Ahead of the OPEC meeting…
As Iran continues to grow…
Oilprice.com wanted to check in with Dr. John C. Edmunds, a Professor of Finance at Babson College, to get his thoughts on the OPEC deal, oil markets, and some developments in Latin America. He is an expert in international finance, capital markets, foreign exchange risk, and Latin American stock markets.
Dr. Edmunds holds a D.B.A. in International Business from Harvard Business School, an M.B.A. in Finance and Quantitative Methods with honors from Boston University, an M.A. in Economics from Northeastern University, and an A.B. in Economics cum laude from Harvard College. He has consulted with the Harvard Institute for International Development, the Rockefeller Foundation, Stanford Research Institute, and numerous private companies.
This interview has been edited for brevity and clarity.
Oilprice.com: I wanted to start off with the OPEC deal that was announced [on February 16], the production freeze. Notably, Iran declined to comment on whether or not they'd freeze production. So most people think that means they won't, and that they will still pursue their pre-sanctions production levels. I was wondering what you thought of this deal and if it had any practical implications for the oil markets?
Dr. John Edmunds: Well, I would say that it has not come together yet. Pretty soon they are going to do something because there are countries that are really just flat out desperate. I wouldn't mention Iran specifically, although, they have been years and years without full income. But the ones I'm aware of right now...Nigeria just announced that they couldn't pay their school teachers.
Venezuela, that place is just flat out desperate. They have had nothing but oil for, well, since the 1920s. And they don't even know how to grow food. So, if they can't get the oil price up, they are going to need missions of mercy to come in and give them food while they figure out what to do in an era beyond oil.
My view is that crude oil is in a long downslide, in the short-term giving way to natural gas, and in the longer-run giving way to wind and solar and batteries and stuff like that. Alternative energy is coming on much faster than expected. And also most people think that alternative energy requires subsidies. No it doesn't. It doesn't. It is now cheaper.
So, we are in a really tough situation for oil producers. This meeting doesn't make it worse but it doesn't make it better.
OP: Do you see this as the extent to which they are going to go, or do you see this as sort of a stepping stone towards an actual production cut, maybe in June?
JE: Well they are going to try. I mean, each one of them will insist on a cut, and it will be like it used to be. What used to happen, if we go back a long time, Saudi Arabia would cut and everyone else would produce flat out and the Saudi cut was enough to make the price go back up.
If you go back to the 1930’s Brazil did that with coffee. Their position with coffee was so large that if they reduced their exports they could make the price go up and their smaller export quantity would then be worth more money. But coffee and crude oil have elasticity, that is, in the short run you can't do much about it. In the case of oil, you can substitute over time, but in the short run your car is your car. You're not going to get another car just because gasoline went up or down a little bit.
But, I would say I don't really believe that it would be possible to put together a cartel. There are too many people that can do something around the edges or can violate and claim that they are not violating.
OP: So, you are saying that the influence of OPEC is kind of permanently weakening?
JE: Yeah. Well, they were losing market share after...pick a date...sometime in the 1970s when they were very strong. What is interesting about the world economy at the moment is that we are seeing the 1973 and 1979 moves, we are seeing those in reverse. When '73 and '79 occurred we had really deep recessions because everyone was just screwed.
Now, we are doing it the other way around. Oil is coming down and the benefit we can see with airlines, for example, and a few others. Some of the folks that use crude oil as a feedstock are doing better.
But as far as the stock market is concerned, we aren’t able to fixate on who is going to be better off. They are talking about who is going to be hurt.
OP: We have always been told that low oil prices have been good for the global economy. Why do you see low oil prices being a drag at this point? Is it just that they have gone down so far so fast?
JE: Yeah, if it had been a gradual decline...this happened too fast. My feeling is that crude oil is in a long-term downtrend but right now it's below the trend line because of this oversupply problem. Just looking at the futures market right now...the backend is almost $12 higher. So, I'm looking at $31 for March 2016, and for March 2017 almost $42.
