Why Is There an Oil Price War?

Over the last several months, OPEC representatives led by Saudi Arabia have been negotiating with Russia for an agreement to cut back on production from all oil and natural gas suppliers. The idea was that this would keep prices up even as global demand fell due to the coronavirus’s effects on the global economy and on China in particular. Russia never budged. In the end, Saudi Arabia refused to cut back its own production and rather decided to ramp up production while cutting prices in an attempt to cut into Russia’s share of the oil market. Neither nation is in a particularly strong economic position these days which makes the Russian foot-dragging and Saudi decision to cut prices an economic game of “chicken.”

How Can You Benefit from the Oil Price War?

As an investor, what can you do? Oil and natural gas companies with strong economic reserves will survive, making this a good time to buy for the long term. Getting out of companies with weak balance sheets, even at a loss, may be what you need to do to avoid further investing “bloodshed” as the virus, price war, and economic downturn play out.

Vox has a few useful ideas about companies benefiting from the coronavirus.

Predicting what people will do as more and more “lock downs” occur across the world or people simply avoid going out and mixing with crowds much as possible. Netflix stock has fallen a few percent, but the stock is trading at what it sold for a year ago and substantially above last fall. The point is that that when people stay at home they get bored and having entertainment will make time go faster. Netflix and similar streaming services may do OK.

Clorox is on a tear. It is trading at an all-time high as everyone is stocking up on cleansers in advance of the arrival of the virus in their area. Companies that sell soap and cleaners, like P&G, are good ideas. P&G has slipped a bit but is now trading at its price for last July.

Even Campbell’s is doing well as people stock up on food that will last (like canned soup) during a prolonged, enforced quarantine. Campbell Soup Company is off a few percent today as we write this, but it is up about 15% since a couple of months ago and more like 60% from last year!

Sitting on Cash and Buying Later

Last August we wrote about the silent warning for investors from Warren Buffett who was accumulating cash and not buying much. His rationale was that stocks were universally overpriced and nothing met his criteria for intrinsic stock value and other reasons for investing in stock.

If you have some cash on hand, it might be an excellent time to sit on it for now as you watch for opportunities in companies with good long term potential but which are being taken down in the current rush to sell.

“Oil down in the $38 range is the bulk of what you see equity-market weakness from,” said Michael Antonelli, equity sales trader at Robert W. Baird.”You’ve seen a lot of people over the last three or four months looking for a low in energy, but it just remains elusive.”

New oil from new oil fields can be cheap to pump and oil from older fields or from fracking is expensive. There may come a point where some oil will become too expensive to pump as the price of crude falls.

Cost of Oil Production by Country

The Knoema web site has useful graphics showing the cost of oil production by country. It makes the point that some nations will find it too expensive to find new oil and bring new wells on line and some will simply need to shut down expensive operations.

The oil price has fallen by more than 30% since Summer 2014. This affected everyone from producers to consumers. The visualization represents Oil Price Dynamics, Breakeven Oil Price which shows oil prices needed to meet general government expenditure and Marginal Cost of Oil Production which shows the change in total cost of producing one additional barrel of oil.
World oil price at $55-$60 / barrel exceeds the cost of Russian Arctic oil production, Europe and Brazil biofuels production, shale and tight oil production in US and Canada and offshore oil extraction in Brazil.

State budgets of oil-producing countries will suffer from oil price decrease if the market price falls below breakeven price. In Dec. 2014 world oil prices fell lower than necessary for almost all oil exporters in order to balance their government expenditures.

It became too expensive for many countries to produce oil in the Russian Arctic and offshore Brazil when oil fell to the $55 range. Today West Texas intermediate crude oil futures fell to $37.59 per barrel. How low can oil prices go? Demand will have to go up or large numbers of oil producers will need to cap their wells.

The World Economy and Especially China

Seeking Alpha writes about the Chinese debt snowball gaining momentum. If oil producers are waiting for a strong rebound of the Chinese economy to drive prices up they may have a long time to wait.

Financial crises can happen quickly, like the bursting of the tech stock bubble in early 2000, or slowly, like the late-1980s junk bond bust. The shape of the crash depends mostly on the asset in question: Equities can plunge literally overnight, while bonds and bank loans can take a while to reach critical mass.

