As WTI oil prices breached $20/bbl, a level not seen since 2002, the question on everyone's mind is, how low can it possibly go? We have heard some scary predictions of negative oil pricing over the last few weeks even and horrendous floating storage economics. One thing we need to know about commodities is that they, unlike equity, can trade at negative pricing levels for certain periods of time until demand and supply match.
At the end of the day, it is a resource that we either need or do not. If we do not, then there is no use for it nor any price anyone is willing to pay for it, or vice versa. This is very different from equity, as they are discounted future cash flows twenty years out with some terminal value and hard physical assets to which we can attribute some "floor value."
Unfortunately, commodities do not work that way. Having said that, I am not proposing that we are going to negative pricing anytime soon, but just illustrating that it is not about an actual fair value price, it is about reaching an equilibrium, a level where demand meets supply. Pure Economics 101.
Since 2014, the oil market has been dogged with a constant state of oversupply as U.S. shale overtook the global oil production landscape, with growth rates above anyone's imagination. During that time, OPEC slowly lost market power -- and with it, the ability to contain prices. Now they can just support them, not actually drive them.
Given OPEC+ members' need for higher prices to save their economies from vast fiscal spending, they kept cutting more and more just to keep afloat. And to the benefit of whom? The U.S. shale industry. Over the past few years, OPEC+ had taken about 2 million barrels per day (mbpd) out of the market, and suggested a desire to do even more. This is a vicious cycle that gets them even deeper in the sand as all that inventory is built up, sitting idly looking for a home.
This was the strategy to avoid short term pain, and was similar to the position of Fed and central banks -- who, like ostriches, kept burying their head in the sand regarding their debt bubble, too scared to deflate it, and kept inflating it hoping the problem would go away.
But a few weeks ago, the Saudis had had enough. Perhaps the Fed should heed this lesson from the oil producers that have finally decided to burst this never-ending excess of oil inventory, so that once and for all the market is cleared as the fittest survive -- washing away all the weak (financial) players. This strategy may prove to be disastrous in the short term, but in the long term, this can actually help the oil market recover a lot higher with the strongest players making out like bandits. Kudos to them for taking this harsh approach.
Last week's oil inventory report showed that U.S. oil production was still holding 13 mbpd, down from 13.1 mbpd. Given the rig counts falling, it is holding stubbornly high, but it won't be too long before we start seeing a falloff in barrels, especially as wells are shut in.
Before an oil producer decides to shut in a well, it will try every single resource on its hand to squeeze the last barrel of oil, even at negative economics for a short time, hoping to ride out the price weakness. So, there is a bit of a lag and prices need to keep falling for them to cave in. At $25/bbl Brent, assuming a $10/bbl discount for Saudi crude, it would imply Russian Urals trading at $15/bbl, which is economically unfeasible for them to produce as Rosneft breakeven for Urals is $50/bbl. At $35/bbl Brent, the hit to them is around $3.3 billion a month, which is unsustainable. It is better for them to store the oil and to shut in wells, rather than produce. We are seeing this happen now.
Speculators and novice traders are suggesting that floating storage around the world will get inundated with spare oil, causing a massive collapse as the world will run out of oil storage. There is about 1 billion barrels of oil storage facility globally. Analysts at Rystad Energy suggest the world will run out of oil storage by April at the current rate. That forecast assumes companies keep producing -- and that is where the flaw in this logic is. Floating storage and pipelines will be used as much as possible, but eventually prices will need to be low enough to shut wells down. Only when this happens can we start talking about the oil market reaching some sort of balance, assuming the coronavirus-induced slowdown remains in place for the next few months. Even if the infection is contained, demand returning will take a lot longer, so those expecting a V-shaped demand recovery in oil will be sadly disappointed.
This ties back into the what is in store for the dollar and equity markets. It is an ever-evolving three-way dynamic matrix with each part mixed with the other. There is about $133 billion of shale debt and interest to be paid between 2020-2026. The longer the demand shock remains in the system, the more distress will be in the energy complex -- leading to more defaults. Sure, the Fed is backstopping everyone for now, but talking the talk and walking the walk are two different things.
This can lead to further dollar margin calls, adding to the aggressive dollar rally, as JPM calls it the $12 trillion margin call. If that is the case, there are too many unknown variables and we are nowhere close to finding a V-shaped, W-shaped, or even a slanting-shaped bottom (admittedly I made that one up).