The GERM Report

Risk level: RED

RED: Severe (+/- 4%) ORANGE: High (+/- 3%) YELLOW: Elevated (+/- 2%) BLUE: Guarded (+/- 1%)

THE BOOSTER SHOT

-Riyadh shifts from oil market offense to defense.

-As oil goes, so too goes the global hierarchy of power.

The diplomatic and defense spat between the United States and Saudi Arabia shows that US shale basins were under de facto attack from a punitive swing producer. Riyadh has, regardless of its stated position, acted as the swing producer in the global market for nearly 40 years. According to a study led in part by Royal Dutch Shell, a swing producer operating in punitive mode is disciplining other producers because of its own loss of revenue or loss in market share. Successful in its campaign to maintain supremacy, Riyadh must now find its Goldilocks moment in its return to normalcy or risk bringing its rivals back to life.

The price for Brent crude oil jumped just over 17% last week to finish trading Friday at $30.97 per barrel, setting what looks to be a new floor for the global benchmark. Improvements in demand, particularly in consumer fuels, drove the rally despite signs of a lingering economic crisis.

US President Donald Trump helped mediate a divorce settlement between Russia and Saudi Arabia after the two fought for market share when an OPEC+ curtailment agreement collapsed early this year. In the midst of demand destruction, Moscow had argued for a wait-and-see approach, with Riyadh advocating for more direct intervention. The split left the two producers waging a price war that, coupled with an unprecedented global economic collapse, pushed the price of crude oil into the upper teens. A trade anomaly in late April left US crude oil prices in negative territory, meaning producers had to pay their clients to take oil away. The resultant pain in the US oil patch prompted lawmakers representing oil-producing states such as North Dakota to turn their ire not on Russia, which is already under sanctions pressure, but on Saudi Arabia, a key ally in the Middle East. Amid calls from Washington for a better treatment of friends, the US Defense Department is now shuttling out some of its flagship Patriot missile systems from Saudi Arabia.

The move has nothing to do with oil and everything to do with oil. The obligatory sources close to Washington thinking revealed the redeployment was in the works last week, raising eyebrows over Trump’s alleged Art-of-the-Deal moment in crude-oil diplomacy. Trump had taken a victory lap after Russia and Saudi Arabia made amends and agreed to new production cuts from May 1, albeit from extraordinary levels. Saudi production last month was up 2% from March and the country is now faced with trimming some 3.2 million barrels per day in order to comply with the new OPEC+ arrangement, which now relies on a handful of G20 and other producers to balance the market. On Monday, the Saudi kingdom announced cuts to government worker allowances and other austerity measures to counter the impact of the coronavirus pandemic. That effort is meant to recalibrate its position after using its global production role to establish market supremacy in the face of an ascendant US shale oil sector.

Saudi production cuts from March levels reinforces its position as a swing producer, according to a 1990 examination of the role from the London Business School and Shell. The authors establish the swing producer as one that can increase or decrease production quickly “by as much as 2 million barrels per day or more,” and indeed, the kingdom announced Monday it not only enacted austerity measures, but would trim production by 1 million bpd above its obligations. The study found that a swing producer operates in either a normal or a punitive mode. In the normal mode, the swing producer responds to deviations in the price of oil by tweaking the spigot to regulate the market. But when the swing producer loses market share or too much revenue, it switches to a punitive role and decides to punish other producers by flooding the market and quickly lower prices. Twice in April, the price for Brent crude oil was around $19 per barrel, a sign of swing-producer control. In April, US crude oil prices went deep into negative territory, indicative of the damage left by a swing producer in punitive mode. Adding insult to injury, and despite the apparent US defensive retreat, an armada of Saudi crude oil tankers are headed to the US to flood an already saturated market. But this, the study notes, is “an act of last resort, because in this mode, the swing producer has abandoned the role of price regulator – essentially the market is no longer managed.” With its latest production salvo, Riyadh has now returned to its management position.

The price of Brent crude oil shot up in early morning trading on Monday after Riyadh announced deeper cuts in production, showing the punitive mode is over. That flip-the-switch control is reserved only for those with genuine and durable supremacy. In international relations, bids for supremacy rarely end in supremacy. In the early part of the 20^th century, an ascendant Germany tried, but failed, to establish a hegemonic position. That led to the rise of Pax Americana as the United States was the only major power left with both the capabilities and the willingness to lead. In the oil markets, Saudi Arabia holds that role, whether by design or intent. Saudi Arabia formally took embraced its swing status in the early 1980s when OPEC spelled out allotments for member states. It took a “never again” approach later in the decade, though its position since then has been that of the inevitable hegemon in the oil market. Like the United States in the post-World War II era, Saudi Arabia is the only power that is both able and willing to lead the system, oil markets in this case, to recovery.

It’s a trifecta week for oil markets, with the IEA, EIA and OPEC all releasing their monthly market reports. Outside of production restraints driving the price of oil, consumer-level pressures will remain in force this week. San Francisco Fed President Mary Daly told CNN last week that the US economic recovery “won’t be ‘V’-shaped.” With 20.5 million US jobs lost in April, US Treasury Secretary Steven Mnuchin told Fox News Sunday that “the reported numbers are probably going to get worse before they get better.” On Tuesday, watch for GDP from Norway, which announced it too was trimming production to help balance the market. We also get a read of US inflation and US Fed presidents take to the podium. A trove of data are out Wednesday, from EIA inventories to British GDP and manufacturing figures. The IEA market report is out on Thursday, as are new US jobless claims. The week ends with inflation readings in some of the European economies coming out of quarantine and the ever-relevant US rig count. For the week, a Red alert is in place, with Brent expected to move by at least +/-4%.