As the world awaited improved results from the Coronavirus cases in Europe and the U.S. over the weekend, with hopes that businesses and demand would slowly return back to some form of normalcy, Saturday's announcement from Saudi Arabia has pretty much dashed any hopes of a recovery for the foreseeable future. After Saudi Arabia did not get the deal they so wanted and Russia walked away, which was perhaps the more responsible move to avoid hyperinflation in the future, the former decided to throw a tantrum on Sunday and go all-in with the oil supply and end production cuts altogether.
If the world was on the brink of deflation and central banks all around the world were rushing to salvage the financial markets, Saudi Arabia just made it worse, throwing a deflationary bomb into the open and pretty much nuking all asset classes into oblivion. After years of cutting production and losing market share to Russia and the U.S., they have decided to go down the route of survival of the fittest and adopt the saying "if I go down, I take you all down." But will it work?
Saudi Aramco offered price discounts of $6-$8/bbl on crude to be delivered in April, engaging in a price war with the two other swing producers -- the gloves are off. Brent oil is down over $12/bbl overnight -- around 30% or more -- as Saudi Arabia announced on Sunday that they can/will flood the market with more than 10 million barrels per day and up to 12 mbpd, even.
This short-sighted strategy might actually come back to haunt them. Their aim, and this is purely speculation on my part as bigger decisions are way beyond my pay grade, is to scare Russia and coerce them into cutting production with the rest of OPEC. In addition, they appear to be using this marketing strategy to flush out U.S. shale, which has been the bane of their existence since 2014. They thought they could crush U.S. shale back in 2014 when they first decided to flood the market with oil, but to their chagrin, that strategy never worked as U.S. shale was more resilient than they imagined.
The beauty and sophistication of U.S. shale players are their credit markets. Given the level of maturity and free market capitalism, mixed with greed and lower and lower yields thanks to their wonderful central bank, U.S. companies and shale have been able to survive even as oil prices touched $27/bbl Brent back in 2014. Arguably, their investors have grown worried as they continue to overspend their profits and the capital markets are now closed to them, but since Q4 2019 they have decided to be more capital disciplined.
Thanks for the power of hedging! U.S. E&P producers and shale are diligent about hedging their 12-18 month production using the forward curve to their advantage locking in securing their profits. This is something that most players in OPEC do not understand, as this systematic hedging allows them to survive a fall longer than other players. This is unlike OPEC, which does not want to hedge or perhaps hedge very little. Instead, they have assumed higher oil prices forever and forward spent their potential profits into projects aimed at diversifying their revenue.
U.S. shale oil breakevens are closer to $40-45 WTI, Russia is happy producing with Brent at $50/bbl, but it has ample reserves to withstand a fall below if need be. But for OPEC, most of its members are under water and have budget deficits and need Brent oil to be higher than $60-80/bbl to survive. Not because their cost of oil is high, but because they have overspent. This strategy of calling the Russia's bluff may prove to be more painful than they imagined.
Today's move down in Brent is the biggest one-day selloff ever in the history of Brent. Equity indices are opening limit down 5%-6%, the 10-year U.S. bond yield is now trading 0.52% screaming recession and will soon go to negative, even. The FX markets are in a tailspin as Emerging Market currencies -- and developed ones like Norwegian krone and the Canadian dollar -- are getting wiped out.
FX and bond markets are some of the most important and sophisticated asset classes. Everything is derived from those two. Investors use the FX markets to short a low-yielding currency to use the proceeds to invest in higher-yielding currencies and risk assets (called the "carry trade"), so when FX markets blow up, all asset classes fall like dominoes one by one. This is not logical, it is not fundamental, it is about deleveraging and margin calls. And Monday will seem like that as value goes out the door.
One thing is certain, the Fed will not solve it with its $500 billion balance sheet expansion and cutting rates by 50 bps. The oil price will cause more defaults in the U.S. corporate bond market, and this will collapse the high yield and Energy market. What was once a small coronavirus-dictated slowdown is now potentially turning into the biggest debt bubble bursting ever imagined. The system has been fragile for some time, but now Saudi decided to remove the wrong pieces in the Jenga tower to prove a point.
Something no one has talked about but is seriously a possibility now is the end of the petrodollar system -- which effectively replaced the Bretton Woods gold standard and refers to any U.S. dollar paid to oil-exporting countries in exchange for oil. The Kissinger/Nixon petrodollar system has been in place since 1970s -- and it is now going to be severely tested. After all, China and Russia had been moving away from trading oil in dollars -- why borrow dollars to trade oil when both parties involved are non-U.S.? Now that OPEC -- specifically Saudi Arabia, a key U.S. ally -- has thrown the gauntlet on the U.S., if the petrodollar system breaks, there will be mass devaluations to come across the board in the oil producing regions: the Black Swan event.
The market could have been fixed last week and contained over this quarter. But now, the timing of oil price announcement could not have come at a worse time as markets can enter the Depression era, or fall back into the stone ages. I don't think even OPEC has realized the consequences of their weekend action, it is about something so much bigger than them. And the irony is, they can't even see it.