I'm a big fan of mystery. The more difficult to crack, the better. The most interesting of mysteries in the past year involves war and intrigue. Politics and history. It impacts more people globally than perhaps any other event in the past year. It impacts every man, woman and child the world over. On the surface there is no mystery, but if we scratch at it a little, we uncover a lot of uncertainty.
To solve this mystery we need to make assumptions. Reread history. Perhaps rewrite it. If you hadn't guessed, we're talking about oil. Crude oil. The more you read about the history of oil and its current state, the more interesting it gets. Did you know the Nobel Prizes are funded from money made by the Nobel brothers who exploited Azerbaijani oil more than a century ago? Not exactly the cleanest source for funds for one of the most prestigious committees that award integrity and scholarship.
Ok, back to our mystery. Let's start with the easiest questions first. The what? The what is the drop in crude oil prices in the last year, the last six months of the year to be precise. The drop is more like a crash. Imagine the U.S. equity index or any other developed nation's major export losing 50 percent in value relatively quickly.
The when has three answers. The first answer is the late '80s. The second "when" is the 2008 Great Recession, and the last "when" or time period we're talking about is from July of 2014 to now. In all instances crude oil prices fell 50 percent in the blink of an eye. Six months is considered a blink of an eye when we're talking about the normal time it takes for such major moves of a commodity that directly affects every living human. Gold, for example, you may never see or touch or buy or sell in your lifetime, but everyone uses products derived from crude oil. Gasoline is actually not the most popular of crude-based products -- polyester probably is. Chances are your clothes are made of thread made from a crude-oil based process.
The where is more complex. The two major players are the West and the East. The United States and Russia. The crash in the 1980s has been attributed to many things. Some argue the United States masterminded a plan to keep crude oil prices artificially low to force the Soviet Union out of business. Literally. The Soviet Union's failure is one of economics. It went bankrupt. Some data reveals that indeed the price of crude oil fell 50 percent in 1986. This forced the Soviets to borrow heavily from the West and later make concessions as part of servicing this debt. The production of crude oil of U.S. allies such as Saudi Arabia fell from over 10,000 barrels a day in 1980 to less than half of that by 1985. The following year output increased.
Some argue the 1980s crash in oil can be attributed to the hard-currency hungry warring nations of Iraq and Iran: Both desperate for cash and both in an existential armed conflict. The argument goes that the Saudis cut production to fend-off pressure on oil prices by the over-producing warring countries. Still another argument claims that the Soviet invasion of Afghanistan spooked the Saudis. That they turned to the U.S. to guarantee their existence, lest the Soviets continue westward and conquer the Middle East as they had done with South Yemen, Angola, Cambodia, Laos and Vietnam to name a few. Why are we discussing events that took place 30 years ago? If the United States (and to a lesser extent Western European countries) were able to lobby their way into lowering oil prices – thus choking-off Soviet ambitions – then perhaps the same thing is happening now.
We skip the Great Recession crisis because it was a crisis of paper trading and stop-losses and an overreaction to a potential fall in demand. On to this year's crisis.
Is the best way to stop Russia's recapture of Crimea to force the nation into bankruptcy again by artificially lowering crude oil prices? Is this what's going on now? To make this argument, we need to assume that the West actually cares about Crimea or more precisely that it wants to stop Russian expansion and influence whether it be in Crimea or anywhere else. This is an easy sell. I'll agree that this is what policy makers in Washington and some in Brussels may want. What about the Russians? What do they say to this?
The Russians deny that this is going on. Surprisingly, they are joined by their OPEC brethren. They claim, unanimously, that the price of crude oil has crashed, yes, but that it has been their purposeful doing. That U.S. shale gas producers have a substitute in very light oil being extruded from the shale underneath the backyards of rural Americans. This is true. The United States has become an energy exporting country. For years there has been a moratorium on exporting oil in the United States, but the abundance of shale gas has thawed this freeze. So what's the endgame? Shale gas is only feasible when crude prices are above $40 a barrel. We're at about $55 a barrel of Brent Sea crude oil now (WTI at close to $50), down from twice that in July. So, okay, shale gas producers break even at $40 and start to lose money at anything below that. Then what?
This is anyone's guess. Three different scenarios will play out in 2015. The first and second scenarios start with OPEC countries being unable to toe the line. There will be under producing and over producing "cheaters": Countries that don't want to export at these prices and countries that can't afford not to produce at maximum capacity to make up for the shortfall of revenue. These are countries that have thick wallets and time to spare and countries that don't have resources or time. At $40 a barrel, we're talking about small Gulf countries like Qatar, Kuwait and UAE at one end of the spectrum and large countries such as Russia, Iran and Iraq at the other end. Saudi Arabia may be able to hold on for a while, so will OPEC observer Norway. Despite the largest sovereign wealth fund, Norway will find that dipping into that wealth fund won't be very easy should crude be infeasible to extract in Norway as it will be near $20-$30 a barrel. Norway is a small boat; turning ahead of choppy waters won't be difficult should it come to that. Russia, however, will be much slower to change direction. This is the point from the West's perspective.
The final scenario is that this was actually a play by OPEC and that enough shale producers were spooked by this decline to exit the market and no longer threaten OPEC's oligarchy. OPEC waits it out and after holding prices below $40 for a year, which has been hinted at, it cuts production and prices go back up. This is the most unlikely of scenarios.
I think oil prices will fall below $40 a barrel and stay there for a few years at which time OPEC countries will find political pressure domestically to cut costs and make up for lost revenue. Some will be successful and some will not. Russia might make it out of this crisis. The Russians are resourceful and have much experience in challenging times.
This mystery will go unsolved for the time being, but by the end of the year, we may discover what really happened to crude in 2014.