How The Oil Crisis Affects You

It’s hard to overstate the nature of what has happened in the oil markets since the beginning of the coronavirus (COVID-19) outbreak in early January. At that time, supply and demand looked fairly balanced. OPEC and its partners (primarily Russia) were taking action to make sure that balance was maintained.

But we have just experienced the fastest and most dramatic change in oil market conditions that I have ever seen in my long career.

It started to become apparent to me early on, given China’s initially insufficient response, that coronavirus could spell the end of our bull stock market. There were shutdowns due to the virus clobbered manufacturing, transportation and leisure travel, to name just a few industries. Restaurants began to empty. Airline flights were cancelled.

Global recession is now more likely. And last week, crude oil suffered a double whammy. Oil is the most important commodity in the world. When the energy sector suffers, the pain spreads throughout the financial markets as a whole.

Oil Demand Collapses

First came news from the IHS Markit Crude Oil Market Service that Q1 2020 world oil demand will decline by 3.8 million barrels per day (bod) from a year earlier. This will represent the largest quarterly demand decline ever reported. That’s what black swans do. They come out of nowhere and lead to significant consequences.

Read This Story: Oilmegeddon: The Shockwaves of Crude’s Crisis

So that’s one thing that has changed in the past two months in the oil market. But there was another.

OPEC and its coalition had been managing production in response to growing U.S. shale oil output. But as oil demand collapsed in February, OPEC had asked for deeper cuts. This time Russia resisted.

It was expected that Russia would evaluate the situation and then agree to deeper cuts when OPEC met in March. Well, that meeting took place last week, and to nearly everyone’s surprise, Russia again said that it wouldn’t further cut production.

Oil prices plunged by nearly 10% following this surprise move from Russia. Analysts expected Russia to go along with the plan, because the alternative seemed much worse. So what exactly are the Russians thinking?

Deja Vu

Let’s rewind back to 2014, when OPEC initially declared war on U.S. shale oil producers. Oil prices had begun to weaken as shale oil production continued to expand, so OPEC decided it needed to act to protect market share. A price war ensued that dropped oil prices all the way into the $20s. At that time I noted that the decision would probably cost OPEC a trillion dollars or more (and it likely did).

While low prices forced some shale producers into bankruptcy, most demonstrated more resilience than OPEC had expected. Two years later, OPEC waved the white flag and returned to the strategy of making production cuts to support prices.

The downside of this strategy for them was that, while these production cuts do help support oil prices, they also keep U.S. shale oil producers in business. Shale production in the U.S. kept expanding. This put OPEC in the cycle of having to cut production again and again as shale production kept climbing. Many OPEC members deemed this unfair, but they had already experienced the alternative and it was worse.

From Russia’s point of view, all this strategy was doing was propping up U.S. oil producers at the expense of everyone else. The only way this strategy would ultimately work would be for OPEC and its partners to keep cutting until U.S. shale oil production began to decline. Their hope was that this happened sooner rather than later, but in the interim OPEC production fell to a 17-year low.

Coronavirus Changes the Equation

But the global coronavirus outbreak has forced the issue. Now, instead of having to deal with the addition of another million bpd of U.S. shale every year, suddenly they had to cope with millions of barrels of excess oil on the market as demand collapsed in response to the coronavirus outbreak.

Russia has decided to reattempt the 2014 strategy of defending market share. Saudi Arabia, in response to Russia’s decision, made the biggest cuts to the price of its crude oil in more than 30 years. Aramco shares, in turn, fell below their initial public offering (IPO) price for the first time.

I wrote last month that oil prices could fall much further without Russia’s cooperation in making additional cuts. Now that it is clear that this is the path forward, we are entering an extremely painful period for oil producers everywhere. Oil prices will collapse (in fact, they plunged 30% just a few hours after I wrote those words). Oil producers will go bankrupt. Governments will drain budgets in oil-exporting countries.

Advice for Investors

It is likely, in my view, that the endpoint will be similar to the last time this strategy was attempted. Oil prices could dip all the way into the $20s (again, that happened a few hours after I wrote those words). Russia will probably eventually decide that the pain is too great, and come back to the table. In the interim, many shale oil producers will be forced out of business.

What should investors do in the interim? It may be instructive to review what happened in 2014 and 2015 as oil prices collapsed. The hardest hit will be shale oil producers, especially those with a lot of debt. There will be a wave of bankruptcies.

However, ConocoPhillips (NYSE: COP), which I have previously recommended, isn’t primarily a shale oil producer. The company has retooled to break even at $40 oil. The company can sustain low prices longer than other producers. COP will be one of the last companies standing, but it will take a hard hit from lower oil prices.

Pipeline companies, especially master limited partnerships (MLPs), were in a bubble in 2014. Their values collapsed along with oil prices, but the underlying fundamentals got stronger for those that weren’t highly leveraged.

In fact, MLPs like Enterprise Products Partners (NYSE: EPD) actually increased their distributions throughout the oil price collapse. It will take a long bear market before the strongest MLPs have to think about cutting distributions.

Refiners, on the other hand, fared well when prices collapsed. They make their money on the price differential between crude oil and finished products. They often make their biggest profits when oil prices are falling. That’s what we saw in 2015, when Valero (NYSE: VLO) returned 43% as other energy companies were plummeting. Conditions are somewhat different today with demand collapsing, but refiners should be in a better overall position than oil producers.

The large integrated companies will not escape this unscathed. There is more downside risk for them. However, they have sufficiently deep pockets to survive the challenging times ahead. Many of the oil supermajors have gone decades without cutting dividends, despite enduring a number of challenging oil markets.

The bottom line, however, is that we just don’t know how bad this is going to get. The oil markets are certainly not alone in rapidly shedding market capitalization. The drop in the S&P 500 last week was the fastest since the 1987 market crash. That should have the attention of investors.

If you have cash on the sidelines, I would move it into this market slowly, and I would favor defensive stocks. It seems likely to me that the worst is still to come.

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