We have been advising clients since October 2014 to heavily underweight oil stocks, and, in particular, to avoid shares of oil producers. At that point, crude oil prices were in the $90 (U.S.) per barrel range. We stayed with that "avoid" advice until last month, when we recommended re-entry. We think oil prices will trend higher in coming months, subject to setbacks, which will offer chances to continue to rebuild exposure, particularly among the oil producers.
Because of a bad geopolitical outlook for this, the most geopolitical of major commodities. Oil was in modest oversupply then. It was about to become heavily oversupplied, collapsing to roughly $30 a barrel before bouncing back to the $40 range.
Think of this as the Saudi Shock of 2014 that is the reverse of the Saudi Shock of 1973. Then it was Israel and its Western allies, this time it has been Iran and its nuclear deal partner, the Obama Administration (backed by the UN Security Council).
In 1973, Egypt and Syria invaded Israel on the holiest Hebrew holiday, Yom Kippur. The sneak attack nearly triumphed. However, with emergency help from Richard Nixon, and a lot of guile, guts and glory, Israel won, and the Arabs were humiliated. Result: led by Saudi Arabia and the Gulf States, OPEC quadrupled the price of oil, triggering a global recession and runaway inflation. The Arab oil states became hugely wealthy. Rarely has revenge been so sweet for the avenger.
The Arabs actually did the world a big favour, and continued to do so for decades. U.S. oil production had peaked, and there would have been a great and sustained global shortage had not prices leapt, reducing consumption and enticing exploration and development across much of the world.
Then, as production began to expand globally, the Saudis protected other OPEC members, and prevented disabling oil shocks to the global economy by reducing their oil production for years—at enormous cost to the Kingdom.
Fast forward to 2014, when the fracking boom that was so bitterly opposed by the American left was doubling U.S. oil output and putting a potential cap on oil in the $90 range, most oil analysts assumed the Saudis would cut oil production, to protect their income and their Arab and OPEC partners.
That is when we told clients to sell oil stocks. We were convinced the Saudis would pump flat out, driving prices down brutally.
We knew from previous Arab contacts and our analysis of Saudi fears and priorities that the Kingdom feared a nuclear Iran more than it feared a temporary loss of income. Barack Obama's drive to get around Republican Congressional opposition to Iran was succeeding. That would mean Iran would be put on a pathway to nuclear weapons and would have gobs of cash in the meantime for other chances to (1) fulfill its weekly screamed pledges after Friday prayers "Death to America!" and "Death to Israel!" and (2) attain leadership in the Muslim world for itself and Shiites everywhere and (3) bring on oil production, thereby once again being a major oil producer. At long last, Sunni global oil dominance would be challenged.
Benjamin Netanyahu's splendid speech to Congress stiffened a few Democratic spines, but not enough to stop Mr. Obama from the deal. Republicans were 100 per cent opposed, but they needed some Democratic help to get a two-thirds Congressional vote to block Obama. Democrats overwhelmingly backed their President. He had convinced himself that the Mideast would remain a horror story unless Iran became part of the solution, rather than a big part of the problem. Remarkably, many Jewish members of Congress and the Senate voted for an Iran deal, although Senator Majority Leader Charles Schumer stood fast.
So the Saudis and their Arab allies pushed their oil production to the limits at a time Russia was also pushing its production to finance Vladimir Putin's aggressions in Europe and his aid to Assad in Syria. This came at a time when global economic growth was slowing, even in China. So oil demand was rising almost imperceptibly while U.S. frackers were drilling furiously, which meant oil prices fell precipitously.
We remained amazed that the investment consensus was that the Saudis would cave in and cut oil production. Why should they do that when one part of the deal Obama was pushing gave Iran full access to oil markets and full access to the global capital markets which had been constrained because of Iranian backing of terrorists in Afghanistan and Iraq, and was propping up Assad in Syria? (Assad had crossed Obama's red line without any American response except a US resolution, and was slaughtering opponents and unleashing a torrent of refugees.)
As oil prices fell, most oil analysts remained bullish. We saw Iran getting almost anything significant it asked from the U.S.-led coalition, and assumed the Saudis and their allies would keep on pumping oil—as long as prices kept weakening.
In recent weeks, we reviewed the situation and noted:
1. Iran was successfully testing 3-stage intercontinental ballistic missiles (ICBMs) without the U.S. intervening. Obama had promised Congress that the deal would ban ICBM tests. Now he announced that this ban was not in the deal, but in a side package, and only the UN Security Council could enforce that—and Russia wasn't on side.
2. Big global corporations were rushing into Iran for mega-billion-dollar deals, and Iran's oil production was rising.
3. The Saudi war against the Iran-backed rebel government in Yemen was going badly.
4. Cheap oil was costing Saudi Arabia heavily. The new regime was becoming unpopular.
5. What the Saudis and their Arab allies saw as terrorist threats—from Iranian-backed rebels, and ISIS and al-Qaeda—multiplied across the Mideast. Needed: more money for men and munitions at a time their foes were gaining in both.
The final inducement to a policy change is the recent pressure from Congress and a U.S. court to force the Administration to release all the sealed information about alleged Saudi treachery in 9/11. This has been simmering for years, but now it is close enough to reality that Riyadh is threatening to sell $750-billion or more of U.S. assets to prevent any government seizure of assets under a court order. We have read enough articles by intelligence experts to believe there may be damaging evidence of participation from Saudis with senior government positions or with imams in U.S. mosques that would convince almost any jury to make gigantic awards.
That was, in our view, the last big argument needed for a change in Saudi policies.
Not only is their over-production draining Saudi treasuries faster than anticipated, it threatens to bankrupt some OPEC allies of long-standing—and it has failed to prevent the Iran-U.S. relationship from becoming closer. Moreover, the Republican Party has produced a grotesque presidential candidate who will surely lose to Hillary Clinton, who swears week-in, week-out to stand by Mr. Obama's deal with Iran. The Saudis' backs are now truly to the wall. They will probably have to rely on their own resources—and their newfound ability to buy high-tech products from their newfound ally Israel, which has even more to fear from Iran than does Riyadh.
The Saudi strategy of excess supply has been successful in achieving a slow decline in crude production globally. Russia is virtually tapped out, American frackers are going bankrupt at almost the rate new companies were going into business a decade ago, and the majors are cancelling big-ticket projects. This means the Saudis can achieve their goal of higher prices with modest cutbacks.
Unless there is a global recession, oil prices should be higher on a sustained basis within weeks.
We will not predict how high they will go. The Saudis remain at the helm. They learned from the 1970s that sky-high oil prices produce deep recessions, and the global economy is more vulnerable now than then. Seventies might be a reasonable range for oil prices to keep unemployed Saudis from rebellion, while supplying funds for weapons to fight ISIS and al-Qaeda now—and maybe Iran later.
Don Coxe is chairman of Coxe Advisors LLC. Based in Chicago, he publishes the Coxe Strategy Journal for investors, and is an adviser to several commodity funds.