Commodity Super Cycle: Bad News for Russia
No one is immune to the “commodity super cycle,” says Dieter Helm, Professor of Energy Policy, University of Oxford, especially states that heavily rely on earnings from hydrocarbons.
With the shale gas revolution in North America having transformed the nature of the markets, he contends the world is different now compared to the in 1980s. Back then, he explains, when an authoritarian government needed cash it pushed production higher, supplies going up despite prices going down.
“This is, of course, very bad news for Putin and for Russia,” he says, recalling that the Russian President had come to power when the price of oil was coming up from $10. “So throughout his entire period in office, except for one blip, he's had more money every single year than the year before; oil and gas revenues are about 70% of the Russian budget.
“This is the first time that the story's gone the other direction,” explains Prof. Helm, who says that because the money had been spent, Russia now needs the price of oil to be at $90-100 to break even on its budget. This, in addition to the impact of sanctions, widespread corruption and its impact upon the performance of the Russian economy, as well as the costs of military intervention, mean that neither Russia nor Saudi Arabia have an easy out in this game.
He notes the overarching development in energy markets: “That is, the oil price has halved.” The industry has not yet adapted to the change, he says, unsure whether this is a temporary phenomenon or not. Opining that he doesn't think these prices are so low, he asks how they got so high, in a new paradigm looking back at the old one.
Why had oil prices been so high for so long? Prof. Helm attributes it to the “phenomenal transition” of China in terms of things like commodities' consumption. He comments: “I happen to think the transition is largely over, but the official growth rates produced by the Chinese government suggest that it might carry on for a long time to come.”
Such a transition had followed the German one following World War II, and the Japanese one until 1989, making it the second largest economy in the world at the time.
China, he explains, like Japan, had gone for energy intensive, export industries – steel, cement, fertilizers, petrochemicals, etc - whose outputs require markets like the US and Europe. “Then, they lent them the money to pay for it,” he says, “so China, like Japan, has about USD 1.5 trillion in Treasury Bonds – the financial flow that supports the purchase of the exports, which drove that boom.”
Showing a macroeconomics chart, Prof. Helm shows the economic busts in the years 2000 (stock market crash) and 2007 (credit crunch); things appear high again in 2015, it shows.
The crash of 2007 had been followed the largest monetary and fiscal injections known to mankind in the US and Europe, according to him. “The big story of China's expansion is powered by that low interest rate boom from the injections of fiscal monetary stimulus over the last decade or so in Europe. And we're now in the negative real interest rate part of that.”
The demand for Chinese goods, he says, remains robust, as does its output, so demand for commodities and energy remains robust. “But it's all over,” he quips, offering evidence like Indonesian coal mines or the oil market. “The demand for a whole range of commodities, which were going overwhelmingly at the margin to additional Chinese demand, has stopped.”
How can this be reconciled with Chinese growth at 7%? he asks.
Part of it, Prof. Helm explains, is a demand-side story: “Economics works. You stick the price up high enough for long enough, demand will go down – in the US and Europe, it's been falling quite substantially.”
It's all about shale oil and shale gas, he says, and the US turnaround, but it may be even more significant than we believe.
The shale revolution in the US being basically less than a decade old, but no one could have predicted it 10 years ago as evidenced by LNG import terminals being converted to export facilities. “The flexibility of these markets,” he says, “is grossly underestimated.”
It was thought that renewables would achieve miracles, becoming cost competitive because of the ever-increasing prices for oil & gas, he recalls, but it's not talked about anymore. Of Europe and its emphasis on renewables, he says, “That's what they believed and that's why they embarked, in part, on selling policies which now dominate our world.
“It's taking a long time to register, that maybe the story of ever-diminishing supply, ever-more expensive supply, ever-rising demand, particularly in oil but also in gas, just may not be the reality we confront.”
This means, he explains, that renewables subsidies will have to be permanent, unless a new generation of renewables come along that have much different cost characteristics.
