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America’s latest weapon designed to punish Russia over its role in Ukraine: Oil

Putin visiting a Rosneft refinery in the Black Sea port of Tuapse in southern Russia Oct. 11, 2013. Source:  Hurriyet Daily News.

Putin visiting a Rosneft refinery in the Black Sea port of Tuapse in southern Russia Oct. 11, 2013.
Source: Hurriyet Daily News.

With American and EU sanctions failing to pinch Russia where it hurts, the American government, with their banker buddies, has found a sure way to hit Russia where it will hurt most – oil.  Western countries have been frustrated with the lack of leverage they have to sway Russia away from meddling in the Ukraine.  After all, Ukraine is their mess and they should be the only ones allowed to mess it up further.  The question is not whether their new weapon will work, but if they have really thought it through.  What effects will their meddling in the oil markets have on the rest of the world?

 

 

Russia has been increasingly securing more long term oil and gas agreements with other countries as a way to reduce its dependence on its main customer – Europe.  Earlier this year, Russia signed a $400 billion deal to deliver gas to China over a 30 year period.  This represents a major step not only in global energy markets but also in geopolitics.   The sanctions imposed by America and the EU have done little to stop Russia’s defiance of their demands or halt its energy expansion plans.  Japan, which has been following along with America’s request for sanctions, is still pursuing a long term energy deal with Russia

In response to these sanctions, Russia has imposed sanctions of its own on EU members, specifically on agriculture.  Greece and Spain are heavily dependent on agricultural exports to Russia and have been trying to find ways to wiggle out of the sanctions.  These countries are not in a position economically to be able to handle the loss of this business right now.  Greece and Spain are not alone; other EU countries are feeling the impact of these latest sanctions, including Finland, which has begun to fracture the unified EU position on Russia.  This is exactly what Russia wants and it’s working well so far.  The biggest beneficiary of the agricultural sanctions so far is Switzerland, thankfully not an EU member, has seen a surge in demand for their agricultural products such as cheese and milk.  So much so, that they are not able to meet all the demand.  I guess there are benefits for being neutral!

America’s frustration with the results so far is pushing it to use its mega-weapon against Russia – oil.  Russian President Vladimir Putin has been spending heavily over the past few years to modernize Russian infrastructure, its economy and its military.  Such heavy spending is having a toll on the country’s budget.  In order to balance the budget, Putin needs the price of oil to stay above $90; otherwise he will have to borrow money.  With sanctions in place and the conflict escalating, it’s not a good time to be going to the debt markets, especially since America has been working on shutting out Russian companies from accessing international markets.  This is affecting some of Russia’s largest companies, such as oil giant Rosneft, which is in constant need of debt to upgrade its capacity.

 

Oil Price Chart up to 27-8-2014 (NYMEX)

 

America’s new plan is to drop the price of oil below where Russia can balance its budget.  Zerohedge is already reporting that oil traders have been liquidating their long positions on oil causing the price to fall.  There are enough geopolitical events in the market to keep oil prices high, why then would the price of oil be falling so drastically?  Expect America’s plan to work.  In fact, it might work too well crashing the price of oil below $80, which would cause problems for other oil producers, namely, US shale oil producers.  These producers can only make money if the price of oil stays above $80.  Below this price, much of the US shale production will come to a halt causing ripple effects in other parts of the economy.  We’ve reported on the issues with US shale in the past, most recently here, here and here.

Overall, we are bearish on the price of oil for the rest of the year and expect prices to come down further.  Keep an eye on oil markets to see how this scenario plays out.