Why Oil Could Head Way Lower If This Happens

The prospect of $20 oil prices has been raised thanks to this one Black Swan. A Black Swan is also known to statisticians as tail risk, or events that are highly improbable but are of great significance. One can liken such an even to a large meteoroid making its way through the Earth's protective atmosphere and impacting land or sea; an extremely unlikely event but if actually true, mankind's existence would be threatened. Most people aren't prepared for Black Swans when they do occur, because most believe they'll never do in their lifetimes.

As for the financial markets, Black Swans have gotten more and more common, occurring with regular frequency and are now more predicable than say 5 years ago, such that the very term is becoming a nomenclature. The 2010 Flash Crash, and the Black Monday of 2015 are some of the more contemporary examples of today's tail risks. These are known unknowns. We have spoken quote a lot about the tale of know and unknown unknowns.

 The week after Christmas saw the largest plunge in Riyal forwards since 2007 (when the oil bubble burst), leaving many to question if a capitulation by Saudi Arabia is indeed impending. The over 200 pip spike in USDSAR 12-month forwards inplies a huge devaluation in the spot market.  Chart courtesy of Zero Hedge

The week after Christmas saw the largest plunge in Riyal forwards since 2007 (when the oil bubble burst), leaving many to question if a capitulation by Saudi Arabia is indeed impending. The over 200 pip spike in USDSAR 12-month forwards inplies a huge devaluation in the spot market.

Chart courtesy of Zero Hedge

Regular readers will know that we don’t make any sort of predictions in the markets, and this is no exception. We have not one idea if $20 oil will ever become a reality. We are merely explaining why it is a possibility in light of the current situation. This has got nothing to do with our biases as to the future trajectory of oil prices, but is a reflection of us sitting on the fence observing both sides and making opinionated remarks.
— Business Of Finance, 30 December 2015

Low oil prices have been the bane of many oil producing and export nations, whose currencies and economies have taken incessant hits every cent crude continues to plunge. The ruthless combination of a huge supply overhang and waning global demand has led to a deadly concoction oil producers and exporters have no choice but to drink. What other choices would they have anyways?

It doesn't get simpler than supply & demand

As we write, both WTI and Brent are hovering near their 2008 lows (lows seen at the nadir of the last oil bubble)  and are not seeing much buying interest, though unidirectional volatility is starting to creep back, but that could be a function of low liquidities this holiday season. Although this isn't a piece about price analysis, we'd be inclined to think there should be more downside left in this bear run.

We've written extensively about the fundamentals of oil earlier in 2015 (here, here, here). Our views haven't changed much, but we must say the basis for even lower prices or a continuation of the current listless price action in crude has gotten even stronger as of late. Developments have occurred in the last few months, and they don't bode well for price recovery usually seen in up cycles.

One of the most impactful developments in 2H15 has to be the liberalization of Iran under the renewed P5+1 treaty where financial and trade sanctions were gradually lifted in return for a cooperative stance towards Iran's nuclear programs. Iran has therefore been able to export oil that it so bountifully has, but for the last 20 years not been able to readily sell. Iran's crude production will continue to add to global supplies, deepening the rout.

You've probably also read that the most recent OPEC summit held December concluded with no cuts to gulf production because individual members couldn't agree on one consensus; Saudi Arabia being the chief protagonist of the 'letting the market do what it needs to do to rebalance' meme.

Earlier today, the world got news that the emirate would no longer contemplate restricting production. To wit the Saudi Oil Minster, "we will satisfy the demand of our customers. We no longer limit production. If there is demand, we will respond. We have the capacity to respond to demand."

Which leads us to the main point of this article - If and when the Saudis will capitulate to market forces.

Black Gold & Black Swans

It's not a capitulation most would hastily refer to, and it has little to do with a supply cut from the Saudis either. Enter the convoluted realm of pegged currencies. Many analysts have called a potential Saudi devaluation the biggest Black Swan for the energy markets going forward. Once we delve into the details, the reason becomes crystal clear.

For almost 18 months of falling crude prices, the kingdom has managed to maintain its currency's (riyal) peg to the U.S. dollar by selling dollars from its huge pot of foreign reserves amassed from more than a decade of rising oil prices (excluding the 2007 oil bubble). Markets on the other hand have been willing sellers of riyal to the Saudis for obvious reasons.

 In this chart, we plot USDSAR spot and forward rates together. The end of the Fed's QE3 heralded a phase of heightened volatility especially amongst EM and commodity sensitive currencies. Royal forwards began to trickle higher and oil prices persistently sled, all while the spot market traded in a tight range. Massive weakness in the Riyal forwards started when China devalued its currency. The currency divergence is too large to turn a blind eye to. Something has to give - either the Saudi's devalue or the market's readjust higher.  Chart courtesy of Zero Hedge

In this chart, we plot USDSAR spot and forward rates together. The end of the Fed's QE3 heralded a phase of heightened volatility especially amongst EM and commodity sensitive currencies. Royal forwards began to trickle higher and oil prices persistently sled, all while the spot market traded in a tight range. Massive weakness in the Riyal forwards started when China devalued its currency. The currency divergence is too large to turn a blind eye to. Something has to give - either the Saudi's devalue or the market's readjust higher.

