Oil has dropped 20% since the highs reached in the first week of January following the Iran crisis, and the killing of their leader, when the world grappled with a potential oil crisis. After retreating 5%, it then dropped another 15% following the full outbreak of the Coronavirus threat, as it no longer seemed to be just a China issue, as cases were being reported abroad, including human-to-human transmission. China has locked down about 15 cities including Wuhan, quarantining about 50 million people with strict orders to try and contain the virus as soon as possible.
This is President Xi Jinping's first priority on the agenda lest the Communist Party receive any backlash. Businesses, travel, factories, shops and restaurants have all come to a standstill until at least February 10 to try and limit the contagion. China accounts for around 14 million barrels per day of oil consumption, so the country coming to a total standstill is bound to have an impact on oil demand. As traders always sell first and ask questions later, what is the real hit to oil demand?
Some reports suggest the demand drop has been around 3 mln bpd, which seem a bit drastic. However, BP suggested the number was closer to 500k, whereas OPEC indicated yesterday that perhaps 200k-300k bpd was more appropriate.
Whatever the number may be, it has gotten OPEC, specifically Saudi Arabia, really worried, as oil precipitously falls way below their targeted level and breakeven levels. Currently, OPEC and Russia (OPEC+ alliance) have an agreement in place to take about 1.7 mln bpd of oil out of the market until the end of March, the next meeting being March 5. An emergency meeting this week was called by Saudi Arabia together with Russia to perhaps extend the agreement until at least June, with a possibility of cutting another 500k bpd out of the market if the Coronavirus impedes China's ability to come back to normal business for longer.
Saudi Arabia needs about $80-$85/bbl Brent to balance its budget, given its spending and growth ambitions, despite the cost of its oil being far the cheapest. Russia, on the other hand, is happy with Brent oil prices above $55/bbl, which explains why they had been slow to meet their lower production targets back in January.
Now as the prices currently trade below $55/bbl, it is no wonder that Russia wants to play ball too, outside of just talk. U.S. shale breakeven point is below $45-$50/bbl WTI -- and today WTI is trading right at $50/bbl. Despite the Coronavirus outbreak, U.S. shale companies have been slowing down drilling due to debt and cash flow constraints.
After years of telling their shareholders that they would be disciplined, they kept pumping at the expense of their cash flows, to the detriment of their shareholders that have bailed them out time and time again. Over the past few months, this rhetoric was changing as U.S. shale top producers were focusing on more cash discipline -- and even share buybacks and dividends. As seen by the Baker Hughes Rig Count, drilling had been curtailed and the rate of growth of U.S. production had massively slowed. The last EIA oil report showed U.S. production at 13 mln bpd, but it has been around that level for some time -- it is not growing exponentially as it did before.
As the Fed was talking about lower interest rates and reflating assets higher, the oil price was in good position to rally. The Coronavirus blind-sided the market and caused the price collapse as we saw hedge funds and speculative traders puke their opening year longs.
Last week, portfolio managers sold 56 million contracts of NYMEX and ICE WTI contracts, 27 million Brent contracts and 28 million Gasoline, 16 million U.S. Diesel and 20 million European gasoil. Since the turn of the year, long-short ratios have fallen from 9:1 to 4:1 in WTI; 13:1 to 8:1 in U.S. gasoline; and 13:1 to 3:1 in European gasoil (according to Reuters). In U.S. diesel, hedge funds moved from a massively long net bullish position of 21 million barrels to a new bearish position of 14 million barrels last week. That is an astonishing turnaround, especially as going into the start of the year, the IMO marine regulations were set to tighten the oil and refined product markets due to tighter fuel specifications. This flush seems to have more than exaggerated what the virus impact may be.
We are at a price wherein two of the largest three producers of oil producers are starting to get in the red, so projects will be at risk. Saudi Arabia will do whatever it takes to support the oil market, and now with hints that China is injecting liquidity and supporting their markets, the levels look extremely attractive.
Oil stocks are down about 25% and it is time to go long selective names -- like Permian producers with great pricing potential and balance sheets and some oil service names that are showing margin growth and great order backlog. The market is worried about this tipping economy into a recession. The central banks, especially the U.S. Fed, will not allow this. We know China just injected about a net 400 billion Yuan in liquidity in just two days.
The selloff and demand destruction fears appear overdone, as Brent oil price won't stay below $55/bbl for too long.