Trump Rescues Shale Oil

For a President obsessed with low oil prices, it is surprising to see what a pivotal role Trump’s decisions have and will play in his rescue of tight oil in the coming year. For those of you oblivious to everything happening on the planet, Trump authorized the assassination Maj. Gen. Qassim Soleimani, Iran’s most powerful commander, much to the surprise (and chagrin, one would assume) of not just the rest of the world, but also his own military advisors. In doing so, he has set the Middle East on edge and virtually ensured another year of profits for shale producers, and at least another three years of survivability when hedging and collateralized debt are taken into account.

The magical thing about oil price is that it’s a force unto itself. The sheer numbers are staggering, and they act as an inertial accelerator in the commodities market. Ultimately, price per barrel is not merely an arbitrage between supply and demand factors. In the arcane financial apparatus of global oil finance, the total global amount of money and its circulation velocity will itself act as a source of demand, given that the debt incurred from trading oil commodities is typically issued as multi-year credit and flows between state economies. Highly leveraged economies such as the United States will drive up oil prices because more capital will be moving between nations and will act as an inflationary force. The Trump paradigm of unnaturally reduced interest rates in support of economic growth will also contribute to this leveraging.

Let’s look into the mechanics of how this works from a commodities’ perspective. Weirdly enough, supply and demand aren’t the primary factors in the price of oil when it comes to spikes in price. It comes down to economic theory and the above-mentioned snowballing effect of the volume and velocity of the monies involved. This is a complex topic, but I’ll try to keep it simple: if I want to buy a barrel of oil as an investment, I will go to a commodities brokerage house and put in a bid. There will be millions of bids out there for both buyers and sellers. You can even buy oil at a price you believe it will be at in the future. Prices tend to be uniform – the economic law of one price states that if a market is efficient, there should only be one price for a commodity.

The futures contracts is where things really get interesting. You’re not buying any actual oil; you’re buying a derivatively priced contract that is based upon the value of what you believe oil will be at the date of maturity of the contract. This market is massive – in 2008, the demand from these contracts was equivalent to the net growth in demand for actual oil from China that year. Of course, this demand wasn’t driven by investors like you and me – it was driven by institutional investors like hedge funds and sovereign wealth funds. Lehman Brothers estimated that for every $100 million in futures contracts, the price of oil increased by about 1.6%.

Congress actually looked into this back in the mid-aughts during this massive price surge. After much deliberation they concluded that speculation (and fear, by deduction) did not play a role in the spike in prices, and it was a result of supply/demand imbalances and low price elasticity. Part of the evidence that was presented was how other non-related commodities also experienced increases in price (although not as severe) during this period. What they failed to consider was that all the commodities they analyzed had one thing in common – they all had to be transported from source to destination, usually by ship or truck. The shipping costs of everything had dramatically increased at that time due to… you guessed it: oil price spikes. This is called symmetric price transmission and is foundational to economic theory.

Another primary driver of oil pricing is fear. When fear is introduced to the system, a completely different mechanism than supply/demand equilibrium takes place: market participants believe that some geopolitical event will cause prices to rise. Afraid of getting caught short or unable to fulfill futures contracts, investors start to stockpile actual contracts, pushing up spot prices. Due to the vast numbers associated with oil contracts, the effects snowball rapidly. Given the global interconnectedness of oil contracts, this snowballing effect spreads like contagion across political and economic boundaries. Simply put, If commodities traders begin to develop irrational expectations about oil prices, then that price is what everyone else has to pay too. The law of one price will hold fast: the efficiency of the market will spread the economic contagion across the world, and the velocity and volume of the monies being handled act as an economic catalyst to infect everything it touches.

With this in mind, consider the consequences of an increase in oil prices due to external geopolitical events. Oil prices jumped from $20/bbl in 2003 to about $150/bbl in 2008: the world did not see a corresponding 750% spike in demand or decrease in supply at that time. Similarly, the world didn’t suddenly see a 4% spike in demand on the Sunday after Soleimani was assassinated. Fear drove those prices to their respective highs and lows, and the law of one price quickly equalized the shock across the globe.

The net of all of this esoteric economic legerdemain is that we will see a non-supply/demand constrained spike in oil prices that will resonate across the globe. This uplift in prices will generate a colossal financial windfall for shale producers here in America, who are at the mercy of oil prices as it relates to profitability. You can only drive so much efficiency when your money is tied into hard assets, after all. As their profits increase, so will their ability to borrow. As the price of oil increases, their proven reserves serving as collateral reduces their overall debt ratios, which will in turn permit lower borrowing rates. The debt gorgon will demand more blood, and Wall Street will happily oblige.

This political crisis spans countries across the Middle East, many of which are either at war or in the midst of a civil war. This is not just about Iran and the United States; it directly effects Iraq, Yemen, Lebanon, and Syria. Global power players have vested interests in the region, including Russia, China, Saudi Arabia, the UAE, and Kuwait. Thankfully the response from Iran was muted and has given the Unites States a chance to walk back from the precipice; nevertheless, bear in mind that this is the first time we have seen nation-to-nation hostilities between these adversarial powers who have entrenched interests in the region. The more political uncertainty there is, the greater the fear of higher oil prices, which will end up feeding an acceleration of oil prices. These prices will be sustained as long as the fear is there, or until greed overcomes fear and investors cash out of their positions in order to consolidate profits.