Putin the Great
Russia’s Imperial Impostor
As recently as late 2014, financial papers were filled with dour forecasts warning that the breakneck expansion of the emerging market economies, China in particular, would keep the price of oil above $100 per barrel for a decade or more. In October 2014, the International Monetary Fund’s respected World Economic Outlook pegged the commodity at $102 a barrel in 2014 and forecasted $99 for 2015. Soon after, prices collapsed, and the same pundits who predicted that oil would stay high now say that $30 a barrel or below will be the new normal for a long time to come.
The conventional wisdom has also declared dead the “commodity supercycle,” the explosion of commodity prices behind the economic growth of the BRICS countries (Brazil, Russia, India, China, and South Africa) and other emerging market economies in the first decade of this century. These days, oil is cited as evidence in this argument.
Forecasting is more art than science. Whether for personal finance, a multinational corporation, or the covert invasion of a neighboring nation, decisions must be made on some kind of intelligence. Best practice suggests that basing decisions on the worst-case and best-case scenarios is unwise; rather, forecasters need to look at middle-range outcomes. One only has to think back to 2013 to see how certainty over the existence of supercycles, the notion that long-term patterns not only exist but can be forecasted, was used to extrapolate growth for decades into the future by the world’s leading economists. But now, those double-digit growth rates attributed to Brazil, China, and other emerging markets have all been proven incorrect.
In fact, the whole concept of supercycles was a cheery oversimplification of best-case supply-and-demand dynamics, used for everything from gold to natural gas. Just months after the supercycle’s bust, it is easy to see how the concept included classic symptoms of a financial bubble—complete with assumptions that this time would be different. For emerging market experts and their investors, forecasts were built upon optimism rather than measured and pragmatic modeling.
Now, with oil prices dropping to their lowest rates in decades, many are looking to go from best-case to worst-case thinking. This, of course, is just as unwise and uncalled for. The supercycle is far from over—it has merely paused. The trend toward higher food, energy, metals, and commodity prices will resume, just as sure as the earth’s population and the size of the middle classes in Brazil, China, Nigeria, and Turkey will continue to grow. These patterns, unlike globalization, rely on supply-and-demand trends that show little sign of abating. And as these patterns have weathered the storm of stalled emerging market growth, so too will commodity prices.
In spite of current market chatter about the death of the supercycle, the laws of supply and demand have not ceased to exist. There has been, however, a tremendous change in these forces and their interaction geopolitics. Hydraulic fracturing in the United States, for example, has changed decades of assumptions about the effects on oil prices on the Middle East, as well as about the control that oil cartels have over global prices. Saudi Arabia, long known as the world’s swing producer of oil, enjoyed near solitary control of global oil prices from 1973 until 2014, when the United States entered the fray. Now, the world has essentially traded in the Saudi swing-state model for a U.S.–Saudi Arabia production seesaw. Some analysts take this notion a step further, suggesting that fracking in the United States has displaced Saudi Arabia altogether, making the United States the world’s new swing producer. In reality, however, the current Saudi Arabia–led effort to defend OPEC against declining market share by refusing to cut production shows that Riyadh retains the power to depress prices by flooding the market. The real question is whether a Saudi decision to turn off the taps would reverse the slide.
Even as oil prices continue their decline in 2016, U.S. oil production has reached historically high levels—hitting about nine million barrels per day in 2015, a figure that is projected to fall to eight million barrels per day in 2016. This, of course, represents a significant drop but must be kept in the context of broader U.S. oil production trends. Between 2000 and 2010, U.S. production hovered between 4.5 and 5.5 million barrels per day. In other words, 2016’s lower production estimates are the equivalent of adding Iraq’s daily production to the last decade’s average U.S. output.
This being the case, how has Saudi pressure on oil prices created a faster slowdown in hydraulic fracking in the United States? In contrast with traditional oil economics, where a huge investment up front is amortized over three decades or more of gradually declining production, fracking wells produce 85 percent of their output in the first two years of production and then slowly churn out smaller amounts for a decade or more after that. The economics of fracking thus makes it necessary for some low-margin or highly leveraged producers to press on despite market conditions. The alternative is selling out or going bust.
To be sure, some fracking operations will go bust in 2016. Steady prices of $30 per barrel and below have exacted a cost on domestic fracking operations, and some fields are beginning to fail to cover their operating costs. But many more will survive. Fracking has proven enormously resilient and agile despite low oil prices, partly because the fracking industry in the United States has a genius for cost control and is blessed by a flexible regulatory environment. Wells are easy to mothball and then revive, unlike conventional oil-drilling operations. So although the number of rigs actively drilling has dropped precipitously during 2015, these rigs are easy to restart once prices rise. But that, unfortunately, hasn’t made it into the worst-case calculations of most observers.
Even if low prices persist for another two years—which might happen thanks to slower growth in China and OPEC’s supply glut—fracking will not die. In effect, the U.S. fracking industry’s ability to ramp up and slow down with minimal damage to the larger U.S. economy has created a new feature in the global oil market: a price ceiling above which a major surge in U.S. production will quickly follow. No one knows the exact price that will trigger the fracking fields back to full production, and indeed the price may be different for different regions of the United States and even within those regions. But one thing is for sure: should Saudi Arabia reverse its position and order OPEC to cut production, prices will rise and the U.S. rig count will, too. And that, again, is left out of the conventional story.
For consumers in oil-importing nations, low oil prices are a boon. But exporters and global energy giants can take solace in the fact that they are not some “new normal.” The high oil and other commodity prices that filled sovereign wealth funds in the first decade of the century may be gone for the moment, but the volatility that has always driven prices up, then down, and then up again is not. As long as unpredictable humans run the planet, they will do things that stoke volatility. High oil prices are just an accidental war or misguided invasion away.