Currency Market, Commodity Market, and Government Securities

Lesson -> The Crude Oil - Part 01

10.1 - Commodities superstar

If I had to choose one international commodity that can provide you with all the dramas of stock market as shown in movies, it would be the Crude Oil. You might be wondering why. This chart will help you to understand the importance of a good team.

The crude oil chart is a movie that can evoke all emotions. From the dramatic rise to $140 a barrel, to the sharp correction and then a rebound to close to $110, to a merciless crash below $30, it can be as well-directed as a movie. This is an international commodity that is actively traded by thousands of traders around the world.

What is the real story behind crude oil? Why did crude oil plummet from $115 to $28? This panicked state is what caused it. What's happening to crude oil now? What's the future of crude oil? This is why we must go back and look at the past of 2014-2015 to fully understand it.

This is precisely what we will do with this chapter. Let's go back to 2015, the first half, and look at how things were then.

10.2 - Rethinking the crisis

Brent Crude oil saw the most drastic drop in its prices in the past five years, falling from $110 per barrel in Jan 2014 to $28 per bar in January 2016. This dramatic price drop has brought joy to some corporations and maybe a few countries but it has also disrupted oil-producing economies. Literally, no one saw this coming. Even if they did, the magnitude (over 75%) was far beyond anyone's wildest dreams. Is this the end of the crash? You can guess my guess, but the severity of the crude oil crash is so intense that it is hard to believe the bottom could be in sight.

What went wrong?

Understanding the dynamics of crude oil is key to understanding what went wrong and how the business process was conducted before the crash. This discussion doubles as an 'oil basics" for you. Many million barrels of crude oil were produced by oil-rich countries. These oil products were then exported daily to the US, China and India. Two baskets are made up of oil-producing countries.

  1. "Organization of the Petroleum Exporting Countries(OPEC)."Nations" include countries such as Saudi Arabia, Qatar and Kuwait, UAE, UAE, etc.
  2. Other oil-producing nations such as Brazil, Canada and Russia have chosen not to join the oil cartel. OPEC. They are referred to simply as "OPEC."Non-OPECCountries

Nearly 90 million barrels of crude oil were pumped each day between the OPEC and non OPEC countries. Below is a graph showing the daily oil production divided between OPEC- and non-OPEC countries.

The Trigger

Oil production rates vary between countries. This is due to the country's technology and finances. Although production is dependent on internal factors such as weather and technology, oil sales have always been driven by the markets. The breakeven point, which is the price at which oil can be sold per barrel to pay for the cost of production, is clearly a country-specific figure. Selling oil below the breakeven level means that the country cannot balance their state budget. Below is a table showing the breakeven points of the OPEC members.

Country*The breakeven point per barrel
Saudi Arabia$106.0

These trade dynamics meant that the oil-producing countries enjoyed a triple-digit oil price until early 2013. Recent developments have changed the dynamics of crude oil business. The three main events that changed the course of crude oil prices were:

  1. American Shale OilTechnology has made it possible to produce American shale oil (oil shale, sedimentary rocks containing bituminous materials), and the price of production was relatively lower. American Shale oil production increased and flooded the market with cheaper oil. According to current estimates, the US may have enough shale oil resources to last generations. Exports of crude oil from OPEC member countries to the USA were replaced by shale oil from Texas and North Dakota. This led to a decline in crude oil prices.
  2. Inadequacy of coordinated action- With the rising production of shale oil in the USA and the continuing slide in crude oil prices, oil producing countries had to find a way to manage the situation. This included lowering the supply and regulating the demand supply. OPEC failed to convince non-OPEC oil producers countries and OPEC to reduce crude oil production in order to support the price. Actually, cutting oil production is more costly than pumping oil.
  3. China Factor -China is one of the top consumers of many major commodities internationally, including iron ore and crude oil. China actually surpassed the US in terms of oil imports in 2013. Reports suggest that China's economy isn't growing at the same rate as it used too, which means there is less demand for international commodities. This has an impact on spiraling crude oil prices, which is obvious.
  4. Market Dynamics- These three points led to a sharp selloff in crude oil. Adding fuel to the fire was the large short position built on Crude Oil contracts.

The US dollar is generally stronger when crude oil prices fall, especially compared to emerging currencies. This is normal.An increase in oilPrice increases the US current account deficit. This is obviously not a major factor for the US Dollar. The reverse helps to strengthen the dollar. Thus, the dollar and oil have an inverted relationship. Recall that in 2008, when Oil reached a peak of $148 per barrel, the US Dollar traded at 1.6 to 1 EURO.

The Russian Episode

Russia is a major oil producer and exporter (non-OPEC). Nearly 40% of total oil exports come from Russia's oil exports. The Russian economy appears to be in decline due to a drop in oil prices. Russia is being affected by three factors, two of which are directly related to oil prices.

  1. Oil PricesRussia requires oil prices in the range of $105-$107 to balance its budget. Russia's budget is clearly being hit by oil at $50.
  2. Rubble TroubleRemember that Russia is an emerging country. The Russian Ruble has suffered a massive fall in value against the US Dollar due to the drop in oil prices. To defend the Ruble, the Russian Central Bank raised the interest rate by 7.5% overnight (yes, it did happen in 2015).
  3. Crimea Curse- Western countries continue their sanctions against Russia for its aggression towards Ukraine. Russia is unable to access external capital, especially when it's needed most.

Add to that the Syrian crisis and a host other local factors, and there is little chance Russia will not slip into a financial coma, dragging it into recession.

The India macro angle

The fall in crude oil appears to be good for India, as the subsidy pressures on petroleum are lessened. India, a net oil importer (nearly three-quarters of India's oil comes from abroad), is responsible for a large portion of its oil imports. The fall in crude oil prices means a decrease in the fiscal deficit, an increase in inflation, and possibly a cut in interest rates. This is all good news for India considering the current economic environment.

Low oil prices have another side. Low oil prices will not only reduce our domestic import bills, but it will also have an impact on our export receipts. The majority of India's exports go to countries that depend on oil, such as the UAE, Saudi Arabia, Kuwait and Iran. These countries spend less when oil prices are low, which can have a negative impact on business with India.

If you look at the RBI October 2014 import and export data, it is clear that the same thing occurred. While the oil import bill decreased by 19% (yo-y), exports fell by 5%. Low oil prices are not as beneficial as they seem. We actually saw a glimpse of what could happen if oil prices continue to fall on the 6th January 2015. The NSE Nifty dropped over 255 points ( 3.0% decrease) creating chaos on the streets.

Indian Companies: The Impact

Lower oil prices directly benefit state-owned oil marketing corporations (OMC), such HPCL and BPCL. By lowering their working capital requirements, Both HPCL and BPCL have repaid over 50% and 30% respectively of their short-term borrowings in the past two years. These companies will benefit from a stabilization in crude oil prices at $50/barrel, which would be a great thing for their bottom lines and balance sheets.

Is this the end of it all?

All of this depends on the supply-demand balance. The US also lifted the 40 year-old ban on oil exports. This has increased supply and placed more pressure on prices.

The market reaction to American shale has been positive, but there's another angle: how solid is the balance sheet of the companies that fracking shale? Are they excessively leveraging? Are they exaggerating their reserves? These are all things that the market will soon learn, which will also impact crude oil prices.

But, I'm not sure if this is the end of the oil price crash at this point. Your guesses are as good as mine.