Mon | Nov 12, 2018

Walter Molano | It's all about oil

Published:Friday | January 19, 2018 | 12:00 AM
In this July 19, 2010 file photo, Iranian workers walk at a construction site which is part of South Pars gas field, on the northern coast of Persian Gulf, Iran.

Riots in Tehran, political unrest in Saudi Arabia and chaos in Venezuela - all of these problems seem to have domestic explanations.

Iranian experts point to rampant corruption, the effect of international sanctions and the unmet aspirations of Iranian middle-class youths.

Saudi analysts say the country's system of royal succession and the looming intergenerational monarchial change explain the recent palace intrigue and the arrests of senior princes.

And some Venezuelan watchers blame the mis-management and corruption of the Maduro administration, along with the dismantling of the democratic regime, for the country's chaos.

It is true that these factors have an important impact on what is occurring. However, the common thread that runs through these countries is the damage that was produced by the 2014 collapse in oil prices. Oil makes up the overwhelming majority of exports in all three of them: 96 per cent of Saudi exports; 91 per cent of Venezuelan embarkations; and 80 per cent of Iranian exports. Such a high degree of dependence on a volatile commodity is the reason these countries are currently in distress. Fortunately, oil is moving in an upward direction, and it is not showing any sign of abating.

Most energy analysts were wrong-footed by the decline in oil prices in 2014, and they have been equally surprised by its recovery. A good part of the problem was due to fracking. Although the technology was on the rise since the start of the new millennium, it became a significant source of US oil production between 2011 and 2014.

Fracking went from an annual output of about 1.2 million barrels per day (bpd) in 2011 to about four million bpd in 2014. This coincided with large increases in traditional oil output in other parts of the world. Part of this increase was due to the jump in capital expenditures and exploration that occurred after the 2008 financial crisis, when the major central banks moved into monetary easing and other forms of monetary accommodation.

Collapse in capex

It was natural that output would eventually rise. However, the opposite occurred in 2014. The collapse of oil prices, along with the easing of monetary accommodation, led to a collapse in capex. Therefore, it was logical that oil production would taper off. As a result, prices would rise - and they did in 2016.

Most oil analysts expected prices to move lower, but they failed to realise the impact that the tremendous collapse in capex would have on the oil markets. Instead, given that they had underestimated the impact of fracking, they overcom-pensated by claiming that fracking would roar back to life when the oil markets recovered, thus triggering another price decline.

However, fracking is still a relatively small segment of the total market, representing about five per cent of global production. Even as it comes back online, it will just compensate for the decline registered in large traditional producers, such as Venezuela and Mexico.

This is not to say that oil prices will never drop. On the contrary, the sector continues to have a very volatile tendency, but this is mainly because of dramatic changes in capex, along with very limited storage capacity.

Oil capex has just started to recover, but it will take some time before the additional investment will manifest into output. Therefore, oil prices should continue their upward trajectory. Moreover, geopolitical problems, particularly, in the Middle East, can only help this scenario.

These conditions help explain why investors are giving Venezuela the benefit of the doubt. The government's willingness to pay has already been established by the level of pain that the regime has been willing to subject its population in order to keep on servicing its debt obligations.

The government's problem has been its capacity to pay. This was a driving issue when oil was less than US$30 per barrel, but with prices reaching US$70 per barrel, their capacity to pay is becoming less of an issue. It is true that oil production has dropped considerably, and it will be difficult to restore due to the fact that much of the technical capacity has fled the country. Yet, after witnessing the nightmare of the Argentine restructuring, the Maduro administration will likely do anything to stay out of US courts and try to cure the default.

At the same time, investors are reticent to embark on the expensive process of hiring legal counsel and accelerating the bonds. The situation will become even more interesting if oil prices continue to rise at the current pace.

Most industry analysts believe that a collapse in oil prices is imminent, but a combination of technical and geopolitical factors will likely push oil prices even higher.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com