Oil Price War — Price Support Vanishes

On top of reduced energy demand resulting from the coronavirus epidemic, further upset arose this weekend when an oil price war began between Russia and Saudi Arabia. Until this price war began, both OPEC—led by Saudi Arabia — and OPEC+ — led by Russia attempted to manage oil prices by cutting production. This agreement broke down between the two groups.

Russia Punishing Shale Producers — U.S. Government

In part, Russia seeks to reduce U.S. oil and gas production by pushing weak U.S. shale producers out of business. Important to this effort, it seeks to punish the United States government for sanctions against various Russians businesses and individuals. If U.S. shale production declines, besides oil, it will also reduce natural gas production. Sometime next year, U.S. natural gas prices would likely escalate as a result.

Saudi — Low-Cost Producer of Oil — High-Cost Government Subsidies

With an excess oil capacity of nearly 20%, Saudi Arabia will likely increase oil production close to 2 million barrels to do battle in this war. Saudi Arabia's marginal production costs represent among the lowest of any producer—estimated below $10/barrel. That marginal cost does not represent the oil price Saudi Arabia truly needs. In reality, to support government spending, the Kingdom needs at least $80/barrel. The government, in various forms, employs roughly 70% of Saudi nationals. In addition, plans by the Kingdom to “deoil” its economy over the next decade will require significant investment spending. In our view, that pressure will come to bear on the Saudis during this price war. No doubt, if the price war continued for an extended period of time, not anticipated, political instability would seem likely. As a side note, Iran faces particular difficulties with the collapse of oil prices on top of U.S. sanctions.

E&P Companies — “Staggering Level of Debt”

In the United States, quoting Moody’s— “North American exploration and production companies have a staggering level of debt maturing over the next five years.” In their comments, Moody’s points out that 62% of the total E&P debt coming due by 2024 arises from speculative-grade E&P companies. With that as background, a rising number of bankruptcies in this industry seems to be a growing probability. Such financial distress creates opportunities for acquisitions by more creditworthy producers.

Low Oil Prices — High-Cost Producers Disappear—Oil Prices Then Slowly Recover

The initial period of cratering oil prices, as is true in most commodity markets, creates the basis for higher prices — of course, with time. In the short run, sharply declining oil prices will force high-cost producers to shut capacity and, in some cases, go out of business. It will also reduce investments in new capacity — a major negative for the U.S. economy. With these industry adjustments reducing supply, observers expect to see improving oil prices sometime early next year and reaching into the $50/barrel range by the second half of 2021.

Lower Oil Prices — Consumers Benefit

This difficult period for oil will lead to lower gasoline prices. In effect, this becomes a form of a quasi-fiscal stimulus for consumers. In particular, low-income consumers will benefit since they likely own less efficient older cars. Low-income consumers tend to be the income category most likely to spend each incremental dollar of income.

Investment Conclusions

The unsettled environment from both the coronavirus epidemic and the oil war, in our view, calls for a more selective approach. Rather than using broad-based ETFs, clearer investment judgments can result by limiting decisions to selected sectors and companies. Employ such selected investments within our recommended asset mix, which continues to be 40% equities, 35% alternatives, and 25% fixed income.

We continue to look to fixed-income investments primarily for capital preservation. Therefore, use shorter duration credits to meet that goal.

Overall, very accommodative monetary policies over the last decade encouraged increased borrowings by speculative credits. Therefore, balance sheet strength should prove key when considering both equity and fixed-income investments.