China’s bursting bubble is of the second type. During its post-2009 infrastructure binge, trillions of dollars were lent to (way too many) producers of cement, steel, chemicals and other basic industrial inputs. And now a growing number of them can’t make their payments:

It’s a safe bet that China, following the developed world’s lead, will soon toss a big chunk of its foreign exchange reserves at the problem. When this fails, the next steps include QE and negative interest rates, which take money from savers and retirees and give it to banks, again with the hope of moving the inevitable crash to some later date. The result? An even more highly-leveraged world and Potemkin markets that look real but no longer are.

If the China situation is as bad as these folks think the global economy will shrink farther. Low can oil prices go? Saudi Arabia can pump a barrel of oil for about $20 each. That is about half of today’s low price!

How Low Can Oil Prices Go? PPT

In October of 2014, Saudi Arabia signaled that it was willing to let oil prices fall and no longer cut production to support higher prices. Since that time Saudi Arabia has spent nearly $50 billion of its foreign reserves to keep its domestic social contract going in the face of diminishing oil revenues.

The oil kingdom has put its money where its mouth is in an effort to protect market share and get both OPEC and non-OPEC members to limit oil production. So what has Saudi Arabia’s $50 billion bought? Saudi Arabia’s policy together with a flood of oil supply and slow global economic growth drove down the price of Brent crude oil from $115 a barrel in June 2014 to as low as about $45 a barrel in January. But the price of oil came roaring back in April, staging its biggest monthly gain in six years, and is now trading above $66 a barrel.

The low price of oil is hurting US producers more than the Saudis because Saudi Arabia spends a lot less to produce a barrel of oil than fracking operations in the Bakken formation of North Dakota. Oil producers such as Russia and Venezuela are begging for a production cut in order to drive prices back up. But decreased global demand coupled with the Saudis wanting to maintain their customer base make this unlikely. The wild card in this situation may be Saudi cash reserves and how far they are willing to spend down.

Saudi Arabia has some $708 billion of foreign oil reserves left to wage its oil war. The country’s new king, Salman bin Adbulaziz Al Saud, is dealing with a budget deficit of at least $40 billion this year – The Financial Times said it could reach $100 billion. Sub-$70 oil does not appear to be sustainable for Saudi Arabia, but for now it seems willing to keep spending its cash in an attempt to assert its will on global oil markets.

Iraq Production Recovers

As bad as things are in Iraq with the ISIS, Iraqi exports are up. Reuters reports that Iraq exports have hit a record high. This is another country that can produce a barrel of crude for substantially less than drillers in the USA.

Oil prices eased off 2015 highs on Friday after Iraq said its crude oil exports hit a record in April, and as the dollar strengthened.

Brent and U.S. crude rallied between 20 and 25 percent in April, helped by a weaker dollar and bets that a global supply glut would ease, following the June-to-January sell-off that halved prices from above $100 a barrel.

Friday’s pullback was sparked first by news that Iraq’s oil exports rose in April to a record 3.08 million barrels per day (bpd) from 2.98 million bpd in March, which served as a reminder of ample supply in the market.

OPEC supply in April rose to its highest in more than two years at 31.04 million bpd, according to a Reuters survey.

Saudi cash reserves may continue to fall if they insist on maintaining production quotas while more cheap oil from the likes of Iraq and Iran come on the market.

Lower Prices

The price of oil was inching up in April until Iraqi production peaked and global demand failed to strengthen. The Wall Street Journal notes how oil slips in price.

Oil prices retreated from 2015 highs Friday as traders assessed the recent strong rally and the still-oversupplied global crude market.

Light, sweet crude for June delivery recently traded down 78 cents, or 1.3%, to $58.85 a barrel on the New York Mercantile Exchange. Prices had soared 25% in April, settling Thursday at the highest price since Dec. 11.

Brent crude, the global benchmark, recently fell 64 cents, or 1%, to $66.14 a barrel on ICE Futures Europe. The contract had gained 21% in April.

Saudi cash reserves are likely to continue to fall if they insist on maintaining production to produce a global glut and in an effort to maintain their market share in light of weakening demand.

Saudi Cash Reserves and the Price of Oil PPT