US shale oil and gas production, he notes, has come on quite quickly, breaking yet another illusion regarding the oil markets. Many, Prof. Helm explained, anticipate Saudi Arabia will cut production and the price will go back up to $70-90/barrel. He opines, “This represents a profound misunderstanding of what's happening in the US and, therefore, what's happened in these markets.”
He explains that supply can be brought on more quickly than anyone anticipated in the US, and it can also be taken off quickly. “US shale production is very flexible and what it tells you is that the old story of swing production in Saudi definitely exists; determining the oil price is no longer correct.”
While volatility will exist, Prof. Helm says the new question is: “What is the equilibrium shale oil price for production, whilst the costs have fallen back down now that the boom's over?”
How long before the next boom? While some oil executives believe the market can normalize in the next couple of years, especially as Americans start driving bigger cars and supply is decreased.
Prof. Helm answers, “Only if the structure of the market does not change.”
The commodity “super cycle,” he explains, has had super effects on all the players in the industry.
What happens if the price of oil never increases ever again – the cycle is bust? He questions whether it really is a temporary situation. The cycle could be broken, he points out, through substitute competition, technical change, and cost.
Gas, he recalls, had largely replaced oil in power stations. Now, plentiful gas is also cutting into the petrochemical market, as is happening in the US.
In transport, he says there are enormous possibilities for electric transport, driverless cars – a whole wave of technological change on the horizon. So demand for cars may no longer translate into demand for oil, he says, adding that gas may substitute for oil in the short to medium term before renewables and other technologies take over.
Moreover, the decarbonization process has a profound technological base, he says, where the next generation of renewables could seriously cut into demand for fossil fuels.
This, opines Prof. Helm, could have profound implications, like, for example, if Saudi Arabia believes the price of oil will not go back up and decides to leave resources in the ground in the belief that “leave it in the ground, it will be worth more tomorrow,” but it turns out it's worth less.
“For regimes which own oil and have dynasties that intend to keep their autocrats in power for generations to come, this is a profound structural challenge, and it determines how you think about your output going forward.”
For gas, he says, considering the oil-gas price linkage, gas cannot escape the commodity super cycle, neither can oil nor coal – all the fuels will be affected.
On top of all this, he says the climate policies add a layer. Believers in the policies think that demand for fossil fuels will go down. He offers: “Don't hold your breath.”
While the pending climate meeting in Paris this year will increase the general awareness of climate change, Prof. Helm says the places where real CO2 reductions are necessary are in China and India; he points out that China plans to carry on increasing emissions until 2030, while India pledges to do the same by 2050.
He comments: “Anyone that thinks that building small windmills in the North Sea against India doubling its coal burn within the next five years is on a different planet than me, and in a different world in terms of addressing the core problems of climate change.”
Of the EU carbon price, Prof. Helm says not to expect a high one. “But the coal phase-out in Europe is significant, and that will be driven by emissions performance standards and not by the EU ETS price.”
Meanwhile, Dieter Helm contends that the end of the commodity cycle is seriously harming Gazprom, for one in terms of revenue margin.
“Gazprom's political control over a long period of time, has resulted in poor investment and poor infrastructure – it always does – as opposed to what happens in commercially-run companies' that are open and transparent.
“And, he adds, “it is not a reliable supplier.”
Calling it a “trust problem,” he cites the supply interruptions in 2006/2009 and the fact that by 2019, Gazprom's gas will no longer run through Ukrainian pipes. “All across Europe, everybody is thinking about how to diversify away from Gazprom,” he observes.
Now, says Prof. Helm, Gazprom is open to a serious competition policy challenge on the grounds of price discrimination, abuse of dominance including not allowing resale. “If we were to apply in the EU the same approach we took to Microsoft and now to Google, this would not be allowed; it would be seriously challenged and taken forward.”
If proven, he says there could be many parties looking to recover damages. “I take the lesson from where we are, is that Gazprom needs Europe much more than Europe needs Gazprom.”
Meanwhile, he says that the future for gas may be much brighter than many imagine, from power markets rather than industrial markets.
-Drew Leifheit