To say that nobody has any idea how to trade oil (except for the now default ramp into the 2:30pm Nymex close which may well be the new 3:30pm stock ramp) in this environment, when crude itself is beginning to trade like the Nikkei225, is an understatement. So here, hopefully to provide some clarity, is billionaire hedge fund manager Paul Singer, who Elliott Management returned 8.2% in 2014, a 12.7% CAGR since inception, and was just over $25 billion in AUM as of the start of the new year.
From Elliott Management Corporation
The Organization of Petroleum Exporting Countries (OPEC) is one of the most powerful and long-standing cartels in the world. Dominated by Saudi Arabia, the world’s largest oil producer, OPEC has mostly played the world oil market (come to think of it, and the world) like a Stradivarius violin over multiple decades. A significant element in the group’s control of the oil market is its ability, every once in a while, to cause oil prices to plunge, thus driving high-cost, highly indebted competitors out of business, or at least severely weakening them. One of the most potentially impactful and significant of these engineered collapses is currently in process. On June 30, 2014, Brent crude oil was over $100 per barrel; by November 1 it had dropped to $80 per barrel, and it now trades below $50 per barrel.
The shortfall in demand which caused this crash is actually not all that great, and economic conditions around the world are not really that bad, and so some high-cost producers and their investors think that they can wait this out. However, since this is largely an engineered price move, we believe that over a period of coming weeks and months an increasing number of leveraged, high-cost producers will shut down production and/or file for bankruptcy. Bank lenders will get nervous and then harsh. Saudi Arabia’s strategy is incredibly effective in keeping this kind of competitor off balance.
We surely cannot even guess about when or at what price oil prices may bottom out, but we certainly can survey the landscape of consequences of this episode. Many people focus on the fact that to consumers around the world, a significant fall in the price of crude oil operates like a “stimulus tax cut,” reducing the price of the gasoline and heating oil used by billions of consumers, thereby giving them more money to spend on other stuff. This force is real, but it is diffuse, and it will take quite a while to exert its positive force. In the meantime, we are more focused on an opposing factor: The oil industry in the U.S. and a number of other places around the world has been one of the few standout growth and jobs areas in the last few years. Credible studies show that over the last few years, at least a third of U.S. GDP growth (and a large portion of growth in high-paying jobs) came from the expansion of the U.S. energy industry. The absence of a strong multi-faceted recovery in the developed world has only highlighted industries such as oil production, and the advance of technology in shale oil development has made a big difference in America’s energy balance and strategic geopolitical position.
The price plunge is new, but if it is not reversed relatively quickly, it could make the apparently strong economic numbers in the U.S. in recent months seem like a lost warm memory by the middle of 2015. The problem, of course, is that the absence of pro-growth economic policies in the developed world (aside from monetary extremism) places a large premium on any industry that is actually growing and providing jobs and GDP. Given the fragility of both the global financial system and the economy, the plummet in the oil price is coming into a world in which any disruption can be harmful, even one resulting from a fall in prices of a major global input into the economic engine. The rise in the U.S. dollar in recent months also operates in the same direction, serving as another growth-dampening force to offset the consumer benefit of reduced-cost gasoline. Most people think the “tax cut” is more important overall than the growth-suppressive effects of the harm to the energy industry and the rise in the dollar, but we disagree.
Another important aspect of the price plunge is its impact on geopolitics. It is interesting that the oil price situation is slamming Russia especially strongly, as Russia has been on a roll in terms of unanswered aggressive moves towards its neighbors. In addition, Iran, one of Saudi Arabia’s chief adversaries, has been seriously hurt by the price decline. One could say that Saudi Arabia is also harmed by the fall in revenues, but it has more staying power than any other OPEC member and will likely (aside from other questions about its leadership succession and long-term stability) emerge stronger from this episode than it was before.