Oil Tanking...Beginning of the End

On January 2, 2020, I wrote a blog post named “Cheap Gas Forever!” describing how the oil market is in the midst of a regime change. This basically means that something big has happened in an industry that will completely change it forever. An example might be the internet for technology or the automobile for transportation. For the oil markets, fracking and shale production has changed the industry forever.

Up until the last 10 years or so, oil prices were basically determined by a group of 3rd world countries where oil supplies are vast. The group is called OPEC, i.e. Organization of Petroleum Exporting Countries. This domination has caused different degrees of turmoil throughout the world over time and shaped foreign policy. As I mentioned in January, this dynamic has changed and it is unlikely to ever revert back.

This weekend the beginning of the end of OPEC has started. I previously discussed that many of the 3rd world countries that export oil are nearly completely dependent on that export to support their countries. Because of that, these countries are FORCED to export oil no matter what the price. To balance oil prices, OPEC countries and Russia (OPEC+) have had to sacrifice market share and such accommodation is wearing thin.

The coronavirus has turned the delicate negotiation between global exporters into a war. See, global oil demand is collapsing under the effects of the coronavirus. This puts even more pressure on OPEC+ countries and now it’s gone too far.

Russia decided over the weekend to break the alliance by not agreeing to cut production in light of coronavirus demand weakness. This incensed fellow dominant producer, Saudi Arabia, and now the fireworks are an all out price war which will likely cause oil prices to plummet. At the time of this writing, oil prices are set to open down about 20% already with the probability of a recovery nowhere in sight.

But why do this???

RUSSIA BELIEVES IT CAN WEATHER THE STORM OF LOWER PRICES BETTER THAN SAUDI ARABIA AND OTHER MIDDLE EASTERN COUNTRIES. THEY ALSO THINK THE LOWER OIL PRICES WILL WIPE OUT THE U.S. SHALE PRODUCERS.

But we’ve seen this movie before, back in 2016. Saudi Arabia themselves thought they could put the U.S. producers out of business. Oil prices fell dramatically to about $26/barrel. Unfortunately for the Saudis, the U.S. producers were able to lower their break-evens and they kept producing in larger and larger quantities. The Saudis eventually gave up and prices recovered, but never to levels they were before.

That’s not to say there won’t be some casualties in this war in the U.S. The amount of debt carried by most of the energy companies will no doubt weigh on their financials given lower oil prices. But like 2016-2017, the result of this new war will likely be the same. Not only are companies likely to adapt, but accelerating trends in battery technology and alternative energy give oil a limited future regardless of the outcome. So the only option will be to produce at whatever the price to get what you can while you can.

THE GOOD NEWS IS THAT GAS PRICES WILL HEAD LOWER IN A BIG WAY. THAT WILL CERTAINLY SUPPORT CONSUMERS AND INDUSTRY DEPENDENT ON OIL PRICES.

The bigger question is what happens to the OPEC+ countries over the long term? Given the dependency on oil exports, their economies could completely break down at some point. Global foreign policy will certainly be changing given these developments. Stay tuned…

Sources: Bloomberg, JP Morgan

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