As OPEC+ alliance group (OPEC + Russia) gathered these past two days to deliberate over the fate of oil production, Brent oil price is firmly below $50/bbl -- now trading at $49/bbl, down another 1.5% from yesterday's close. The proposal presented by OPEC members is to cut oil production by an extra 1.5 million barrels per day (mbpd) in Q2 2020. This is already in addition to the 1.7 mbpd in place since last year, which would bring a total of 3.2 mbpd out of the market, just sitting idly, until demand picks up.
OPEC, which is mainly dictated by Saudi Arabia as its key member and swing state, is pressuring Russia (also another key swing member) to agree to this in order to stem oil prices that started falling back in January this year. Russia is not in agreement with Saudi Arabia right now, and left the meeting on Thursday without giving a final answer. Saudi Arabia, and rest of OPEC, are desperate for a cut as their economy and growth ambitions for the future rely on the price of oil. Even as they diversify their economies away from oil, it will still take quite some time. Russia played ball with their first production cut in 2018, firming their alliance with OPEC. But what happens today can define the future of their alliance going forward.
Saudi Arabia, Russia and the U.S. are the 3 swing producers that dictate the supply of oil -- in short, what they do matters the most for the oil market, but supply only goes so far, if the demand side of the equation is not playing ball. That is the crux of the problem here. During the past few years, all oil price corrections and peaks have boiled down to getting the demand side wrong. Sell side and analysts get used to using past estimates to forecast future projections, assuming the same natural rate of growth.
But those are normal times. In times of war or geopolitical crisis, or even macro exogenous events, the oil price falls as demand is called into question. This is something neither OPEC nor any of the members can seem to get right. Looking at the price and halting supply can work to a small degree, but one has to seriously ask oneself if the problem is cyclical or structural. If they just look at the screen and say let's cut 2 mln, if this problem subsides in the next few weeks, the market can have one of the nastiest squeezes and inflation surprises, which could eventually choke off demand for good. Even though the revenue will tick positive with higher oil prices, one has to think of longer term and not just short term.
This is the issue with the coronavirus. Most media outlets and press are blaming this entire equity market collapse on the coronavirus spreading. What they fail to tell you is that the system has been weak and fragile for over a year now, only propped up by further Fed monetary easing and constant liquidity being pumped to keep the car moving. The entire financial system was showing cracks way before this virus even hit the world. The reason is corporate debt and leverage. According to an OECD report of 36 member states in February2020, total corporate debt amounted to $13.5 trillion at the end of 2019. The more astonishing fact is that the quality of this debt is even lower, due to loose monetary conditions and financial conditions as central banks keep companies afloat, subsidizing their losses, but making the situation even worse.
Global debt is estimated to reach $257 trillion by Q1 2020. According to S&P Global Credit report, in their base line scenario, they estimate around $62 trillion in global corporate credit demand during 2016-2020, with debt representing two-fifth -- and rest is for refinancing. Outstanding debt would expand by half to $75 trillion, with China's share rising from 35% to 43%. Around 40% of the non-financial corporates are highly leveraged and 2%-5% of them face negative cash flow or earnings (of sample of 14,400 corporates). And voila! Therein lies the problem. The term "zombie" companies exists for a reason -- and a good proportion of them exist in China.
So, when the world issues debt to service that debt, and corporates use that money to buy back their own shares to "fool" the public that their earnings per share is moving higher (technically, as earnings are not growing but the share count is decreasing, see most large-cap technology companies), what do you think happens to rates? They have to keep falling lower and lower to service or help these companies. That is the dilemma of the central banks the world over, and especially the U.S.
Coronavirus just came out of the blue and brought the engine to a grinding halt. We do not know how long or extended this virus can or will be, but the longer factories and business are shut, the more money these corporates lose and the more they need to be bailed out by the governments to protect them. Cutting rates will not solve the problem. Fiscal measures are needed to hand it out to the companies that actually need the cash to survive lest they all blow up.
Despite how much "value" there is and how fundamentally cheap the energy sector is right now, the oil price is perhaps the most severely affected during this crisis, as businesses, conferences, events, restaurants, travel and tourism all shut down as people are self-quarantining to avoid catching the viral infection, which is different from other viruses in that it is asymptomatic and can be spread even before showing any symptoms.
All around the world, conferences are empty, travel is cancelled, people are too scared to commute -- and that is and will kill oil demand, via jet fuel gasoline and what have you. When China shut down in January, the market repriced economic slowdown from China going to 0. But now it has spread to rest of the world -- despite Trump and the world saying it will pass over. There are now 207 cases reported in the U.S., schools shut down, California declared a state of emergency, Europe seeing about 4000 cases with most being in Italy but spreading to France and Germany, as well.
This thing has gone global. For now, even companies like Microsoft (MSFT), Google (GOOGL) and Netflix (NFLX) have asked employees to work from home and cancelled events. As an example, the Swiss Motor Show in Geneva is cancelled, which usually brings about hundreds of millions in revenue. If one adds it all up, the supply chain is impacted and earnings of these companies will be hurt. At a time when corporate debt is so elevated, this thing can get seriously out of hand.
Oil is and will be impacted most, as the rest of the world goes into lockdown mode. The problem is we do not know if it will be for two weeks or two months. Given the rate of the spread, the next few weeks are extremely critical. OPEC wants to cut 1.5 mbpd now, but Russia may be wise to wait. The last thing the world needs is 3 mbpd of oil out of the market, the coronavirus cases stabilize, business not effected -- it will cause a massive oil price spike at a time when growth is delicate. Then you can say goodbye to recovery forever as we will be in stagflation for good. But of course, when one is bleeding, these matters do not come into consideration.
The energy sector and oil price has great value over the medium term, as and when inflation takes hold. But in the next two weeks it is like catching a falling knife as the world goes into hibernation. As bond yields are cratering, signifying deflation, there will be margin calls and de-risking, the oil price and energy sector will be hit the hardest. But make no mistake, even the precious S&P 500 is at risk here despite how hard it is trying to hold onto the 3050 level. Watch the bond market, it always leads the less sophisticated Equities.