Chart courtesy of Zero Hedge

If there is an economy that is as close to purely dependent on oil revenues, it would be Saudi Arabia. It wouldn't be atrocious to believe that USDSAR should be trading 50% higher (riyal weaker) after all the carnage crude prices have suffered. The pent-up forces within the kingdom's fiscal position, real and financial economy shouldn't be undermined.

The Saudis are countering blatant market forces by bluntly absorbing whatever supply of riyals comes their way, while selling from its vast pool (which they seem to believe is infinitely deep)  of foreign reserves. Call it hubris or denial, but it is a train wreck waiting to happen in our minds.

 A succinct view of the forces at play when it comes to Saudi Arabia's ability to maintain the Riyal's present peg to the U.S. dollar. As cude prices started their cataclysmic plunge on 2014, Saudi crude production actually rose to an all time record in 2015 as Brent was trading somewhere in the $40s. Surging USDSAR forwards are screaming that the Saudi playbook is not only obtusely unsustainable, it is signaling that the nation is digging its own grave.  Chart courtesy of Zero Hedge

A succinct view of the forces at play when it comes to Saudi Arabia's ability to maintain the Riyal's present peg to the U.S. dollar. As cude prices started their cataclysmic plunge on 2014, Saudi crude production actually rose to an all time record in 2015 as Brent was trading somewhere in the $40s. Surging USDSAR forwards are screaming that the Saudi playbook is not only obtusely unsustainable, it is signaling that the nation is digging its own grave.

Chart courtesy of Zero Hedge

Remember also that under $35 a barrel, drilling for oil becomes unprofitable for the average Saudi producer. We are very close to that threshold. Despite the multiple red flags which have been raised, Saudi ministers persistently refuse to cave in to what the markets have been saying.

Their insistence to pump crude at a record pace while reeling from a rapidly atrophying fiscal position (deficits, indebtedness, credit ratings), an economy that has been going downhill for the last year, and capital markets which have seen gargantuan outflows for most of 2015, will sooner or later rear its ugly head. The chickens have come home to roost, as they put it.

We'll leave the details to the professionals, but whatever the Saudis are doing, it is very likely setting up the stage for the biggest Black Swan to ever grace the global energy markets in a long while

Bank Of America's take on a potentially game changing Saudi devaluation:

"For oil, however, the most crucial point is what happens to Middle East currencies and in particular to the Saudi Riyal. In fact, Saudi Arabia’s FX reserves are still high and point to an ample buffer for now, but they have been falling at a relatively fast rate (Chart 21). However, should China allow for significantly faster FX depreciation than is currently priced in by markets, we believe oil prices could fall further. Naturally, the FX reserve drain on Saudi could accelerate to $18bn per month if Brent crude oil prices average $30/bbl (Chart 22), sharply reducing the Kingdom’s ability to retain its currency peg.
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Saudi has been forcing prices lower by increasing production into an oversupplied market so far (Chart 23), and it also rushed to issue debt in its local market to fill a soaring budget gap. We have previously argued that Saudi Arabia’s surging output is responsible for almost half of the 520 million barrel global petroleum inventory build in the last 7 quarters. Can the government maintain this strategy of flooding the oil market? In our view, it is unlikely that Saudi leaders would want to exacerbate its ongoing reserve drain by pushing prices below $40/bbl. After all, pressure will quickly build on the riyal’s 30 year peg to the USD (Chart 24) if Brent crude oil prices keep falling. And frankly, it is a lot easier politically to implement a modest supply cut at first than allow for a full-blown currency devaluation. But a CNY meltdown could ultimately force Saudi’s hand.
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In short, a depeg of the Saudi riyal is our number one black-swan event for the global oil market in 2016, a highly unlikely but highly impactful.
However, if Saudi cannot resist the gravitational forces created by a persistently strong USD and depegs the SAR to follow Russia or Brazil, oil prices could collapse to $25/bbl. Weaker commodity prices would in turn add more downward pressure on EMs. Thus, even if micro supply and demand dynamics are improving, the path for oil prices in 2016 will heavily depend on how the USD moves against the CNY and the SAR, or on a Saudi supply cut."

 The Saudis still have the luxury of a few choices. Either they put a stop with the entire flooding an oversupplied market with even more supply strategy (which has so far backfired in just about every possible way) and cede some market share to more well deserving nations while allowing prices to 'correct' themselves, or they could continue with a failed strategy with the market eventually breaking the currency peg once the Saudis run out of reserves to sell.

Bear in mind that it's not just falling prices, the peg, and generous subsidies that are weighing on the Saudis. There's also the war in Yemen and the prospect of a stepped up role in Syria that will continue to pressure the kingdom on all sides, until a crack leads to a complete shatter.