Oil War: How to Add Insult to Injury

As the coronavirus outbreak sweeps across the globe, we expect economic activity over the coming months to weaken. While I’m not an epidemiologist, many signs point to the virus spreading further before it is contained. It’s too early to tell how much of an economic impact the virus will have, but it is potentially the negative shock that we have been planning for. To add insult to injury, the development on Sunday (3/8/2020) that the oil market is now in a full-blown price war could be a second negative shock to the system.

What Happened

Over the past two months weakening global growth expectations began impacting the oil market. These new weaker growth expectations lowered oil demand by about 2.5 million barrels a day. As such, OPEC discussed instituting production cuts in response. After great debate, OPEC was unable to come to an agreement; Russia was the main dissenter. In response, Saudi Arabia, the world’s lowest-cost producer, instituted a $6-8/barrel price cut and announced they would ramp up production by up to 2 million barrels a day. Instantly, the energy market dynamics changed; it is now an all-out battle to gain market share.

Saudi Arabia’s decision to compete for market share, instead of trying to stabilize prices, sent shockwaves throughout the world. Overnight crude oil prices dropped roughly 30% in response, the largest single-day decline since the 1991 Gulf War. With crude oil prices in the low-$30/barrel range, energy companies now have a difficult reality. Their assets are not worth what they used to be. More importantly, their cash flow going forward will be lower.

What This Means

A lot has changed since the last time energy prices were this low (the 2014-2016 decline), but some things have stayed the same. In good news, the energy sector only accounts for roughly 3% of the S&P 500 versus over 10% in 2014. As such, the energy price fallout impacted S&P 500 earnings much more in 2014-2016 than today. 

In not so good news, the energy industry is still a large contributor to U.S. economic growth. Up until the last decade, lower oil prices were a benefit to the U.S. As a large net importer of oil, lower prices were great for consumers and the negative impact on business was small. That dynamic changed over the past decade as the shale boom ignited, which we detailed in our 2014 Energy Brief. Now, the United States is the world’s largest producer of oil. The short-term negative impact on the energy industry from a quick and dramatic drop in the price of oil outweighs the benefit to consumers. 

What is Next

It is not too late for OPEC to come to a production cut agreement. The pain inflicted by Saudi Arabia could be what is needed to get an agreement. If so, prices could rebound as quickly as they fell. However, after years of struggles, OPEC has lost some of its luster. Saudi Arabia may be willing to take some short-term pain to send a longer-term message to its competitors. It will be interesting to watch how the situation unfolds.

Either way, the current impact on U.S. energy companies is real. Oil prices are below widely known breakeven levels. New drilling projects will be scrapped or put on hold indefinitely. More importantly, producers will be forced to decide if they should keep producing from the wells already in operation. I wouldn’t expect any quick reaction to the news, but this will play out over the weeks and months to come. The longer this price war lasts, the more production will be shut down. 

Consequently, if oil prices stay here or go lower, we expect there will be layoffs in the energy sector. We also expect there will be bankruptcies. This is clearly evident in the sell-off of energy-related debt following the price drop. Corporate cash flow will be under scrutiny, which means as revenues decline, expenses (and investment) will come down as well.  

Outside the energy industry there will be some pain. The energy price decline of 2014-2016 is a good example to reference. As prices hit sub-$30/barrel the economic impact spread past the energy sector into the rest of the economy. In 2015, economic growth was strong enough to absorb the weakness. This time could be different. 

Three Strikes and You’re Out

To borrow a baseball analogy, the U.S. economy now has two strikes. The developing coronavirus outbreak was the first strike. An oil price war is the second strike. One more strike and we risk striking out. Will we see the third strike?

All eyes are on the consumer, the current strength of the economy. If consumers hold their ground, then the economy can get through this slow patch. On the other hand, any consumer weakness would be a signal to the Allegiant Investment Research Team that this may lead to the next recession. Fortunately, we have not identified any evidence that the consumer is rolling over. As data continues to trickle in, the Investment Research Team will continue to provide updates.

Benjamin W. Jones, CFP®, AIF®
CERTIFIED FINANCIAL PLANNER™️
President, Chief Investment Officer, Principal