an ugly day: coronavirus + oil

oil

In normal times, the world produces about 100 million barrels of oil daily and consumes about the same amount.  Small changes in either supply or demand can cause huge changes in price.  That’s because demand–autos, jet fuel, heating oil…is relatively inflexible (if seasonal).  Supply is also inflexible, because a cartel of suppliers, led by Saudi Arabia has been able to control output levels.  Their goal:  highest price possible without encouraging substitution.

A problem has surfaced, however.  A mild winter + reduced demand from airlines have combined to cause a potential supply overhang.  Negotiations between Saudi Arabia and Russia about production cuts to offset this and keep prices high broke down.  Not only that, but the Saudis have apparently decided to punish Russia (and themselves) by starting to sell large amounts of oil at about $30 a barrel, or $10 a barrel below Friday’s price.

Implications:

–the consensus view is that Saudi Arabia, radically dependent on oil exports, needs a price of $80+ to balance its budget; Russia, smaller and economically much weaker, needs $40+.  So both are it trouble.  Riyadh’s calculation must be that Moscow will soon feel the pain more quickly and will agree to production cuts

–a $30 price has two bad consequences for oil production companies in the US and elsewhere.  The lower price reduces revenues and profits.  This is an acute problem for some US shale companies, which have borrowed heavily in the junk bond market.  In addition, a standard way of evaluating natural resource companies is to compare the stock price with the per share value of the reserves they hold.  The price fall not only reduces the value of those reserves but also shrinks the amount, since some oil that’s viable at $40 becomes economically unfeasible to drill for at $30.

–if oil companies make up 4% of the S&P 500 and we say that they have lost a third of their value over the weekend, then the S&P should open 1.2% lower because of that.  Add in banks that will be in trouble and maybe that figure drops to down 2%.  Conceptually offsetting that would be the benefit to oil consumers of lower prices.  But that’s a diffuse group that is typically overlooked in a market downdraft   …and in this case prime beneficiaries like transport companies are being hit by coronavirus fears.

–as I’m writing, the S&P 500 is trading down about 5% in the premarket.  So the other 3% must be due to other factors–presumably coronavirus fears.  Those, in turn, break out, I think, into two factors:  the virus itself and the efforts of the Trump administration to prevent disease preparedness, information exchange and treatment.  To my mind, the last is the scariest part.

–if we were to posit no AI involvement in the premarket decline, this would look to me like the start of an old-fashioned selling panic.  In an AI-driven world, however, it’s not clear that that the idea of a cathartic release of pent-up fear setting the emotional stage for the next upswing still holds water.

All in all, for almost everyone a day to turn off the screen and go out in the sunshine.