10 Mar 2020

OPEC+: a broken cartel

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Thumb: OPEC+: a broken cartel
by Binay Chandgothia, CFA, Managing Director, Portfolio Manager and Head of Asia
Seema Shah, Chief Strategist

The global economy was regaining its pulse when COVID-19 hit global oil, creating both a demand and supply shock simultaneously and rocking the markets. Here's how it happened.

  • COVID-19 has impacted global oil demand adversely as the global economy was showing signs of recovering, putting the oil market in a surplus situation. There's little historic precedent for the industry experiencing both a demand and supply shock simultaneously.
  • OPEC+ and Russia met on March 6 to discuss output cuts in continuance of their price-defense strategy, in place since 2016. Going into the meeting, expectations were for additional cuts of 1.5 million barrels per day (mbpd), which would’ve taken total cuts to 3.6mbpd (~4% of global supply).
  • Saudi Arabia was the cut's biggest proponent, supported by most other OPEC members, while Russia seems to have opposed primarily because the move essentially handed over market share to United States shale oil producers. In addition, Russia wanted more time to assess the hit to demand from coronavirus.
  • The meeting ended without a formal communique. Reports indicate it became a clash of egos between Saudis and Russians, the latter not wanting to be seen as a junior partner.
  • Following the meeting, Saudi Arabia enacted large price cuts to Asian buyers and threatened to jack its production significantly higher, as it set itself on the market-share defense strategy, unravelling the oligopolistic alliance in place for the past four years.

An immediate market reaction

  • Markets, reeling under uncertainty thrust upon them by COVID-19, added the OPEC+ news to an existing wall of worries.
  • Oil prices began falling as markets prepared for a worst-case scenario—one that could see benchmark prices drop as low as $25/barrel.
  • This oil price shock comes at a time when market liquidity was already beginning to be compromised by both economic risk and fewer people on trading desks, exacerbating market moves.
  • Global equity markets suffered deep falls, safe-haven yields crashed yet again, the USD and JPY appreciated sharply, particularly against oil/commodity exporter currencies like the AUD, Norwegian krone, and Mexican peso.
  • Credit spreads have widened sharply, while the cost to protect U.S. investment grade debt against default surged by the most since the collapse of Lehman Brothers.

U.S. oil output has grown rapidly over the past decade
Oil output, millions of barrels per day
U.S. oil output has grown rapidly over the past decade
Source: Bloomberg, Principal Portfolio Solutions. Data as of February 29, 2020.

The medium-term impact on global asset markets

Down: oil prices
We're already seeing capitulation by sell-side energy analysts with several of them chopping their oil price estimates overnight. One is calling for Nymex crude oil prices in the range of $25-$30 a barrel, with a chance that we may even hit $20. Unless Russia capitulates or OPEC finds a quick fix (we understand its technical committee is scheduled to meet March 18 to review the situation), it could take a long time for prices to recover to healthier levels.

Down: global inflation
Global inflation is sure to take another leg down. Our lead indicator was suggesting weaker readings into 2020, but with oil and other commodity prices dipping sharply, the forward-looking path is almost certainly lower.

Advantage: global consumers
High oil prices are a transfer of wealth from consumers to a few producers. With prices dropping sharply, consumers, particularly in economies with large consumption pockets (India, China, most of Asia, the U.S., and Europe), will benefit.

Disadvantage: capex spending
At current oil price levels, many producers will be cash-flow negative and struggling to secure new lending, signaling a likely drop in oil-related capex spending. An immediate result would be the adverse impact to employment in areas that see the deepest cuts in oil production. Over the longer term, the washout of oil producers as they struggle to retain their footing will reduce supplies, providing a price support.

Disadvantage: oil producers
At a sovereign level, oil-producing countries dependent on surpluses will face challenges in meeting domestic spending requirements (Russia, OPEC countries, Mexico, Malaysia). The U.S., historically a big beneficiary of low oil prices, is likely to see shale output take a knock. Beneficiaries will be countries with large oil deficit accounts, such as India, China, and many Asian countries.

Pay attention to: credit spreads
As many oil producers face challenges to staying profitable and meeting debt obligations, segments of the credit market will be particularly negatively impacted. Energy comprises about 11.4% of the U.S. high yield market (ICE BOFAML Index), with a composite rating of B1. Credit spreads for the U.S. high yield sector had already widened significantly this year (1,099bps over Treasurys as of March 6, 2020), even before the overnight carnage in oil prices. For reference, the spread had widened to 1,650bps in Feb 2016 at the peak of a similar oil-bust episode. Unless prices recover quickly, spreads could widen further in coming weeks, pricing in a more severe cycle of downgrades/defaults.

Oil price slide pushes high yield spreads to their widest since mid-2016
High yield spread vs. Treasurys, bps
Oil price slide pushes high yield spreads to their widest since mid-2016
Source: Bloomberg, Principal Portfolio Solutions. Data as of February 29, 2020.

The possibility of a bear market in equities

  • The fear that's gripped markets could lead to a bear market in equities—and technically, some are already there. Several indices are already down 20% or more from their 52-week highs.
  • For the U.S., based on historical observations, high oil prices (not low) are an important condition for recessions. However, that historical link is complicated somewhat by the recent status of the U.S. as one of the world's largest oil producers. Furthermore, the high yield credit markets' exposure to the energy sector suggests that further spread-widening would be an additional tailwind to recessionary risk.
  • We'll be watching the reaction of credit markets to help determine if the current shocks will be simply transitory hits or something more durable. As a result, the role of economic policymakers will now be to prevent the supply and demand shocks from mutating into an insolvency shock.
  • Global coordinated policy action (both monetary and fiscal) is possible. Targeted liquidity measures by central banks are becoming more likely, aimed primarily at the corporate sector rather than the sovereign. On the fiscal side, beyond funding for COVID-19 testing and treatment, governments will be strongly considering aid to small and large businesses.
  • As a reminder, we were in similar territory in early 2016. At that time, global policymakers united against competitive currency depreciation and pledged strong fiscal and monetary support, enabling markets to find a way of bouncing back from a deflationary bust scenario.
  • The shedding of risk-on positions suggest technicals are becoming more favorable. However, the drastic deterioration in fundamentals implies that further cheapening may be required before risk assets become a compelling buy.
  • While these last few weeks have been painful for investors, it's worth remembering that the past few years of calm markets have been the exception to the rule, and volatility is normal. Powerful central bank and fiscal action over the coming weeks means that when the fear and nerves eventually subside, the fundamentals of the economic recovery that was just getting underway at the turn of the year should reassert themselves.


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