The oil price fall is mainly the result of the rise in US interest rates rather than the supply glut. It does not threaten the Russian budget or mean Russia is running out of money, but it has delayed cuts in Russian interest rates
This post first appeared on Russia Insider
The year 2015 ended with further falls in oil prices.
As is now traditional, this have given rise to more predictions of disaster for Russia’s economy.
This whole subject is much misunderstood. The major effect on the oil price is on interest rates - not the Russian budget, which gets all the attention.
Oil prices are anyway likely to stabilise - and even rise - before long, whilst the effect of their fall on the Russian economy is diminishing.
To explain all this it is necessary to begin with oil prices, since they are the heart of the story.
The Oil Price Fall
Firstly, it should be said clearly that the short term reason for the oil price fall since November is the US Federal Reserve Board’s decision to increase US interest rates.
Given the close correlation between oil price movements and those of US interest rates, the well nigh universal failure to recognise this fact is baffling.
Oil prices started to slip in mid November, when it finally became clear the long period of dithering at the US Federal Reserve Board about whether or not to raise interest rates was finally coming to an end, and that US interest rates would indeed rise in December.
That it is rises in US interest rates that cause oil prices to fall is shown by recent history.
Oil prices began their fall in the summer of 2014, as the US Federal Reserve Board’s quantitative easing programme ended and as rumours spread of an imminent rise in US interest rates.
As it became clear over the course of the winter of 2015 that the Federal Reserve Board would not raise US interest rates, oil prices stabilised and briefly rose.
In August 2015, as rumours again began to spread that the Federal Reserve Board would raise interest rates in September, oil prices fell again.
They then stabilised when the US Federal Reserve Board put off its decision again.
Finally, in November, when it became clear US interest rates would finally rise in December, oil prices fell again, and continued to do so in December after the rate rise took place.
The reason the price of oil is so closely linked to US interest rate movements is because oil trades have acquired something of the quality of a hedge against falls in the value of the dollar.
As the value of the dollar is largely determined by the state of US interest rates, rises or falls in US interest rates have an immediate effect on the price of oil.
That is not to say that the other factor that determines the oil price - supply and demand - has no role. However, as with the price of gold, supply and demand for oil is only one factor in determining its price.
World Recession Coming?
If the short-term reason for the oil price fall since November was the rise in US interest rates in December, it is now starting to look as if there might be another, longer-term reason.
Manufacturing in the US and China and in parts of Europe has been steadily contracting for the last few months. World stock markets performed poorly in 2015.
It is possible that just as the oil price rise of 2006 to 2008 was a harbinger of the 2008 financial crisis, so the collapse in oil prices since 2014 is a harbinger of a coming world recession.
It is still too early to say this for sure. However if there is a global recession, then the upward trend in US interest rates will go into reverse, which should - as it did in 2009 - strengthen the oil price.
The Supply Glut
Understanding of this issue is clouded by the present supply glut. Those however who point to the supply glut as the cause of the oil price fall are confusing cause and effect.
As I have laboured to explain before, the oil supply glut is the result of the oil price fall, not its cause.
Oil prices began their fall in the summer of 2014, before OPEC’s decision in November 2014 not to go for production cuts.
Oil prices fell again in August and November 2015, in both case before OPEC reaffirmed its decision in November 2015 that it would not go for production cuts.
In all these cases OPEC’s - or rather Saudi Arabia’s - decision to resist production cuts has undoubtedly put more downward pressure on oil prices. However since oil prices began their fall before those decisions were made, these decisions cannot have caused the fall.
In fact, an oil supply glut is precisely what would be expected to happen when oil prices fall, as producers scramble to produce more oil to maintain their cash flow in order to compensate themselves to the extent they can for the fall in the price of their product.
The Effect on the US Shale Oil Industry
Those who cite record US oil production figures in early 2015 as proof of the resilience of US shale producers misunderstand the connection between prices and output.
It is precisely the most heavily indebted and highest cost producers - in this case the US shale oil producers - who in conditions of an oil price fall are under the greatest pressure to step up production to maintain their cash flow so that they can service their debts.
These same producers are also the ones who are simultaneously under the greatest pressure to cut their costs, in order to squeeze the most they can from what oil they produce.
Neither the higher production nor the cost cutting are however in the end sustainable.
In the case of the cost cutting, one should be especially careful about accepting some of the claims made about it, which speak of costs being slashed by as much 30%.
