Russia, Oil, China and the Dollar

By Marc Chandler

As the year winds down, a Gordian knot tying Russia, oil prices and China together is receiving a great deal of attention.  Let’s see if we can unravel some of the confusing twists and turns.

We turn first to China’s offer of assistance to Russia.  The idea that Russia could activate its CNY150 bln (~$24 bln) currency swap line with China is capturing the imagination of many.

Could China be challenging the IMF as several media reports suggest?  Hardly.  It can only be a challenge if there the IMF was a viable alternative.  To contrary, it does not appear the IMF is an alternative to Russia.  The sanctions would likely mean that any formal request to the IMF would be rejected.

China has also recently come to the assistance of two other economic pariahs, Argentina, and Venezuela.  The sums appear modest  (~$2.3 bln and ~$4 bln) the terms and conditions unknown.  However, the overall point remains valid.  China is not competing with the IMF because the IMF does not appear to want that business.

Nor is the China-Russia three-year swap line a very useful assistance tool for Russia under present circumstances.  What will the CNY150 bln, or more do for Russia?  Does it have yuan-denominated debt that is maturing?  Does it buy many goods from China that it could use the yuan instead of hard currencies?   It can sell the yuan and buy dollars or euros, but then it has a currency mismatch.

Under a swap agreement, Russia would be obligated to return the CNY150 bln no matter how many roubles it costs to secure.  If it were to activate the swap today, it would be paying almost 8.8 roubles per yuan.  At the end of H1 14, there a rouble could buy 5.4 yuan.

Does the possibility of operationalizing the swap line reaffirm the significance of China’s swap lines as a parallel financial architecture to the dollar?  Probably not.  If a swap line was not in place, China quickly establish a loan facility.    Better for Russia than a swap line or loan would be for  China to fund infrastructure projects, such as gas pipeline and railway projects in the east, and perhaps a deeper port in Crimea.

Chinese officials seem willing to help Russia, especially to the extent that it frustrates the US (the enemy of my enemy is my friend), but it also realizes that some of Russia’s problems are of its own doing.  Chinese officials that have spoken about being prepared to give some financial assistance if Russia requests, realize that Russia’s economic structure is not conducive for strong sustained growth and that it relies too much on low-value added commodity (energy) exports.

There had been some hope that the economic pressure would soften Russia’s stance.  Even though Putin’s press conference last week was strident, he did refrain from referring to east Ukraine as “Novorossiya” (New Russia) has he had earlier this year.  Putin also seemed to drop his demand for Ukraine federalism.  Some European countries, like France, seemed to want to consider easing the sanction regime.    However, Ukraine’s parliament’s decision earlier today to drop its non-aligned status can only aggravate Russia as it is widely understood to be a step closer to NATO membership.

This will likely stiffen Russia’s resolve.  It already feels put upon having NATO on it borders.  The threat of Ukraine joining NATO is not just adding insult to injury, but feeds into the Russian sense of being encircled.    Rather than capitulating, Putin may be emboldened, sensing less to lose.

Russia could be among the biggest beneficiaries of higher oil prices.  Brent crude oil prices have stabilized around $60 a barrel in recent days.  However, the risk is still on the downside.  The Saudi oil minister was quoted in the media indicating that its decision not to cut production regardless of the price.  “Whether it goes down to $20, $40, $50, $60 is irrelevant.”  He explained that if Saudi Arabia, or OPEC cut its output, the price will go up and the Russians, the Brazilians, US shale oil producers will take my share.”

Saudi Arabia clearly wants to reduce the supply of oil by squeezing out the high cost producers.  US shale producers, like Canada’s tar sands and Brazil’s deep water fields are high cost producers.  Given the amount of oil being produced, and possibility that US will relax its ban on oil exports, US shale producers are the most immediate threat.

The US shale industry is predicated on three factors.  High oil prices is one of them.  It is necessary but insufficient.  It has been financed by cheap credit.  It has also made possible by a greater disregard to health and environmental issues.   These factors are changing.    Oil prices have fallen sharply, making some projects less economically feasible.  The price of credit has risen and reportedly is less available.  Health and environmental issues were behind NY state’s decision to ban fracking entirely.

Shale wells deplete quickly and permits for new wells are needed to replace the older ones.  It is such spending plans that are being hit.  Already more than dozen companies have announced cuts in spending plans.  This will not impact US shale production until late 2015, and maybe not until 2016.

The issue that the highly respected Antaloe Kaletsky raises is whether the US shale producers can replace OPEC in general, and Saudi Arabia in particular, as the swing producer.  He argues that it is fairly easy to turn off or ramp up shale production, and that in truly competitive market, Saudi Arabia and other low cost producers would maximize output.

Kaletsky paints a scenario that shale producers reduce supply when demand is weak and ramp up output when demand is strong.   That their low cost of production (what he calls ‘marginal’) is $40-$50 a barrel and that this could become the ceiling not the floor going forward.  He recognizes the possibility that OPEC re-establishes oligopolistic control.  He asks, “So which of these arguments will prove right:  The bearish case for $20-$50 trading range based on competitive market pricing?  Or a bullish one for $50 to $120 based on resumed OPEC dominance?  Ask me again once the price of oil has fallen to $50–a stayed there for a year or so.”

What does it mean to talk about oil being in a competitive market, when many of the world’s largest producers are state-owned? This is true not just in OPEC and Russia, but also Norway, Mexico, and Brazil. And what if the central bank buys government bonds and pushes down interest rates to levels that it may make sense to borrow funds (and get favorable tax treatment for that debt) and press water and other chemicals into shale formations to extract oil?

Kaletsky may be exaggerating the flexibility of US shale producers, especially in an environment of falling oil prices and rising interest rates.  The overhead for next year’s output is already in place. The relatively high fixed costs mean that many will produce even at a loss, if necessary. Next year could be the peak in shale production. Already the EIA is cutting its longer-term forecasts.   Between OPEC and US shale producers, we don’t have to wait for oil prices to fall to $50 and stay there to expect US shale producers to cry uncle before the Saudis.

Marc Chandler

About 

Marc Chandler joined Brown Brothers Harriman in October 2005 as the global head of currency strategy. Previously he was the chief currency strategist for HSBC Bank USA and Mellon Bank. In addition to frequently providing insight into the developments of the day to newspapers and news wires, Chandler's essays have been published in the Financial Times, Barron's, Euromoney, Corporate Finance, and Foreign Affairs. Marc appears often on business television and is a regular guest on CNBC and writes a blog called Marc to Market. Follow him on twitter.