House Mountain Partners

The Grand Disconnect As The Geopolitical Great Game Starts Anew

Chris BerryComment

By Chris Berry (@cberry1)

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By the time you read this, I’ll be in London attending Mines and Money as a speaker and hosting a roundtable on Energy Metals. I think it’s fitting that I’ll be in the city which was at the heart of the last Great Game, the name for the geopolitical and strategic rivalry between the British and Russian empires in the 19th century. After last week’s events in the financial markets, it appears that a new Great Game has begun. The carnage last week made two issues abundantly clear.

First, OPEC has thrown down the gauntlet and is serious about asserting its dominance in the global oil markets. It appears to be every man for himself with the Saudis holding all the cards as just about all members of the cartel will have to stomach current oil prices (which could easily fall further). The strategy seems clear. OPEC is willing to let oil prices fall until US shale producers, some who funded expansion with cheap debt, feel real pain and it becomes uneconomic to produce oil. Industry sources tell me that there isn't one single price point for oil which will curtail production on a mass scale, so as oil prices fall, some, but not necessarily all, of US shale oil production should come offline, giving respite to OPEC members. The chart below from The Economist shows the approximate break even levels necessary for members of the cartel.

Source: The Economist

What seems clear at this point, however, is that either way, OPEC loses. If oil prices fall further this means additional pain for OPEC members dependent on high oil prices to balance their budgets. An inability to run a budget surplus means foreign reserves must be utilized which can have repercussions for both relative currency values and domestic interest rates making the cost of doing business in a given country problematic. Overproduction and slack demand due to sluggish economic growth have conspired to throw the cartel into temporary disarray.

If oil prices rise, this induces more supply from US shale producers, adding to the current oil glut. This is incredibly good news for consumers suffering from stagnant wages who now have a de facto tax cut via lower gas prices. Our good friend Keith Schaefer who writes the popular Oil and Gas Investments Bulletin put out a note last week highlighting what he believes to be the single most important metric he is watching. This is the increase/decrease in US oil production in the previous week. The data is released each Wednesday at 10:30 am and can be found here.

The market’s reaction to the OPEC decision not to curtail production was swift and relentless with the price of a barrel of WTI crude finishing the day down 10%.

Source: Bloomberg

The behavior of the oil price over the next few months will be a crucial indicator of the overall direction of the global economy.

The second takeaway from Friday’s events involves the performance of the commodity and bond markets. Here is the performance of the most widely followed commodities year-to-date:

Source: Bloomberg

Here is a view of the US, German, and Japanese 10 year Government bond performance:

Source: Bloomberg

Neither chart seems to be telegraphing inflation, does it? It fact, perhaps the bond and commodity markets are efficient after all in that they’re telegraphing disinflation or deflation. The “grand disconnect” I mentioned above concerns why the equity markets are generally at all time highs indicating economic strength if both the commodity and bond markets are telegraphing a much different story?

Source: Bloomberg

Who is right? OPEC? Powerful disruptive technologies like hydraulic fracking? The bond market? Central Bankers inflating equity valuations through cheap money? These are the questions I intend to address upon my return from London and as we head into 2015. The strategic significance of oil and access to cheap energy cannot be understated.

If you’ll be attending Mines & Money, please do let me know as I would enjoy the opportunity to meet.





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