Cost cutting on such a scale suggests radical action taken by an industry in crisis - for example by freezing work on new sites - rather than a genuine sustainable improvement in productivity.
Shale oil is here to stay. The technological breakthrough is real, and the industry will survive in some form.
That is not inconsistent with an immature industry that has grown over-fast on the back of high prices now finding itself in crisis.
Human nature being what it is, the inclination to hang on as long as possible in the false hope that the lower cost producers who are currently flooding the market - the Saudis and the Russians - will crack first, is understandable.
Eventually - when it becomes clear this will not happen - investors and creditors lose hope and pull out, bankruptcies spread, and production collapses.
All the indications we have suggest this process is now underway.
Saudi Arabia and the Oil Price Fall
As I predicted, the Saudis have made it perfectly clear they have no intention of raising the oil price by cutting their production.
Constant speculation the Saudis cannot absorb the low prices are wrong, and fail to take into account the depth of their financial resources.
Obviously the Saudis cannot withstand low prices indefinitely at current levels of spending. However they certainly have the financial firepower to outlast the shale producers, which is all they have to do.
Saudi Arabia’s 2016 budget, which has attracted so much attention, drives home the point.
The widely quoted claim that it is based on an oil price of $29 a barrel is unconfirmed and most likely wrong. There is in fact a wide range of estimates - or more properly guesstimates - of the level at which the Saudi budget has pitched the oil price. One puts it as high as $45 a barrel.
The point is anyway meaningless. A budget is not a price forecast.
Finance officers when drawing a budget have to take a plausible seeming price as a basis for their calculations. Finance officers tend to err on the side of caution, and it would not be surprising if Saudi Arabia's finance officers - many of whom are foreign consultants - have just done so when drawing up the Saudi budget. The fact the Saudis have calculated their budget around a certain oil price does not mean they expect oil to be that price.
What the Saudi budget shows - and is intended to show - is that the Saudis can and will run a deficit of 15% of GDP in order to achieve their objective - which is to knock out the shale oil producers - and that they have both the will and the financial resources to do this.
In this calculation the Saudis are right. Whilst their financial resources are not infinite, they are of a scale the US shale producers simply cannot match.
As it happens information coming out of both Saudi Arabia and the US suggests the Saudis think victory over the US shale producers is now in sight, and that it will take no more than a few more months.
Prospects for a "Snap-back" in Oil Prices
If that is true, then a sustained increase in oil prices in the second half of 2016 is very likely.
This is because lurid headlines of filled oil tankers unable to find ports to unload their cargoes grossly exaggerate the true size of the present oil glut.
By historic standards this glut is small.
Estimates vary, but the best guesses put the global over supply of oil at between 1 to 3 million barrels of oil a day, as against total global consumption of oil of 96 million barrels a day.
This level of over supply only exists because oil producers are working flat out to produce as much oil as they can in order to maintain cash flow at a time of depressed prices.
Saudi Arabia’s production alone has increased by roughly 1.5 million barrels since oil prices began their fall in the summer of 2014 - an amount that alone may cover the entirety of the current over supply.
Saudi Arabia is not the only producer working flat out to pump out as much oil as it can.
Russia is doing the same, as are all the other OPEC producers, and as are the shale producers in the US.
It is this tightness of the oil supply glut that argues against oil prices falling as far and remaining low for as long as they did in the 1980s-1990s.
The glut in that period was much bigger, with producers like the Saudis and the Russians producing far below their potential levels, which meant that any increase in demand could almost immediately be matched by a rise in supply.
That is definitely not the situation today, which is why comparisons between that period and now are certainly wrong.
The fact that the supply glut is so small means is that it will take only relatively small falls in output - or increases in demand - to bring the oil market back into balance, or even to create an oil shortage.
Given that current levels of output are unsustainable - even in Saudi Arabia, which cannot maintain production at existing levels for long without causing lasting damage to its wells - that is almost certain to happen, probably sooner rather than later, and more probably in 2016 than 2017.
When that happens oil prices will stabilise and probably rise.
Iran and the Oil Glut
What of Iran, whose extra output following the lifting of sanctions is believed by some to be a further factor extending the oil glut?
The reality is the impact of Iran on the oil market will be smaller than some are expecting
Iran claims it can supply half a million barrels of oil a day in addition to the one million barrels of oil a day it is currently exporting as soon as sanctions are lifted. It says it can then double this amount to one million barrels of oil a day a within a month.
