- Monday's sell-off resulted in extreme losses for energy commodities, net energy exporting countries, and cyclically-sensitive sectors.
- Losses can be tied to Russia's departure of "OPEC+" and plans to drastically increase production by both Russia and Saudi Arabia.
- The collapse of OPEC+ brings Saudi Arabia's power over energy prices to essentially zero as OPEC now produces less than half of global supply.
- 2020 is likely to see global oil production increase substantially while evidence from China suggests an unprecedented drop in consumption.
- Given the likely glut, investors should not expect crude prices to recover this year, drastically increasing bankruptcy risk for U.S. producers.
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In the heat of market volatility, it is often difficult to zoom out and see the situation for what it is. The disastrous global crash in equity markets on Monday can be tied to the collapse of OPEC's power over oil prices over the weekend. In order to begin to understand the situation better, let's quickly recap the damage by commodity, sector, and region.
First, take a look at a table of Monday's percentage price changes by commodity:
"Crude Monday" Price Change
As you can see, oil fell by a staggering 25% followed by gasoline. This was the second-worst day in oil history beaten only by the 1991 gulf-war crisis.
Interestingly, natural gas, which is usually correlated to crude, had a great day. This likely relates to my theory that crude and natural gas are negatively correlated due to the hedge-fund crude/nat-gas pair trade strategy that has been taken to an extreme.
The drop in crude oil prices had a pronounced impact on equity markets with the S&P 500 seeing its worst day since 2008. Cyclical and inflation-sensitive sectors were hit particularly hard as you can see below:
"Crude Monday" Price Change
Most obviously, E&Ps were hit extremely hard with a staggering 37% blow. This was XOP's worst day in its history. That said, even risk-off sectors like utilities that stand to gain from the extreme decline in long-term interest rates saw significant historical declines. This goes to show that equity investors are looking to reduce exposure on all fronts and likely want to raise cash wherever they can find it.
I believe that the most interesting table on price changes is by country. As you can see below, net oil exporters were generally hit the hardest by the price collapse:
"Crude Monday" Price Change
|Net Oil Exporter?|
|(EUSA)||United States||-8.47%||Yes (though, barely)|
Of course, there are many more countries, but I picked this sample to show the most notable ones.
While Greece is not a net oil exporter, I believe it was hit particularly hard due to its extreme debt levels. Since global energy companies and Greece both have high credit risk, a tightening of global liquidity and a rise in interest rates for high-risk companies is likely to hurt the Greek economy.
This is not true for Israel which was also hit extremely hard by the shock. EIS has been an outperformer lately, so it may have just been due for price discovery. Even more, as I'll explain in the next section, the shock is likely to increase geopolitical conflict between Russia and Saudi Arabia. Saudi Arabia is generally friendlier to Israel than are its neighbors while Iran and Russia are strategic allies. Since Iran is very unfriendly to both Saudi Arabia and Israel, any increase in geopolitical conflict between the two promotes uncertainty for Israel.
On a related note, let's dive deeper into the recent OPEC collapse that spurred these extreme drawdowns.
The Collapse Of OPEC+
Russia was the cornerstone that was holding the struggling energy market together. When it broke over the weekend, it pulled oil and the entire global equity market down with it.
In the past, the oil market was effectively controlled by OPEC as the cartel nations produced the majority of the global oil supply. However, from the late 90s to 2010, Russia effectively doubled production. At the time, the U.S. was still a net importer and Russia piggy-backed on OPEC's pricing power that held oil prices above $100 per barrel.
However, after a series of technological breakthroughs and discoveries last decade, the United States has become the global leader in oil production at 12 Mbpd. Unlike Russia, the United States never agreed to follow cartel production limits. This has tarnished the historical pricing power of OPEC and has helped to spur the ongoing energy price depression (that began around 2014). The U.S. production surge's impact had held crude oil in the $50-$65 range until recently.
The ongoing Coronavirus pandemic has drastically reduced global oil demand for travel, pushing oil prices below the $50 support level to around $45 per barrel. In fact, China's demand for oil fell by a staggering 20% or 3 Mbpd in January. In order to combat this decline, "OPEC+" (which includes Russia) met over the weekend to agree on a production cut. Saudi Arabia surprised partners by pushing for even steeper and longer-lasting cuts than expected.
Since doing so would throw a (much-needed) lifeline to U.S. shale producers who would likely increase production with higher prices, Russia did not agree to make cuts. As a matter of retaliation against Russia, Saudi Arabia reversed its stance and decided to drastically increase production by 25% to 12.3 Mbpd. Instead of cutting production by 500K bpd as Saudi Arabia asked, Russia followed suit and said it would increase production by 500K bpd.
To make matters worse, the U.S. is expected to increase production by about 1.1 Mbpd this year to 13.3 Mpd. These recent events indicate that total global production is likely to increase by around 3-4 Mpd to a total of around 103-104 Mpd, beating EIA's previous forecast of 101 Mpd.
Given, China's 20% demand decline is likely to soon be reflected across the globe, it is conceivable that the total 2020 oil consumption falls by 5-10 Mbpd (if not more). Unless Russia and OPEC decide to get along or another geopolitical oil-production shock occurs (which are both certainly possible), it is likely that 2020 will see an unprecedented 7-15 Mbpd glut of oil. To put that in perspective, the ongoing "glut" has never seen an ongoing surplus over 3 Mbpd.
Unless a positive shock occurs, this is extremely bearish for energy companies. As you may know, until recently I was very bullish on energy. If we take out the temporary shocks related to the production price war and Coronavirus, the long-term supply-demand fundamentals for oil clearly favor a bull market. This is mainly because U.S. production is reaching its upper bound.
On the other hand, 2020 will likely be a record year for the crude oil surplus. Remember, lower oil prices do little to increase demand since that factor is highly inelastic. This means that crude oil prices will likely remain far below U.S. production costs (likely around $65-$75 today for most producers).
While most U.S. energy companies trade at extremely low valuations (often less than 5X earnings), a company that cannot make debt payments is worthless. Based on many of my past views it pains me to say it, but the fact is that many U.S. energy producers will likely go bankrupt if this year's glut is as expected.
Of course, if U.S. producers close shop, it only adds to the long-run bullish outlook for energy commodities. If you're willing to handle extreme volatility in the short run, I believe that crude oil commodity funds like USO are a solid bet and are unlikely to fall much lower. Since almost no producer in the world can make a profit with crude below $30, I do not believe it can sustainably be below that level. This gives the ETF USO a solid support level of around $6 today and a high long-run upside.
Still, I reverse my previous position and believe that E&P ETFs like XOP may not be great today. I remain bullish on those that focus mainly on natural gas as that commodity has less exposure to global energy titans, but those with high exposure to crude oil are in peril. I would not dare to short energy producers since a reversal of recent events could cause many to double or more in value, but hoping for such a turnaround does not make for a good investment strategy.
I also believe that single-country ETFs like Russia's RSX or Saudi Arabia's KSA are not dip-buying opportunities for the same reason, not to mention their additional geopolitical risks.
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