The energy sector and its stocks witnessed their biggest one-day record selling on Monday as most Exploration & Production companies were down between 20%-40% -- digits not witnessed even on September 15 2008, when the financial system broke down as Lehman Brothers went bankrupt. This is also the biggest move in the sector going all the way back to 1994. Brent oil price fell more in percentage terms in the aftermath of the Gulf War Crisis in 1991, but that was a different time.
Looking back at previous shocks and awe in the energy sector, ranging from the 1970s to 2008 and 2014, what is different this time around is that Saudi Arabia is no longer the swing producer, or the producer of last resort. It would serve them well to understand this as the game is very different today than it was back then. Also when someone acts out of a position of weakness, it rarely yields the results they intend.
The press would seem to suggest this is a rift between Saudi Arabia and Russia, as the latter did not share their kindergarten lunch with the former, and the former threw a tantrum. But it goes way beyond that. It is about getting U.S. shale to crumble, indirectly of course, as well. OPEC, mainly Saudi Arabia, used to be the largest producer of oil in the world, averaging close to 10 million barrels per day (mbpd) with Russia behind them also at around 10 mbpd. But all that changed in 2012. The U.S. went from 6 mbpd in 2012 to 13 mbpd in a matter of eight years as fracking and the U.S. shale revolution changed the landscape of international energy markets forever. From being a net importer of oil, they have now become a net exporter -- and a growing thorn in the side of Saudi Arabia's aspirations.
Most quote that Saudi is the lowest-cost producer, with oil costing around $5-10/bbl. Russia needs $40-45/bbl and the U.S. requiring at least the same. But it is not about actual cost of production, it is the fiscal breakeven price of oil that matters the most to these regions. Fossil fuel demand is a slowly dying commodity as renewables, solar, electric vehicles will be in full swing by 2030 onwards. And OPEC knows this, hence their rush to diversify away from oil as soon as possible.
Unfortunately the process started a bit too late. Not to mention that oil subsidies are a big part of keeping the region happy, as excess profits go back to citizens to avoid social unrest. It is a lot more complicated than just looking at the cost of oil production. For Saudi Aramco, the state crown asset, profits were down 18% in the first nine months of 2019 when oil averaged $66/bbl. vs. $69/bbl. the previous year. What on earth will it report when oil has fallen 30%?
Part of the reason why Russia probably did not want to endorse another deeper cut of 1.5 mbpd is that it could lead to massive hyperinflation as the effects of Coronavirus settled down. Waiting was the sensible thing to do. Cutting now to prop up prices would only allow the U.S. to merrily keep pumping away and enjoying profits. Saudi hopes that this strong-arm tactic will get Russia to come to the table, but Putin is a lot smarter than that -- and even said they had ample reserves to withstand oil at $25-30/bbl. for 10 years. But as WTI oil prices are below $35/bbl, more than 80% of U.S. shale companies cannot survive let alone drill new wells at these economics. For Saudi's plan to work, prices need to stay here sub $40/bbl WTI at least for the next few months, to really see U.S. shale falling off a cliff.
We have already seen announcements from likes of Occidental Petroleum $ (OXY) slashing its dividend, and Diamondback Energy $ (FANG) cutting its capex for this year. In the weeks to come, we shall see more companies put the brakes on their drilling, and U.S. production should start to fall from highs of 13 mbpd. According to an HFI Research note, if prices stay here until June, we could potentially see U.S. oil production fall to 11 mbpd. That would be close to the 2.5 mbpd increase Saudi has just pushed through, levelling the playing field a bit. If prices stay here for the next six months, we would then reach a situation of an actual deficit in the oil market.
The U.S. energy sector is the heart and soul of the U.S. economy. U.S. shale companies have been able to keep producing at cheaper and cheaper levels thanks to the wonderful cheap money credit system in the U.S. open to them and greedy enough investors. Around $200 billion worth of debt is set to mature over the next 4 years, about $41 billion set to expire this year alone. Furthermore, U.S. banks are extremely exposed to these debts, as banks have about $100 billion exposure from loans to the energy sector, from likes of Bank of America (BAC) and a host of other regional banks. That is based on $50/bbl WTI oil. When the books reset today at prices of $35/bbl WTI, there is bound to be an implosion.
President Trump is trying to get a "huge" fiscal package through Congress to bail out not only the airlines, cruise liners, but also the U.S. shale companies, as these are all his friends (sorry, donors). In 2008, banks were too big to fail, what is this time? The entire corporate bond market? Are we set to print trillions in dollar to bail them all out or just to keep a failing system afloat with even more debt?
One thing is certain, fiscal packages actually handed out to companies or citizens who need them is better than monetary policy that just finds its way back to the big corporates who end up buying back their stock. But monetary policy needs to be exhausted before the Fed embarks on a new fiscal package. Congress is set to exit next week, let's see if the U.S. can get a bipartisan fiscal package issued, not just talk and words.
The next few weeks will be critical. The longer oil prices stays below $40/bbl WTI and Coronavirus impedes demand in U.S. and EU now as well, the faster they will need to come to the rescue. The S&P 500 has only fallen 15% and it seems the world is about to come to an end. We are still 18% up from the lows reached in December 2018. But then again, this was never about the economy, it has always been just about the stock market and higher asset prices.