On the face of it, this appears to mean that the Iranians will double the amount of oil they supply to the market from one million to two million barrels a day within one month of sanctions being lifted.
These figures however put the impact of what the Iranians claim they will do in perspective.
The amount the Iranians say they will add to the oil they are already exporting is one million barrels of oil a day.
This is actually less than the amount by which the Saudis have increased their oil production since the oil price fall began in the summer of 2014.
If Saudi Arabia simply cuts back to the levels of early 2014, it will absorb the entirety of any new production coming from Iran in 2016, after sanctions are lifted.
In reality this “extra” million barrels of Iranian oil is a fiction.
What the sanctions on Iran prevent Iran doing is legally selling more than one million barrels of oil a day.
That does not mean that Iran is not already producing and selling more than one million barrels of oil a day.
As is well-known in the oil industry, Iran is already selling a large part of the oil it produces over and above one million barrels a day illegally, at a heavy discount, through various intermediaries in places like Bahrain.
The lifting of sanctions will not add an extra million extra barrels of Iranian oil to the oil market. It will simply mean the Iranians can sell their oil legally themselves rather than have to go through intermediaries to whom they have to give discounts.
It is because the Iranians are already producing - and selling - most if not all the “extra” oil they say they will sell once the sanctions are lifted, that they can be so precise about how much more oil they will sell once the sanctions are lifted.
The Coming Stabilisation of the Oil Market
If the oil market does balance at some point in 2016 - as the Saudis expect and as all the indications suggest - does that mean there will be a dramatic snap-back in prices?
Oil prices will surely rise - probably by more than most expect - but probably not to anything like the figure of $100 a barrel we saw in 2014 - and especially not if there is a global recession - unless there is a dramatic shift in monetary policy in the US, which for the moment looks unlikely.
With further US interest rates unlikely in an election year, the oil market should however finally stabilise, bringing the extraordinary period of volatility that began in the summer of 2014 finally to an end.
The Oil Price and the Russian Budget
Before discussing the effect of the recent oil price fall on the Russian economy as a whole, it is necessary to say something about the Russian budget.
When oil prices began to fall in the summer of 2014 various supposedly knowledgeable people predicted it would be a disaster for the Russian budget, which supposedly needed an oil price of $110 a barrel in order to balance.
Though 2015 proved that claim totally wrong, the same supposedly knowledgeable people are now saying that because Russia’s draft budget for 2016 is based on an oil price of $50 a barrel, the budget - and Russia - face disaster or a “fiscal crisis” if the oil price falls below that level - as it has currently done - and remains below $50 a barrel into 2017, when the Reserve Fund will supposedly run out.
It is very strange that after being proved so completely wrong about the Russian budget in 2015, the same people insist on making the same mistake about the Russian budget in 2016.
However, as Russia Insider has said many times, there is no penalty in the West for getting Russia wrong, provided one does so from an anti-Russian position, and this is just one more example.
In the case of the 2015 budget, the supposedly knowledgeable people overlooked the possibility Russia would float the rouble, allowing it to decline in line with oil prices, insulating the budget from the effect of the oil price fall.
For 2016 some commentators claim they have taken this factor into account - though it is not clear whether they have really done so - and that they still expect the budget to go into deficit if the oil price remains below $50 a barrel.
This whole theory of a “break-even” oil price for Russia’s budget - or indeed the budget of any oil producer - is methodologically highly dubious, and should be abandoned - a fact recently pointed out in a study discussed by one of its authors in the Financial Times.
Nonetheless it is likely Russia’s budget will be in deficit in 2016. The Russian government after all predicts it will be.
However, some perspective and a sense of proportion are needed.
The very worst case scenario so far outlined - Citi’s - puts the Russian budget deficit in 2016 at 4.4% of GDP if the oil price falls to $30 a barrel.
A budget deficit of 4.4% of GDP scarcely looks like an unaffordable figure. In fact it looks fully in line with what might normally be expected of an economy going through a recession. By way of comparison, the British budget deficit at the moment - during a period of “recovery” - is 4.9% of GDP.
Can Russia finance a deficit of 4.4% of GDP, assuming the Reserve Fund runs out?
The short answer is of course it can.
The question people who talk in apocalyptic terms about the future of the Russian budget never ask themselves is how do governments which run budget deficits - which is to say most governments most of the time - finance them?