So, that's the easiest way to figure out the situation with storage. The person you want to be right now is somebody who's got an empty tank. Because what you can do is sell crude oil for future delivery and take your sweet time buying it because nobody else has a tank, and you can just call around say "I've got an empty tank. If you've got crude oil that you need to put in a tank, I've got one. What are you offering me?" Because if you pump the stuff out of the ground you have no place to put it. You can't pump it back into the ground and you also can't throw it into the river and you can't throw it into the ocean. So the producers are really in a tough spot in terms of getting the oil into pipelines, getting the oil into storage, getting the oil into refineries.
The refineries, by the way, are not running at 100 percent. They can't anyway, no factory can run at 100% forever, but they are not even running above 90 percent. And the reason is that the final demand is not there either. The final demand is growing slightly, but not enough to soak up the oversupply.
You've got a million and a half barrels and the question is, "where are you going to put that?" So, they've got these tankers that don't have to go anywhere, very large crude carriers that just sit there. And those are full. And if you want to build one and you start today, it will be done in two years. So...
OP: So we've got a worsening storage problem. Cushing is 90 percent full. If storage is so full, at what point do producers need to shut in production?
JE: We should dissect the term "shut in." In the case of crude oil, I would say, shutting down is happening in several ways. One is no new investment in drilling. Any offshore drilling ship that is coming off a charter won't get another charter. It will have an anchor for a while waiting for the markets to come back. If the market doesn't come back sooner or later they are going to scrap it.
One of the reasons that the stock market is so negative on the outlook is that we...I'm a professor of finance so I say "we"...we don't know what percentage of the capital assets in the world are tied to crude oil - exploration, production, transport, refining, and distribution. That might be 25 or 30 percent of the [total] capital assets in the world. It wouldn’t be as low as 10 percent.
So if somewhere between 10 and 30 percent of the fixed assets in the world are considerably less valuable than they used to be...I'm not saying they are worthless. I'm just saying that they are a lot less valuable than they used to be. If you own an oil rig right now in Oklahoma or North Dakota, um, good luck man. I'm not sure you are going to find any work for that thing very quickly.
OP: So, you are saying that the sharp fall in the value of these assets helps explain the volatility in the broader financial markets.
JE: Yeah, yeah, because a lot of that was bought with borrowed money, and that's where we get into the bond market and the bank situation. A lot of banks loaned money to people that used to be called "wildcatters." And people supplying those sectors...let's say you ran a fleet of trucks that took lunch around to the workers. And you borrowed money for the trucks. Well you can't pay that loan.
OP: Do you see a ripple effect in the banking system? Are banks in trouble here?
JE: Yes, well, specific banks have bad loans in their portfolio, which doesn't mean that they are in trouble. It means that their earnings will be much lower than they were supposed to be.
OP: I've read that energy debt is a small part of the banks' portfolio. So, it's not as if these banks will go belly up?
JE: No, they won't fail. It wouldn't be 2008. It's not time to run down and pull your money out of your bank and put it under your mattress. The system is much more solid. But if you own stock in a bank, particularly in what are called the "super regionals," some of them have too much stuff in their portfolios that's linked to that.
Let's go to Houston in the 1980s. Crude oil goes down and whole suburbs were emptied. After '08, if you are a lending officer at a bank, you've got like 5 people looking over your shoulder. And you should! You could do a lot of damage!
So, the market is acting crazy because first of all they don't know how far down this goes. They don't know how long this stays low. They know that it has already stayed low long enough to do a lot of damage to a lot of people. It's not a good day to be trading – not a good month – to be trading stocks, but it actually kind of makes sense that it's shaking out.
OP: I want to get back to the banks and oil companies. There have been a lot of bankruptcies and defaults, a few dozen so far, and the credit redetermination period is coming up. I was wondering if you see lenders cutting credit to the oil patch and how that will affect the rate of bankruptcies and how that will affect the state of oversupply?
JE: I would say lenders would have to cut back because their method involves an engineering estimate of recoverable resources with the price. They've got a standard methodology. So that's going to come out with a lower number.
So the base of lending is going to come down and some people are going to be over that. The bank is going to say, "Sorry your review came in lower. You need to give us $5 million and we need it pretty quick." And then the borrower says: "Sorry I don't have it."
