It seems President Trump is as deluded as ever with his grand statements -- perhaps not reckoning the sheer stroke of genius on the part of Saudi Arabia and Russia to actually corner the U.S. via crippling its shale oil industry. Oil prices are down 60% from the highs in February 2020 as price has been hit not only by around 25 million barrels per day of demand lost but also by the surge of around 3 mbpd, as Saudi Arabia finally gave up on being the lone player supporting this market to help U.S. shale and other players grab their lost market share.
This is not just about coronavirus slowdown. The oil market has been in perennial oversupply for the past two years, with only Saudi Arabia and Russia supporting the price by taking about 2 mbpd out of the market, helping the U.S. shale companies to keep pumping and raking in more revenue. Since the two countries were not getting their way, they pulled this trick at the worst possible time for the U.S. when coronavirus was hitting its economy.
It may have proved damaging to everyone, but if Saudi waits it out, this can certainly get them back to being the swing producer as they used to be back in the 1970s. Russia's Putin is sitting back and enjoying the show as it would suit him very well to let shale collapse -- and they can continue producing once oil price stabilizes, as their cost of production is around $15-20/bbl Brent, still a lot lower than shale at $45/bbl WTI. Needless to say, Russia would not even consider a cut unless the U.S. remove any and all of its sanctions. Will Trump really give in to all of this? Does he have anything to bring to the table here?
At first Trump touted this price decline as a victory for consumers, taking credit as he does for every single thing that happens in the U.S., with no regard for the actual implications. But now, given how many shale companies are suffering and facing potential bankruptcy -- as Occidental Petroleum (OXY) teeters and Whiting Petroleum (WLL) has filed for Chapter 11 -- this matter is now concerning him as a lot of his donors are from Texas and shale is America's baby.
Of course, in his usual fake news style, he utters headlines about how he will manage to broker a deal. It is virtually impossible for Trump to broker any oil deal unless he can get all the U.S. shale companies to cut, along with Saudi Arabia and Russia; an impossible feat.
Even with OPEC's select members, they could not coordinate a cut. Do we really think we are going to be able to manage a global cut on that sheer scale and trust Saudi and Russia? I think imagining penguins flying would be more probable.
The commodity itself is quite frankly following its physical market dynamics, and rightfully so. As oil in various regions are landlocked, their prices are trading even negative as physical oil has nowhere to go.
On the equity side, the biggest anomaly, or trading opportunity, seen here is to sell the European oil majors like British Petroleum (BP) , Royal Dutch Shell (RDS.B) , Totalfina (TOT) , and Equinor (EQNR) . Oil Majors have been one of the worst proxies to play oil -- despite their dividends, they have been in perennial decline as they just never manage to capture higher oil prices on the way up, and lose more on the way down.
Now with oil prices below the average breakeven of $50/bbl Brent, even their share buybacks and dividends are in danger as we see in the dividend swap and credit default swap markets. Over the past two weeks, European oil majors are up 50%, as oil is still teetering on its lows of $27/bbl. This anomaly only presents itself in European names as all U.S. oil majors like Exxon Mobil (XOM) , and even the more-levered ones like Diamondback Energy (FANG) , are down logically with the oil price, as the companies are slowly running out of cash. How is that possible? Blame the European exchanges and regulators.
Exchanges and regulators never seem to learn from the mistakes of the past. They are bent on following the same actions as they did during the past crisis, hoping that it would stabilize the system, but in fact they cause even more volatility and financial pain for investors, companies and asset managers by doing so.
European bourses, including Italy, Spain and France, have banned short selling of around 90 stocks. It was meant to last a day, but now has been in place over the past two weeks to curtail the index decline. It is virtually impossible to find the list of stocks, as their aim was to prevent the banks from being sold more, but in effect it has distorted all large-cap stocks of the European entities. How is that legal or a viable strategy? One may as well just close trading altogether than put forth such damaging rules, as they do not help.
An equity is just a company that is valued off of its cash flows and dividends. If those are falling, so too does the equity -- that is financial modelling 101. Its top line is driven by the actual commodity that drives its earnings, in this case Brent oil. When one models the top line and calculates its earnings per share, there is no way, justifiably, it can present an earnings upgrade to see stocks up 50%. The European majors are down 20% year to date after the latest short squeeze, with oil price down 60%. They are fundamentally mispriced.
This is classic manipulation and highway robbery by the European exchanges. The last few weeks hedge funds have been forced to cover their shorts to be compliant with the regulators. However, these are $100 billion multinational companies, not some small mid-cap entities that have no free float.
Every day that we see the oil price averaging $27/bbl Brent, their earnings will keep declining and cash flow dwindling. Stocks can only diverge for so long before reality kicks in and longer-term holders like pension funds -- who actually do hold this in their portfolio -- will start to scratch their heads and saying this is just beyond ridiculous. This is perhaps one of the best-selling opportunities in this market, if you can get access to borrow quickly and early enough, or as the exchanges remove the ban now that now that markets are up.
These divergences tend to happen once in a rare while when the market is dysfunctional or we go through an exogenous shock, as we are going through one right now. But after a period of volatility, logic does prevail and fundamentals do converge. After all, that is the arbitrage between equities and commodities -- a loosely defined one, but one nonetheless. For right or wrong reasons, the oil price will only stabilize once all the supply is cleaned up and demand slowly returns, which is not for at least a few months at the earliest, given all airlines grounded. For the supply to clean up, we need to start seeing well shut-ins.
As of last week's DOE oil inventory data, U.S. oil production was still hovering around 13 mbpd. The oil price will need to stay lower for longer until all the weak players get flushed out and shut wells. Filing for bankruptcy is not enough, as oil can still be produced but via a third party. We need to see companies going away, for good. Once this is done, only the strong with the lowest cost will survive. And once demand returns, perhaps Saudi Arabia and Russia can finally come out on top. Checkmate Trump.
