Oil! Oil! Oil! Embrace the opportunity
The plunge in commodity prices has taken the world by surprise.
While the move appears to have been triggered by Saudi Arabia, it has reverberated in many unintended and damaging ways.
Predatory pricing is a tried and tested tactic used to drive out competitors and increase market share.
Dumping is as old as the oil industry itself, and it was the way John D. Rockefeller was able to transform Standard Oil into the most powerful company in the world more than a hundred years ago. It is very effective in sectors with a large number of small competitors, a few dominant players and high production costs.
SAUDIS IN DRIVER'S SEAT
A coordinated move by one or more of the large players to push prices below production costs does not take long to drive the weaker companies out of business. With more than US$700 billion in international reserves and the lowest extraction costs in the world, the Saudis are in the driver's seat.
The principles of the phenomenon are found in classical economic theory. Say's Law argues that when supply determines demand, the adjustment mechanism is price; hence these forces have been unleashed in the oil sector.
Over the last five years, global oil production increased 5.5 million barrels per day to 87 million bpd. In aggregate, the expansion was only about five per cent. It was not a huge number. Of the total increase, three million bpd were from the US shale industry, one million bpd were from Canadian oil sands, 700,000 bpd were from Iraq, 200,000 bpd from Colombia and the rest were from small producers in Africa.
The market absorbed the incremental production in an orderly manner, but the situation began to change midway through 2014, when Saudi Arabian oil exports to the United States began to fall. In fact, they plunged by half, dropping from 1.6 million bpd in May to 850,000 bpd in December, despite a downward adjustment in price. At the same time, oil exports from Canada began to climb, rising from 2.5 million bpd to three million bpd, during the same time period.
The Saudi's were losing market share to two alternative energy sources, shale and oil sands. Both of them have high extraction costs, with a large number of small producers. Therefore, they were perfectly vulnerable to a predatory pricing attack.
Instead of cutting output to stabilise prices, the Saudis decided to keep output high to drive out the weaker competitors.
Prices plunged as the world choked on the unrelenting supply of oil. Global demand is determined by output, but pricing is dictated by the marginal buyer.
The great neoclassical economist, Alfred Marshall, found that valuations were not dictated by the absolute utility of a good, but by its marginal utility. The first glass of water has enormous utility for a person dying of thirst, but the utility of the 500th glass of water is close to zero.
The collapse in oil prices sparked a search for other explanations of what was happening. Perhaps, the Chinese were fudging their numbers, and the economy had actually experienced the hard landing that everyone was fearing early last year. Suddenly, no one wanted to take a chance that the drop in oil prices was just an aggressive move by the Saudis to recoup market share.
Investors began to dump other industrial commodities, particularly copper. With very little liquidity on the Street, and the prop desks a distant memory, it did not take long for other commodity prices to fall. Momentum traders soon jumped in, and the drop in oil prices was converted into a commodity rout.
The carnage wreaked havoc among emerging market corporate issuers and currencies.
To add to the mix, concerns about global deflation surfaced once more. Interest rates came tumbling down, the euro was crushed by the Swiss franc and people stopped talking about the Fed raising rates in 2015.
It was as if a delicate ecosystem had been thrown into disarray by a very small action.
But in the same way that Mother Nature can stabilise itself after unexpected trauma, the market has many heuristic mechanisms that quickly come into play.
Oil companies have slashed billions of dollars off their exploration and production budgets, thus ensuring that supply will fall in the future.
The half-life of a shale well is very short, and US output is expected to decline by 900,000 bpd before the end of the year.
On the other side of the equation, demand is expected to climb. US auto producers are reporting record sales, as consumers pile back into gas-guzzling SUVs and trucks.
The decline in oil prices will also turbocharge India. It is a large oil importer, and the lower price is giving the economy an important boost.
Therefore, this is not the time to run away from oil. It is time to embrace it. Such rare opportunities seldom appear in life, and they should be taken advantage when they do.
n Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.