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KMW Blog Feb 4, 2016: The expanding commodity war


Posted: Feb 4, 2016JK: The expanding commodity war
Published: Feb 4, 2016FT: Gas price war rumbles on the Russian front
Jack Farchy of the Financial Times raises the question of whether Russia's Gazprom is about to launch a a global natural gas price war to fight the arrival of US liquified natural gas shipments to Europe over the next two months. The shale oil revolution that propelled the United States into first place globally for oil production in 2014 has also yielded a bounty of natural gas that spurred the construction of LNG plants during the past couple years that are now becoming operational. The portability of LNG is seen as a solution to countries such as Japan and Germany which are reducing their reliance on nuclear energy, lack domestic sources of natural gas, and do not wish to generate power from thermal coal. In the case of Germany and the rest of Europe there is also a security of supply concern about pipeline transported gas from Russia and the Middle East created by the ISIS turmoil and Putin's increasingly bellicose attitude toward former members of the Soviet empire such as Ukraine. The threat of natural gas supply disruptions created by terrorist activity or state level manipulations, especially during winter, has made Europe nervous in the past, though this anxiety has been offset by the belief in rational behaviour by commodity export dependent nations such as Russia. Since 2014, however, the risk of supply shortages and high prices due to artificial restrictions has been replaced by a commodity price war on multiple fronts. The most dramatic example was the rare earth supply squeeze by China in 2010 that caused rare earth prices to increase tenfold in China and twentyfold for the export market in 2011 before crashing as end-users resorted to substitution and thrifting of these critical metals. Rare earth prices have since crashed to lower levels than existed at the start of 2009 as a couple non-Chinese rare earth mines came on stream and illegal Chinese production and smuggling skyrocketed. China's efforts to consolidate its rare earth industry by shutting down illegal and polluting operations have proven less than effectual, which is remarkable for a central command economy and raises suspicion that a campaign is underway to destroy emerging higher cost foreign supply and restore the world's dependency on China for its rare earth supply.

The iron sector is the focus of a similar commodity price war as the big producers Rio Tinto, BHP and Vale have used the slumping steel demand in China as a cover for ramping up their low cost production in Australia and Brazil at the expense of new developments elsewhere. Given that Australia and Brazil are stable jurisdictions and supply related decisions are in the hands of management teams working on behalf of shareholders, the iron war has no geopolitical or macro-economic implications.

Other commodity wars pose serious threats. During 2014 Saudi Arabia decided to switch from defending the oil price to defending its dominant market share which had been matched by the US shale oil boom. Not many people realized that in 2014 the United States squeaked into first place thanks to hydraulic fracking of tight shale oil deposits which ended a multi-decade need to import oil and resulted in lifting of a ban on crude oil exports. The crash in crude oil prices caused by the Saudis' refusal to cut back production has put extreme pressure on oil producing nations and has failed to generate the economic stimulus windfall that sharply lower gasoline prices are supposed to bring. In 2014 global oil production of 32.4 billion barrels had a value of about $3 trillion at an average price of $93 per barrel. At the current level of $30-$32 per barrel the oil producers have lost $2 trillion in revenes. Could it be that this lost revenue is to some degree feeding China's slowdown in terms of reduced demand for China's output, which in turn decreases China's demand for raw materials coming from other ermerging market nations? There seems to be a vicious circle at work which is grinding global trade to a halt and undermining the Federal Reserve's attempt to normalize interest rates.

Russia, the third largest oil producer in 2014 at 12.1% compared to 13.1% for the United States and 13% for Saudia Arabia, has suffered a double whammy from the oil price decline because much of its European natural gas supply contracts are linked to the price of oil. The 50% decline in the price of European natural gas, however, is making it easier for Russia to contemplate using its low cost advantage of $3.50/mm BTU compared to the $4.30/mm BTU cost of delivered US LNG to launch a price war designed to undermine the American shipments which benefit from a $2.50/mm BTU domestic price but need to add the cost of liquifying and shipping the natural gas. The extra pain of marginalizing US LNG imports is a fraction of what Russia has already had to absorb.

While a global commodity price war benefits the United States whose anti-mining lobby works hard to stymie the development of domestic mine production, the multi-pronged attack on its shale oil/gas production capacity cannot sit well with strategists. It is generally assumed that $60 oil or higher is needed to make shale oil viable. Since the start of 2015 the so-called "miining and logging jobs" employment sector which includes oil servicing jobs has lost 156,000 jobs, a drop of 17%. Unlike big offshore or remote conventional oil projects which have a heavy upfront capital cost but then produce at a fairly low operating cost for decades, shale oil development has a high up front "stimulation" cost that yields a burst of oil production with a steep production decline curve. The shale oil boom of the past five years has been funded by debt whose payback prospect was good at $90 plus oil. But as oil dropped below $60 the ability to "refinance" payback with new debt to restimulate tight oil vanished. Now the United States faces an energy debt related crisis that needs $60 plus oil to smooth away. It also faces the prospect of a return to oil import dependency. The bankruptcy of many shale oil energy companies is likely unavoidable, but the creditors will end up with title to the shale oil resources. Innovation is underway to improve the fracking technology so as to flatten the production decline curve and give the stimulation cost a longer payback period. Bring back $60 plus oil and the shale oil boom can restart on a dime, which cannot be said for the big conventional oil projects that have been suspended. The United States needs oil self-sufficiency as it spends the next decade transitioning away from gasoline as a transportation fuel.

At the same time Saudi Arabia is playing with fire as it attempts to bring other higher cost oil producing nations to their knees. It is dipping into its foreign currency reserves to pay for the welfare state that keeps its citizens from revolting. The monarchy has an alliance with the Wahhabist clergy which has been exporting an extreme, intolerant version of Islam around the world. Suspicions are growing that the rise of jihadi extremism may not be a random phenomenon among discontented young people. ISIS appears to operate with impunity in Syria and western Iraq. How secure is the Saudi monarchy from a coup that puts the Sunni clergy in charge of Saudi Arabia much in the manner that the Shiite clergy replaced the Shah of Iran in 1979? What would be the world's reaction to the ISIS caliphate expanding to include Saudi Arabia? I suspect the result will be that a lot of Saudi oil production goes off-line as an erupting civil war compromises the capacity to load Saudi oil onto oil tankers. The likelihood that Iran will muddy the waters by interfering is high. Anybody who has been reading the mainstream media will have noticed during the past six months the emergence of articles addressing the Wahhabist influence in places like Pakistan and elsewhere that jihadi extremism has started to flourish. A train wreck in Saudi Arabia solves quite a few problems afflicting countries caught by the commodity wars. The complacency about "permanently" cheap oil is mis-guided.

 
 

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