Oil prices collapsed in early March due to the price war between the Organization of the Petroleum Exporting Countries (OPEC), led by Saudi Arabia, and Russia. Saudi Arabia had threatened to raise output by over 2 million barrels per day (bpd) to 12.3 million bpd. Russia retaliated in kind, threatening to increase their output.
Saudi Arabia and Russia have since been locked in a war of words on the next steps. Saudi Arabia has called on a meeting of major oil producers around the world to discuss curbing output. This meeting, originally scheduled for April 6, has been pushed back to April 9. Meanwhile, President Trump has been leaning on both sides to reduce excess supply and restore order in the energy market. The U.S. and Canada have reportedly looked into imposing tariffs on Saudi Arabian oil exports to North America in order to pressure Riyadh to give up the price war. Washington may also put further pressure on Saudi Arabia via their military connections.
It is possible for Saudi Arabia and Russia to keep up their rhetoric in the weeks, and perhaps months, ahead. Their costs of production are amongst the lowest in the world. However, this is not a sustainable situation as oil revenue is a crucial source of their government income. Hence, they would eventually need to restore oil prices to a higher level in the medium term. The bottom right hand chart of Exhibit 1 on the next page shows the fiscal breakeven cost of oil prices for various oil producing countries. This shows that there is always the incentive for both sides to reach an agreement at some point. The challenge is that they have the luxury of months to stay locked in this stalemate. Energy companies, especially in the U.S., do not.
EXHIBIT 1: Oil: Short-term Market Dynamics
Even if the two sides can reach a deal in the near term and there is a global coordinated effort to reduce production, the question is whether this cutback will be deep enough to restore balance in the global oil market. Oil demand is expected to take a hit. During the 2008/09 global financial crisis (GFC), oil consumption fell by 1.5%, or 1.3 million bpd, between 2007 and 2009. We have already observed that the immediate economic impact from lockdown, social distancing policies and border closure is greater than the GFC. This implies that a near term demand drop is likely to be significant and the duration of the pandemic will determine the extent of demand cutback in the energy market.
Overall, a compromise to remove output increases threatened in early March would help to set a floor in oil prices, for instance at around USD 30-35 per barrel (pb). For oil prices to recover to a more sustainable USD 50-60pb, oil producing countries will need to offer more aggressive cuts, or the global economy will need to recover from the pandemic.
Oil prices are likely to remain depressed by weak demand in the near term. There are three asset classes that investors should pay attention to.
U.S. high yield corporate debt has already seen a considerable spread-widening and the energy sub-index has seen its spread-to-worst widen to above 2,100 basis points. This has resulted in a year-to-date return of -43%. While crude oil price is only one of many factors driving energy companies’ debt sustainability, government policies to protect energy producers could attract bargain hunters. Stocks of energy companies have also been an underperformer. Their earnings outlook remains under challenge due to weaker demand, even if oil prices stabilize. It is also worth paying attention to their dividend pay-out, since some investors are attracted by return from dividends. Lower oil prices may pressure investors to reassess their dividend strategy.
Finally, lower energy prices should benefit oil importing emerging market economies, while challenging exporters. Most Asian economies, with the exception of Malaysia, are net importers of oil. Hence, cheaper oil will help to improve their balance of payments position. In contrast, the Middle East and some economies in Latin America and Africa will come under more pressure from lower energy prices. Their currencies could be vulnerable to depreciation and this could translate to spread-widening in their hard currency debt.