Markets Fear New Combined Spectre = Grexit & Oil

Two major world events - the RealPolitiks of oil as well as the domino-effect linked to a Grexit, if blowing to full force - would not only cause financial markets to go down a wild river of systemic crisis, but the combination of both events would even trigger a global crisis with far reaching geopolitical consequences.

On the one hand - in one part of the world - financial markets are now entering what could be the final chapter of the Greek saga, in which the indebted nation breaks free from the single currency and tries to go it alone. In the wake of the coming elections (25 January) the rise of the anti-austerity Syriza party has sent shivers down the spine of dealers as they are well positioned for the election this month. A victory for the left-wing party does not automatically mean a Greek exit but traders will certainly see it that way - particularly as senior executives all over the European Union are judging this scenario as acceptable and even (naively) doable.

A decision by a new Greek government to leave the eurozone would set off devastating turmoil in financial markets as a Greek exit would also spill into other countries as investors speculate about which might be next to leave the currency union.

The options being discussed to stem the crisis, including launch of full scale quantitative easing by the European Central Bank are not likely to be any more successful. Indeed, first of all, an increase in money supply will not likely incentivize European commercial banks in increase lending activities as these same banks - being already highly leveraged - are restricted by CRD IV (Basel III) in lending en masse. Secondly, because of the ongoing austerity measures, the power purchasing/investing capacity of households and firms alike is so eroded that there is no real demand as overall economic growth is down.Thirdly, interest rates being already so low, that even lower interests would bring no added benefit to the economy.

Indeed, at the meeting held on December 4th, the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility would remain unchanged at 0.05%, 0.30% and -0.20% respectively. Interest Rate in the Euro Area averaged 2.40% from 1998 until 2014, reaching an all time high of 4.75% in October of 2000 and a record low of 0.05% in September of 2014.

At the end of the day, the introduction of QE would bring the eurozone in line with most of the other main central banks, including the US and UK, which have purchased large amounts of their own government's debt debt since the recession bit.

Unfortunately, despite this projected increase in the European money supply, there may be no way to end to euro crisis, and markets have maybe finally understood it (albeit government yields are still ridiculously low) illustrated by the fact that the euro meanwhile fell to nine-year lows as the spectre of a 'Grexit' rose again and expectations hardened that the European Central Bank will soon resort to cash injections to prop up the eurozone economy.

Greece Government Bond 10Y 1998-2015

While holding the eurozone together will be costly and difficult and painful for the politicians, breaking it up will be even more costly and more difficult. But, once a Grexit is contemplated and put into effect, no one knows really what the spillovers might be, but the worse might be expected (ie. the same way as the collateral damage related to the collapse of Lehman Brothers was underestimated).

But, the bigger issue is of political contagion across the EU, with anti-austerity parties across the continent likely to be further boosted. Clearly, if radical left Syriza party wins the January 25 polls, this would be the worst case scenario. as the new Greek government would reject the conditions set forth by the Troika, and most likely walk away from the Eurosystem. The uncertainty is a stark reminder the crisis is not over.

A Greek exit could meanwhile also cause broader geopolitical problems. There is a risk that if Europe fails to act then Athens could be bailed out by China or even Russia, both of which have a "huge geopolitical interest in gaining influence. European leaders in Brussels do not want that country under the influence of an outside power, adding Greece could be under pressure to veto EU decisions on sanctions on or trade with other countries. As a reminder, the European Union has imposed a series of economic and other sanctions against Russia over the crisis in Ukraine.

The other (uncorrelated) major event - in another part of the world - that would exponentially multiply the collateral effects linked to a Grexit is the seemingly unstoppable fall of the energy prices. Indeed, oil traders expect that the supply of oil will remain plentiful for the foreseeable future, while demand will remain weak — which is exactly what that IEA chart shows. And, since the price of oil is determined by contracts for future delivery, these expectations for the future matter a lot. That's why oil prices keep falling, not to mention the fact that Saudi Arabia has started a trench warfare by purposely keeping prices low attempting to break the back of other oil producers, amongst others U.S. shale oil explorers.

Back in June 2014, Brent crude went for $115 per barrel. That price has dropped in half, down to $53 per barrel. And, the world is experiencing much more than a temporary dip in oil prices. Because of a change in the supply model, this is a fundamental shift that will likely have long-lasting effects.

Saudi Arabia being the big cat on the block claims that a $20 per barrel would be "really fine". And, in terms of the ability to pump oil out of the ground at $20 per barrel, the Saudi oil minister is not fudging facts. Saudi Arabia contains some of the world’s last reserves of conventional crude that’s relatively cheap and easy to extract. Contrast that with the U.S., whose energy renaissance has relied on more complicated techniques and, as a result, requires a higher price to remain profitable (U.S. shale formations have widely variable breakeven prices).

But as a petrostate, the calculus is not as simple as whether or not the Saudis can profitably drill. Like the rest of OPEC’s members, Saudi Arabia’s government relies heavily on crude revenues—it needs oil prices of at least $93 per barrel to stay in the black. It can withstand a bear market for a time, but those budget deficits could eventually induce the Saudis to cut production to stabilize prices.

The Saudis decision not to cut production likely has two aims. First, it hurts their regional rival Iran more than it hurts themselves: Iran has a breakeven price north of $140 per barrel. Second, it hurts their new, out-of-the-blue competitors: American shale producers. Unfortunately for Riyadh, that second aim may be more difficult to achieve, as American frackers continue to improve drilling techniques and get more oil out of shale for less money and time.

Yet in serving as the swing producer through the years, Saudi Arabia learned an important lesson: It isn’t easy to regain market share. This difficulty is greatly amplified now that significant non-traditional energy supplies, including shale, are hitting the market.

Overall, there is a change in the production model means it is up to natural market forces to restore pricing power to the oil markets. Low prices will lead to the gradual shutdown of what are now unprofitable oil fields and alternative energy supplies, and they will discourage investment in new capacity. At the same time, they will encourage higher demand for oil. This will all happen, but it will take a while. In the meantime, as oil prices settle at significantly lower levels, economic behavior will change beyond the “one-off” impact.

Now, the biggest game changer in relation to this oil trench warfare is on the geopolitical front: indeed, the Saudis (as well as the other Gulf members) are at the end of the day clearly worried that there is a lingering question mark over the Middle East as a dominant global energy source, and thus that the Persian Gulf will increasingly represent only a secondary interest to the US.

Interestingly, as the US edges closer to energy self-sufficiency and the Middle East becomes more chaotic, the United States relevance in the region would decline and the region would become a problem for China and India, whose economies are becoming increasingly reliant on Middle Eastern energy – just as a more energy-sufficient US economy becomes less so.

In other words, and in the mean time, the likelihood of longer-lasting changes is intensified when we include the geopolitical ripple effects. In addition to creating huge domestic problems for some producers such as Russia and Venezuela, the lower prices reduce these nations’ real and perceived influence on other countries. Some believe Cuba, for example, agreed to the recent deal with the U.S. because its leaders worried they would be getting less support from Russia and Venezuela. And for countries such as Iraq and Nigeria, low oil prices can fuel more unrest and fragmentation, and increase the domestic and regional disruptive impact of extremist groups.

Up until recently, few expected a Grexit or/and oil prices to fall so far, especially in such a short time. The surprises will not stop here. A prolonged period of European chaos combined with low oil prices are also likely to result in durable economic, political and geopolitical changes that, not so long ago, would have been considered remote, if not unthinkable.