The markets have gone mad. An oil war between Russia and Saudi-Arabia, along with a full-blown pandemic, has fueled people into a panic selling that is on par with the crash of 1929, during the last few months. Volatility is rampant, and only time will tell where the world is headed in the long term.
The Saudi-Russian oil war
A few weeks ago Russia walked out of an OPEC meeting. This happened after the Saudis pushed for further production cuts in the oil market, from its fellow oil nations. Saudi-Arabia wanted oil producers to cut down to about one to 1,5 million barrels a day. Russia refused. And this made all hell break loose. The Saudis then opened up a lot more production, as a punishment against Russia.
The oil war and the Corona pandemic has sent the world into a chaos, that we could have hardly imagined just two months ago. And the uncertainty is big. Let’s try to find some clarity.
Saudi Aramco unleashed the floodgates
Saudi Aramco is an enormous state owned oil producer, in Saudi Arabia, and the world’s largest oil company. Aramco announced a few weeks ago, that they will produce 12,3 million barrels a day, by April. This is a substantial increase in global oil supply. And this sent the oil price down the toilets, in early March.
When the Saudis started to bump their chest and increase production it led the Russians to respond with production increases as well. Increasing global oil supplies substantially. This has now led to an oil war and a game of chicken where the statement from Russia seems to go something like this: “Yeah, you think that will hurt us? We can do that too you know. Now, let’s play”.
The Russians then stated that they could increase production up to 500 million barrels. And this further sent the oil price down tumbling.
The impact on the oil space
When the Saudis and the Russians increase oil supplies in this way, it leads to more oil on the market, which drives down oil prices globally. This hurts the competitors of Russia and Saudi-Arabia, within the oil space, more than it hurts Ryiadh and Moscow themselves.
The countries that are hit the hardest are the ones which are major oil exporters, but which have high production costs. For example, the United States and Norway. Although this is only partially true. Since the United States benefits from its reserve currency status, the global Petrodollar-system and now has a very diversified and robust economy in other areas. For example, technology.
Game theory
From the standpoint of Moscow and Ryiadh it is a stroke of genius to unleash these production increases during a pandemic. Because the two countries have lower costs, compared to many other countries. Therefore, other countries will get hit harder by this oil war. For example, Iran is getting hit hard now, according to oil-experts.
Sunset over the Kremlin, in Moscow. The Russian market has been hit hard by the falling oil price. But the country can sustain a drop better than other oil producing countries. Because the country is self-sufficient, has large reserves and a state owned debt that is among the lowest in the world. The impact of the Corona virus has also been smaller on Russia.
The Corona virus and its impact on commodities
The effect of the Corona virus on the economy in the long run is veiled in uncertainty. But if we know one thing for certain, it is that Wall Street hates uncertainty. And because of the Corona virus many countries will utilize commodities to a much lesser extent. Which means that the oil war is not the only thing that is going to weigh down the oil price.
The economic shutdown will perpetuate the fall in oil prices. For example, Chinese demand is a substantial amount of world demand and without it the price is going to plummet. Also, if the shutdown of the economy continues for a longer time, than first expected, it will impact other commodities as well. For example, copper, iron ore and uranium. Natural gas has already been hit hard, along with oil.
Black Monday dripping with oil
On March ninth, 2020, the Dow had its biggest drop since the great Wall Street crash of 1929, “Black tuesday”. It fell over 2000 points. From its high, on February 12, the Dow fell 19,3 percent until March 9. And on the following Thursday the Dow entered bear market territory.
This ended the 11-year bull run that began in 2009, according to several analysts. For example, Goldman Sachs and a few other large banks.
China
The Corona virus originated in China. And when this economic powerhouse, which now constitutes close to 18 percent of global GDP, had to shut down entire cities and a large part of its economy, the world was warned that this was not “just the flu”.
The Chinese stock market has been holding up relatively well though, both during the oil crash and the following Corona crash. Looking at the Shanghai composite we can see that it has not fallen very much. Even though the U.S. stock market has been having daily swings of more than ten percent lately.
Russia
To withstand the pain of a lower oil price the Russians have amassed large reserves in recent years. These reserves are estimated to keep the Russian economy above water for more than ten years, even if the oil price hovers between 25 and 30 dollars. Russia restructured its economy after the oil price crash, in 2014, and the sanctions imposed on it over the Crimea situation. And because of this it is now in a better position to withstand economic pain, than many other oil producing economies. Only time will tell if Russia can withstand an oil price between ten and 20 dollars, for a prolonged period of time, if it were to go that low.
The United States
The shale boom in the United States, in the last decade, have turned the United States from a major oil importer to a powerhouse of oil production, and a net exporting oil country. But the producing companies have higher production costs than their Russian and Saudi counterparts. They also have higher debts. Which means that a lower oil price could hurt them badly over the long run.
A prolonged period of low oil prices could even blow up the entire U.S. debt market, according to some analysts. But the shale industry in the U.S. have proven resilient in the past. And the dollar also enjoys the status of global reserve currency. Only time will tell which countries will be hit the hardest by this crisis. But one thing is certain. The world will not be the same when all the smoke has cleared.
Buying opportunity or a falling knife?
A long known strategy among traders is to buy transportation companies when oil prices are low, and sell them when oil prices are high. But if this is the time to buy airlines, railroads and other transport companies remains to be seen. When looking at the extreme momentum of the sell off in march, I am cautious to buy the market here. Because I don’t want to catch a falling knife and there is potential for more downside here.
Cash is king
As I’ve written about earlier the momentum of this sell-off was even greater than in the financial crisis of 2008. Therefore caution is advised in this environment. Because the market might fall even lower. These times show the value of having cash ready to be deployed more than ever. Even though the market goes up again or crashes more from this point, the value of having cash at hands cannot be understated. When the buying opportunity comes I know I want to be ready.
Negative oil prices?
According to game theorists the oil price could actually turn negative. Because in earlier price shocks, like the one in 2014, the low oil price spurred new demand for oil. But in this crisis that won’t happen. Because the low demand is a result of the corona-virus, and that could even send the price lower from this point on.
An even lower oil price would give Russia and Saudi-Arabia the chance to test global storage limits, according to oil-analysts. Because they have the lowest costs of the oil producing countries. Further, when global storage capacity is maxed out the oil price could actually turn negative. And this would hurt high cost producers immensely.
Conclusion
Right now the markets are in chaos. And it is hard to know exactly how severe this market crash is going to be, and what its long term consequences will be. But when all the smoke has cleared we will be in a better position to evaluate what is happening right now. Therefore it is probably wise to be cautious and to keep a cool head in this chaos. Because chaos creates resilience and strength, and above all, opportunity.
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