Meanwhile the [bank] auditors are going to say, "You gotta write that one down." The auditor will err in the direction of caution. And that means they have to cancel their dividend or cut back on some salaries and executive perks. [The bank] would not fail. But what it means is that bank profits are going to be well below what they would have been...the decline [in oil prices] happened too fast.
OP: The banks will be hurt, but they will be OK. But from the oil patch perspective, we will probably see more bankruptcies, I'm assuming. What will that mean for the current state of production?
JE: Well, you'll see more bankruptcies of third and second tier exploration and production companies and some junior integrated oils, but the big ones are going to be bulletproof because they are getting their money from the bond market.
The ratings agencies are also running scared. They got crucified after the financial crisis because they gave some ratings that they shouldn't have given. So, you come in, you should have an "A," they're gonna give you a "BBB." You should have a "BBB," they are going to give you a "BB." Well that's “junk.” That means many buyers can't buy that bond. Some portfolios have to sell it.
For the junk bond market, what I'm seeing, the people I talk to are telling me that it's time to start picking over the trash. They are throwing it all out equally. Suppose you are running this ETF. And a retail investor sells the ETF. And you're the portfolio manager. You've got to sell something because you have to reduce the size of the portfolio. Well, how do you do that? The only bond that you can sell is the one that's not in the oil sector. Any bond in the oil sector, nobody will buy it or the bid will be so ridiculously low. So, it's called "contagion." You get bonds in one sector decline, which drags down bonds in the other sector that really shouldn't have been dragged down.
But the feeling that somehow this would spread to other parts of the economy, I really don't see that. I'm with you. This is hopeful. I don't drive much but it costs me $17 to fill my tank instead of $30. A guy who drives something with a bigger engine and filling his tank twice a week and it used to cost $60 and it's now costing, let's say, half of that. He's got extra money in his pocket. That's supposed to come out. He's supposed to take his family out to a restaurant or something. We are seeing it, but it's not happening very fast. It's like they don't believe it themselves. Instead of using that money to spend they are using that money to build up some cash in the cookie jar or pay off the credit card or something. The public is being very cautious, and that hurts.
OP: I wanted to shift gears a little bit and talk about Venezuela. [On February 17] President Maduro decided to raise fuel prices for the first time in a long time, and alter the exchange rate. I saw a pretty eye-popping number: the state-owned oil company PDVSA only transferred $77 million in funds to the central bank, which is a tiny fraction of what it brought in a year ago, and less than it brought in two years ago. So it seems to be a pretty bad situation. I was wondering what your perspective is on what happens next in Venezuela?
JE: It's going to get a lot worse. And I feel...I wish I didn't have to say that because I have a lot of Venezuelan friends. I've spent a lot of time in Latin America. Venezuela, if you go back to the 1960s, was the richest country in Latin American on a per capita basis. And now, it's pretty much the poorest, with the possible exceptions of Honduras and Haiti, and nobody is poorer than they are.
Maduro is trying to be the second coming of Chavez. He's got all the same whacko ideas but without the charisma. He's hurting and he has around him people that he's selected for ideological reasons rather than for competence.
I don't know what I'd do if they made me the actual dictator of the place. Everyone there [in the pre-Chavez era] was either in some sort of extremely rudimentary subsistence agriculture or they were somehow tied to the oil business. Or they were working in an import-substitution industry that isn't economically viable but is surviving on tariff protection and stuff like that. They were basically a big oil well and a bunch of people sitting around regretting that most of the money was going to one neighborhood in Miami - half of it was Venezuelan millionaires who have hardly ever really been to Venezuela. It's sad, but that's why they got Chavez.
What will happen now...they don't really have a consensus. Although the government lost the recent election and lost control of the Congress...they have a Congress but it's pretty much powerless. So what Maduro is doing is sending ambassadors around to every other oil-producing country and saying "please guys, let's get together and cut production." I mean, what else is he supposed to do?
There is nothing that he can do that would help right now, except try to get a higher oil price. I don't see how he's going to do it. Everybody knows that if anybody cuts...that's a schmuck.
There's a whole bunch of players in this business: countries, individual producers, individual producing countries, governments, and all kinds of people who desperately need money right now.