The short answer is that if they are Japan, Britain or the US, they increasingly print the money, but if they are other governments they borrow it.
If Russia ever were to find itself in a position where it had to finance a budget deficit of 4.4% of GDP after the Reserve Fund had run out, it would do so by raising the money by floating a bond on the international money markets - or conceivably in Russia - something which most governments do most of the time.
The sanctions do not prevent Russia from doing this and - since what we are talking about is a sovereign bond - it is legally doubtful they can be extended to prevent it.
Barring a government like Russia’s from floating a bond would be a far more radical step than disconnecting Russia from SWIFT, and would not only invite a legal challenge but would be certain to encounter intense opposition from the financial communities of the various European capital markets where such a bond would probably be floated.
Even if Western governments took this extreme step, the Russians could still try to float their bond in one of the Far Eastern markets which have a legal system strong enough to enforce it (Singapore might be a possibility), or conceivably they might try to float it in Moscow itself - an action that might actually strengthen the Russian financial markets by drawing in Asian and Middle Eastern investors, and by offering Russian financial institutions the security of a government bond to invest in.
In reality Western governments are most unlikely to try to interfere with a bond.
The device the Western powers are using to try to stop Russia raising money in this way is not sanctions - which would be legally highly dubious and extremely controversial - but downgrades of Russia's credit rating.
I have previously discussed how dubious and overtly politicised the credit rating downgrades Russia has suffered are.
The point is that Russia’s rating is now so obviously unfair and politicised that it by now must cut little ice with the Asian and Middle Eastern institutional investors - many of them sovereign wealth funds - to whom the bond would mainly be pitched.
Most probably they would be anxious to hold the bonds of a powerful country with a huge raw materials base, a small deficit, a large trade surplus, very low levels of government debt, and a record of paying its debts on time.
I have discussed this possibility at some length not because I think it is going to happen - I don’t - but because the constant myth-making about the Russian economy makes doing so unavoidable.
Briefly, because the Russian government has avoided borrowing during the Putin era - running a budget surplus whenever it can, and relying on the accumulated savings in the Reserve Fund when it has been obliged to run a deficit - it doesn’t mean it cannot do so.
As it happens, it briefly considered doing so during the 2009 crisis - when the budget deficit was 6% of GDP - and there is nothing to prevent it doing so in future if the need arises.
I suspect that if and when that does ever happen, it will cause as much surprise to the supposedly knowledgeable people currently predicting disaster, as did floating the rouble in 2014.
Putin has insisted that the budget deficit in 2016 must be no more than 3% of GDP, and has said that if the oil price stays below $50 a barrel the budget will have to be cut.
There is almost certainly sufficient slack in the budget to make cuts possible if the need is there, and Putin is quite obviously determined to avoid Russia having to borrow if it possibly can. Rather than resort to borrowing, I suspect the government will prefer to impose cuts.
As to the future, what happens to the budget ultimately depends less on oil prices and more on what happens to the economy, to which I shall now turn.
The Oil Price, the Rouble and Inflation in Russia
The major effect for Russia of the collapse in oil prices is not its effect on the budget, but its effect on the rouble.
The rouble has fallen in lockstep with oil prices, causing double-digit inflation in 2015, and making repayment of debt in foreign currency more difficult.
Both these processes however now appear to be coming to an end.
Inflation in 2015 peaked at annualised rate of 17%. It may have been even higher in the first few weeks of 2015, with some prices rising by 20%. As recently as November it was running at an annualised rate of 15%.
Rosstat - Russia’s statistical agency - has now reported inflation for the whole year of 12.9%.
This suggests inflation has been falling rapidly in recent weeks, and that it may already be in single figures.
The official prediction for inflation in 2016 is 6-7%, though Economics Minister Ulyukaev has said that because of the further fall in the rouble since November headline inflation may not hit single fingers until the second half of 2016.
The major effect of a currency devaluation on inflation is that it makes imports more expensive.
With the quantity of imports already slashed because of the size of the devaluation in 2014, the effect on inflation of any further devaluation of the rouble is diminishing.
It may be diminishing even faster than the government realises. The government predicted just a few weeks ago that inflation in 2015 would be “just above 13%” To the government’s surprise it turned out less at 12.9%.
Though there could still be the odd rises over the course of the coming year, overall the inflation trend seems to be firmly down.
