For the time being Russia and Saudi Arabia have pretty much ended all speculation surrounding the next step in the energy markets. Two words – higher production, but does higher production necessarily mean lower oil prices? As the energy markets are faced with a great deal of uncertainty, nothing is out of the question just yet.
OPEC and non-OPEC member increased production would naturally take the ‘higher-price scenario’ off the table if we look at the supply and demand equation. However, there’s a Venezuela out there, and its production is completely collapsing which puts the $100 per barrel level on the horizon. But it’s not just Venezuela that has put the $100 per barrel on the horizon. There’s an Iran too, and they’re getting heavily sanctioned which, combined with Venezuela’s “complete collapse” could knock production down by approximately 1.6 million barrels a day. The $100 per barrel doesn’t seem so unreal now does it, says Bank of America Merrill Lynch. Now there are three factors that could shut down the triple figure oil scenario and perhaps leave oil at around $80-90 per barrel. The solution is either increased production from Saudi Arabia, Russia or U.S petroleum reserves.
Be that as it may, we’ve only looked at the supply aspect of things, which at this point is not the only driving force of prices and therefore not the only factor we need to take into account. The equation is supply AND… Exactly, demand – and I believe the demand scenario has received much less attention in the last months than it deserves. Most oil traders are focused on whether or not Russia/OPEC “will offset outages” in Iran and Venezuela but while everyone’s eyes are turned, emerging economies which are starting to crack under pressure, are threatening to derail the entire oil market. Even more so than the ‘increased production by OPEC and non-OPEC members’ scenario.
This ties in nicely with the U.S Federal Reserve’s outlook for a stronger Dollar and higher interest rates, which would ripple across emerging markets. Come to think of it, Dollar denominated debts would be much more painful to handle, taking a massive toll on economic activity and ultimately each country’s local currency. Weak currencies would only make Dollar denominated debts even more painful and the vicious cycle would likely continue. Paul Krugman, an esteemed economist, believes that the cracks we’re currently seeing in these emerging markets are similar to the ones that led to the Asian financial crisis in 1998.
The truth is, evidence keeps piling on one side and it seems even the Forex markets have already started feeling the impact. The Turkish Lira has plunged by 20% in just the last two months, while Argentina is desperately looking for a way out of the IMF with the collapse of the Peso draining public coffers. We see the same kind of appetite reflected in investors, who seem to be somewhat nervous about investing in emerging markets. In fact, funds are flowing out of emerging markets and into the U.S where a relatively stronger economy and higher bank rates seem to provide peace of mind to investors.
This is good for the U.S, perhaps, but it’s mostly bad news for emerging countries and their markets. With the Greenback gaining meaningful value as the U.S’ economic story strays from that of the rest of the globe, a feedback loop is created where emerging countries just cannot pay off Dollar denominated debts. Further validation of the Dollar’s increase is the WSJ Dollar Index, which measures the Dollar’s purchasing power against 16 currencies, and it has managed a 5.6% increase in the last three months. As a reserve currency, the Dollar pretty much impacts everything, and since the price of oil is denominated in Dollars, oil would fall under the category of ‘unaffordable goods.’
We all pretty much know what the worst scenario is. A complete and total collapse of all emerging markets. Governments unable to pay off debts, local currencies losing their value and it’s a global financial crisis all over again. Bank of America Merrill Lynch believes this scenario is quite far-fetched, for now, but it’s still at the back of everyone’s mind. It’s more of a tail-risk event but that doesn’t mean it’s improbable.
Stay tuned while we follow the oil saga. Until next time.
This article is for educational and informative purposes only and should not be considered as investment or trading advice.