OP: Venezuela has something like $10 billion in debt coming due this year. Do you see them defaulting?
JE: Well, what they will try to do is some sort of refinancing. They are going to squeeze bondholders. They are going to say "we'll give a higher coupon at a later maturity date." And a lot of people will take that because if you insist on getting pay now they are just going to default.
OP: OK, so shifting to Brazil. I saw that Shell this week completed the takeover of BG Group and Shell's CEO was in Brazil extolling the potential of Brazil. I was curious what your take was Shell going big in Brazil on their offshore sector?
JE: I would say it makes sense from Shell's point of view provided that their assessment is that in the long run oil would get back over, let's pick a number, let's say back over $80 or $100.
In the case of Brazil, it's a democracy, it's a complicated political situation. It's a shithouse mess right now, but it will not be always. Also, you have a very large and diversified economy outside of the oil sector and outside of iron ore. They are still the number one producer in coffee, the number one producer of cacao. They are number one or number two in soy beans. They produce corn. They produce aircraft. They produce some high-tech stuff. They've got a lot of people there with PhDs. So it's not this huge place with subsistence farmers and an oil well offshore.
I consider the pre-salt...the deposits of crude oil are offshore and under a huge overburden, sometimes as much as 25,000 feet. When you get it, it's really sweet crude. But, so what? There's plenty of crude closer to the surface. If oil had gone to $200 per barrel, the scandal with Petrobras would have never come out. The crude oil really is there. And so what? If it was on the moon it would be about as useful.
OP: Yeah. So, does it make sense, in this era right now, to try to bet the farm on the pre-salt?
JE: Well, also, [Brazil is] chaotic, but they are not going to shoot you. They are western...the language is not completely inaccessible. So, it's a reasonable place because it's big. Big in terms of the amount of crude they have. Big in terms of how many people you can sell it to right there. Big in terms of how many people you can hire.
OP: Shell's CEO just said that he thought that the Brazilian government and Petrobras should sort of loosen the rules on the state-owned company being the operator on these fields. Politically, do you think that is likely or unlikely that such a thing would occur?
JE: I would say maybe not right now but probably pretty soon. And the reason is that Mexico did it. And in that case it is more obvious because one of the reasons for 1910 revolution was the strong position of the foreign railroad companies and oil companies...
They had a guy in 1937, Lazaro Cardenas, who nationalized the oil industry. And he's a national hero. He's like Abraham Lincoln or something. So, the idea that they would let foreigners into the oil business…
OP: So the last thing that I wanted to ask about was just the state of the global economy. Everything looks pretty volatile right now. I was wondering if you see a recession or what do you forecast for the next year or so?
JE: No, actually I don't see a recession. What I see is further distortion in the direction of asset inflation because interest rates are going down. They asked Janet Yellen about negative interest rates in the U.S., which I didn't really think we would have, and her answer - she's very circumspect and she says exactly what she's supposed to say - she didn't close that door. So I take that to mean that we might get even lower interest rates in the dollar market, even lower interests in the euro market, and it can't get much lower in Japan.
What that would mean is that you have asset price inflation in a lot of places that haven't had it yet. But you could also have further skewing of the distribution of income. In other words, you get more and more people just concerned about eating three times a day, and more and more people picking out whether they want the $50,000 wrist watch or if they are going to go ahead and buy the leer jet. That's bad, but it's not a recession.
Everyone says that central banks are tapped out, that they have done everything that they can do. That's not true. There's a lot of stuff that they can do that's within in their mandate.
What they are really saying is that it would be nice if we could have some fiscal policy but we are not going to get that so [laughs]...we are not going to get anything in Washington. I've been saying for quite a while that they couldn't vote to leave a burning building [laughs].
Well, it's an interesting situation and I decided that I'm going to enjoy it because otherwise I'd be crying.
OP: Well, Dr. Edmunds, thank you so much.
JE: It's really good to talk and I'd love to talk so more. It's a fascinating situation.
By Nick Cunningham of OIlprice.com
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Nick Cunningham is a Vermont-based writer on energy and environmental issues. You can follow him on twitter.