That suggest that single figure inflation is indeed in sight, and that any forecasts - such as Citi's - that increase the rate of inflation and of the budget deficit mechanically in response to every fall in the rouble and in the price of oil are wrong.
The Oil Price, the Rouble and Foreign Debt Payment
December is traditionally a month for heavy debt repayment, a factor that generally adds to the downward pressure on the rouble during that month.
The big story of the rouble this December is however that it fell more gradually than oil prices - the reverse of what happened December 2014, which was a month of particularly heavy debt payments.
This together with capital inflow in the last two quarters of 2015, strengthens the impression that the major period of deleveraging and of foreign debt payment is coming to an end.
Repayment of foreign debt at a time of falling oil prices and when Russian banks and companies are effectively cut off from Western capital markets, has been a heavy burden on the economy, and has put more pressure on the rouble. Many Western analysts - and some Western governments - doubted it could be done.
As German Gref, Sberbank’s CEO, has however said, Russia has improved its reputation for financial solidity by doing it, and it will reap the rewards in the future.
The end of the period of repaying foreign debt should - all other things being equal - finally ease the pressure on Russian banks and companies, leaving them with more money to invest.
It should also relieve pressure on the rouble, causing it to steady, and eventually to decouple from the oil price.
The Oil Price and Russian Interest Rates
With the levels of inflation and of foreign debt payment falling, it is interest rates which now are the principal drag on the economy.
Interest rates peaked at 17% during the rouble crisis in December 2014.
They were then steadily reduced over the first half of 2015, falling to 11% by July.
They have however remained at this still very high level ever since.
It is these very high interest rates that are preventing business investment, and which are deterring consumers from buying high value items - such as cars - on credit.
It is the Central Bank’s failure to cut interest rates further since July that is what was almost certainly responsible for the further contraction in the economy which happened in November.
It is also the reason for the darkening in the mood some have noticed in December.
The Central Bank’s failure to cut interest rates despite falling inflation has met with incomprehension and anger - with accusations flying around that it is part of a “5th column” that is serving Western interests, and which is undermining Russia.
My own view is that the Central Bank - shell-shocked by its failure to anticipate the rouble collapse in December 2014, and humiliated by the way the Finance Ministry had to ride to its rescue that month - missed its window to cut interest rates below 10% in the summer.
The country has paid a heavy price for that failure in the form of a deeper recession in 2015. I am confident that if interest rates had been cut below 10% in the summer, the effect on inflation and the rouble would have been minimal, but production this autumn would have been higher, and the contraction of the economy for the whole year would have been less than 3% instead of 3.8%.
By contrast, I think the Central Bank has been right to leave interest rates alone in the second half of 2015.
With oil prices falling and the rouble under renewed pressure the Central Bank simply didn’t have the option of cutting interest rates once it missed its window in July.
That is the single biggest consequence of the renewed oil price fall since the summer.
It has delayed by several months the reduction in Russian interest rates because the Central Bank is not willing to take risks with the rouble.
The point was recently explained by Russian Economics Ulyukaev, who said it is not the level of the rouble that matters, but the volatility there has been over the last few months, caused by uncertainty over the price of oil.
Looking Forward - the Russian Economy in 2016
Economics is not an exact science despite the attempts by some of its practitioners to argue otherwise.
The Russian economy has however in 2015 performed much in line with what might have been expected given the oil price collapse and the decision to float the rouble in 2014: a severe inflation spike in the first quarter, a severe contraction in the second quarter, and a general stabilisation in the second half of the year, with output stabilising and inflation falling.
With the economy’s exposure to external shocks diminishing as imports are choked off and as debt is paid off, the big question now is how quickly the Central Bank will bring down interest rates.
If it maintains them at current levels for much longer then it will prolong the recession to no good purpose.
I strongly doubt that will happen given the political storm that would cause. Though much will depend on what happens to oil prices in the next few weeks, I suspect the Central Bank is already planning further cuts in interest rates at its next meeting in January.
Regardless of what happens in January, by midyear the situation should be sufficiently stable, with inflation falling fast, more foreign debt paid off, and the rouble sufficiently stable, for more cuts in interest rates to take place.
By that point output should already be rising and it will then be possible to say that the period of economic rebalancing was drawing to an end within the two year period that Putin predicted a year ago.
If oil prices by then are also rising, it will be more icing on the cake.
This post first appeared on Russia Insider
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