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Frenemies

Summary:
The oil narrative is not as it seems. We think there will be a superficial deal between Russia and the Saudis sometime this week – just as we wrote last week. However, the narrative is not as one-dimensional as president Trump has been suggesting in his press briefings. Trump’s narrative has been that low oil prices are bad for both the Saudis and Russians. Therefore, he concludes, they have incentive to do a deal. Sure they are ‘bad’ right now – but long-term gain (for them) comes from short term pain if US E&P is permanently impaired. In our opinion, the popular oil narrative is generally ill-premised, as it assumes the Saudis and Russians to be at odds. Don’t be so sure. Their interests are aligned around disabling U.S. production. Period. The President’s recent tweet (last

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Frenemies

The oil narrative is not as it seems. We think there will be a superficial deal between Russia and the Saudis sometime this week – just as we wrote last week. However, the narrative is not as one-dimensional as president Trump has been suggesting in his press briefings. Trump’s narrative has been that low oil prices are bad for both the Saudis and Russians. Therefore, he concludes, they have incentive to do a deal. Sure they are ‘bad’ right now – but long-term gain (for them) comes from short term pain if US E&P is permanently impaired. In our opinion, the popular oil narrative is generally ill-premised, as it assumes the Saudis and Russians to be at odds. Don’t be so sure. Their interests are aligned around disabling U.S. production. Period.

The President’s recent tweet (last week) made me wince, and I’m guessing it may have made Vladimir Putin laugh – you know, one of those evil genius laughs. President Trump tweeted:

I pray that the President does not have a sincere belief in this friendship or outcome. Brinkmanship combined with narcissism make him a hard read, and that’s probably a good thing. Does he really believe he’s going to drive a deal here? It would certainly be ironic if the Saudis and Russians actually gave him an illusory win and do cut some – allowing him to think he’s actually a real ‘influencer’ in a game that is ultimately of their design. Is a cut in the amount he cites completely unprecedented? No, there were large cuts in the early to mid-1980s.[2] But if the cuts were 10 to 15 million barrels per day, that would amount to between roughly 25% and 38% of current output for OPEC+. Interestingly, the tweet was countered by immediate denials from Russia that any conversation between MBS and Putin had yet occurred – which means it probably has occurred – but not for the purpose of easing production. A high five perhaps?

For anybody naïve enough to think that the current production ramp-up is not a coordinated effort between the Saudi’s and Russia, I have two words: wake up. This artful play will likely have may acts. Putin and MBS are ‘frenemies.’ They will at times emphasize their friendship and at other times their adversarial relationship. That dichotomy is helpful to their narrative. Feigned compromise on production cuts should make the nefarious collaboration more believable within the context of the long-game they are playing. Whatever cuts occur will make a for a great headline, but they will be short-lived. Their goal is most likely to eliminate the high-cost U.S. producers that have survived only because of access to capital markets. Few are cash flow positive below $45/bbl, so oil probably does not have to be this low anyway. A small superficial cut will make little difference at prices this low and with demand so weak.

On March 9th, my team and I wrote in our Morning Read:

Frenemies

“Does anyone remember the infamous high-five between Putin and MBS (pictured)? One theory is that the Saudis are playing a game of chicken with the Russians. Unfortunately for the Saudis, the Russians have positioned away from the U.S. dollar, and ruble depreciation cushions the blow of lower oil prices for Russian producers. The Russians also have an estimated $100 billion in gold reserves after dumping most of their USTs. They have little external debt. In short, Russia has staying power. Alternatively, the Saudi’s actions could be yet another high five veiled as a slap in the face. Now that Aramco IPO done, something else could be going on here.

Perhaps this is not a game of chicken at all and instead a far more coordinated effort with Russia to finally crush US E&P. Given lack of access to credit markets E&P defaults will begin to spike. Breakevens are in the low to mid 40s, so cash burn already underway (given steep decline rates and continuous capex) will accelerate. Both the Russians and MBS seem to value instability, and this could be their moment to disable debt laden U.S. E&P companies.”

OPEC+ has seized the opportunity for which they have been waiting. Oil demand by EIA estimates was already slated to fall in the first quarter even before coronavirus hit. That said, the impact on demand from the virus is unarguably severe. Like the meme that low rates justify high equity valuations, we disagree that lower oil prices will act as a tax cut to the consumer. Rates are low for a reason; oil prices are low for a reason. In fact, low rates for far too long led to massive overcapacity in U.S. E&P. Capital markets remained open to companies because of the ‘Fed put.’ This is at the root of what catalyzed the price war we now have. OPEC+ had simply had enough. Perhaps most importantly, we suggest the oil price war is between OPEC+ and the U.S. – not between Russia and the Saudis.


[1] The inflation-adjusted real 2004-dollar value of oil fell from an average of $78.2 in 1981 to an average of $26.8 per barrel in 1986.

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