this was that low prices would hit two birds with one stone. Oil shale companies in the U.S. wouldn’t be able to make a profit and might even go under with such prices, as the majority of them are new companies with relatively modest cash reserves and business plans that rely on prices between $60-100 per barrel. If these companies were to go bankrupt in the near future, that would immediately return things back to how they were for Saudi Arabia, and demand for their oil would go up, pushing prices higher again.
Second on their list is Iran, their local rival, who is a substantial exporter of oil and depends on it to grow its economy that still suffers from sanctions. Iran mainly sell their oil to other Asian countries, chief among them China. So Saudi Arabia as one of the strongest allies of the U.S. has no qualms in helping them out with indirect pressure on Russia and Iran and to some extent even China.
But a change in any of these players would switch things around – if shale production decreases in the U.S., oil will go up. If Russia backs down from Ukraine, sanctions and geopolitical pressure will dissipate. If Saudi Arabia is content with U.S. shale production – then they might lower production, pushing the price higher.
Other global factors such as increased gas production, improved energy efficiency for manufacturing companies and auto transportation and the slow but steady rise of green energy, all contribute to lower oil prices, but at the moment they are just whispers in a very, very loud crowd. This crowd thinks we are definitely living in a different world from several weeks ago, but things might go back to how they were. At least for oil prices.