What You Should Know about the Other Shock: Oil Prices

The outbreak of Covid-19 continues to be the major disruptive force, impacting households, investors, businesses, and policymakers.  The virus hits vulnerable individuals and institutions.  Monetary policy, and in some places, including Italy, fiscal policy will be deployed too.  The handling of the crisis could shape both Chairman Xi and President Trump's political futures.  

The coronavirus is disrupting supply and demand.  The near shutdown of the world's second-largest economy and the downgrade of global growth prospects lowered the anticipated demand for oil.  It exposed an underlying problem of coordination among the OPEC and its allies (OPEC+), especially Russia.  An agreement was struck among 20 countries to reduce output by 2.1 mln barrels per day.  The deal expires at the end of this month.  Russia was believed to have been violating its agreement, and most of the cuts were borne by the Saudis. 

The Saudis seemed to overplay their hand last week and failed to roll over the old agreement, let alone get secure a deal that would have support oil prices going forward.   By tieing an agreement to the Russian participation, which was always questionable, Saudi Arabia deferred the initiative to Moscow.  There has been a regime change of sorts in Riyadh.  The Crown Prince Mohammad bin Salman, who seems to be in yet another effort to enforce loyalty within the extended royal household, and Energy Minister Khalid Al-Falih, are both relative novices in the game of great powers. 

In 2014, the challenge of supply was posed by US shale producers.  Now the underlying supply problem has been exacerbated with a demand shock stemming from Covid-19.  Saudi Arabia is ambivalent.  Its instincts and traditional modus operandi are for production cuts, of which as the largest OPEC producer bears the bulk of adjustment.  However, the new leadership seems particularly sensitive to the fact that there is a free-rider problem.  Most of OPEC continues to produce near capacity, and non-OPEC countries have been consistently complying with the existing agreement, even after Russia got exceptions for its condensate.  

The governance failure at OPEC+ means starting April 1, countries are free to produce at will.  The Saudis produced about 9.7 mln bpd in February, and officials claim it can produce as much as 12.5 mln bpd.  Outside observes suspect near-term capacity is probably limited to around 11 mln bpd.  Besides it, the other two that could increase output would be the UAE and Russia, and that appears limited to about 100k bpd on top of current production.   

In 2014, as the Saudis struggled to regain control/influence over the oil market, US shale producers proved amazingly resilient.  The shale revolution was facilitated by three factors, innovation, cheap credit, and a certain attitude about the environment.  The fracking, horizontal drilling, and other technical developments made possible getting oil out of rocks instead of practically sticking a straw in the ground in Saudi Arabia.  

Access to cheap credit was also critical.  It appeared that banks and other investors for willing to fund operations not based on the creditworthiness of the borrower, but on the value of the collateral, which is similar to what financial institutions did in housing previously.  US shale production is capital intensive, and debt servicing made for high fixed costs.  Even before the latest shocks, shale producers were struggling.  Estimates suggest that in 2019, there were 42 failures on $26 bln, twice the dollar hit as in 2018.  

Not everyone with shale formations is willing to make the environmental trade-off.  New York, for example, prohibits fracking, on such grounds.  A different calculation of the trade-off is necessary for the capability (formations and funds) to be realized.  

Putin may be clever than the new generation of Saudi leaders or maybe just luckier.  The Saudi-led attempt to dislodge the American producers in 2014 proved for naught, but maybe the try in 2020 will be more successful.  US shale explosion is slowing.  The Energy Information Agency expects US crude output to rise by about 300k to 13.2 mln bpd. The entire increase is from the Permian Basin. Several large producers have announced lay-offs.  Baker-Hughes oil rig count as of March 6 stood at 682, which is almost 20% less than a year ago.  The EIA estimates that drilled but uncompleted wells have fallen by about 10% as companies seek to defer drilling costs, which are nearly a third the total for a fracked well.  

It appears shale productivity may be slipping.  As fields mature, competing wells are too close to each other, according to reports.  Fracking often produced steep falls in output quickly, but it appears to be happening faster than many companies anticipated. That means that new production is necessary to replace the old to the tune of about 1.5 mln bpd, according to some estimates.  Investors do not seem to be getting returns they expected.  

The past three US recessions (1991, 2001, and 2008) were preceded by significant rallies in crude oil prices (~135%, 200%, and 100%, respectively).  It is possible, with the US becoming a net oil and gas exporter, and the important role of shale in US capital expenditures and growth over the past decade has changed the dynamics.  The past and future drop in oil prices accelerate the consolidation in the industry through failures and acquisitions, which over the medium-term may make the sector more resilient in the next cycle. 

Different market measures of inflation expectations closely linked to oil prices.  The precipitous decline will weigh on headline measures of inflation and will hamper monetary officials' efforts to reach inflation targets.  Although most of the decline in US Treasury yields can be accounted for by the dramatic swing in expectations of overnight money (i.e., Fed policy), the decline in inflation and inflation expectations exert downward pressure on yields.   

Since oil is mostly traded in dollars, a sharp decline in oil prices is thought to weigh on the dollar.  However, this factor should not be exaggerated.  Oil is a small part of the dollar-trade in goods and services and accounts for a small part of the demand for dollars, which is on one side of around 90% of the trades in the $6.6 trillion-a-day foreign exchange market. 

A sharp decline in oil prices leads to s transfer from producers to consumers.  China is the largest importer of crude, and its recent trade figures suggest oil and gas imports rose in the January-February period even though overall imports slipped.  However, refineries reportedly are reducing their demand, and storage facilities are being filled.  East Asia as a whole is a large oil importer, while several countries in Latam (e.g., Mexico, Colombia, and Brazil) are producers.   The Russian ruble is one of the most sensitive currencies to oil prices.  The correlation of the percentage change of the ruble and the percentage change of oil over the past 60 days is around 0.5, near the most over the last couple of years.  Among the major currencies, the Canadian dollar and Norwegian krone are often the most sensitive to the price of oil.  

Disclaimer