Market Overview

10 March 2020

Is the Devil as Black as He Is Painted? There Is Only One Way to Find Out

The failure of the deal within the Organization of the Petroleum Exporting Countries (OPEC) and other major oil producers sent oil prices into a steep dive. May 2020 futures for the North Sea Brent benchmark fell once again by more than a quarter in London on Monday, after its 31.6% drop since the beginning of this year. Brent prices updated the minimum of February 2016. The US West Texas Intermediate (WTI) has fallen below $30 per barrel touching $27 at some moments, and it traded a little higher today in between $30 and $34 per barrel.


The trigger for the sale-off was a contrived refusal of Russian delegation to participate in any form in OPEC's proposed additional production cuts by 1.5 million bpd altogether. As Russian energy minister Alexander Novak has already stated, he and his colleagues felt it more reasonable to extend an existing deal instead. After many hours of discussions, the result of contradictions was that the negotiating partners dropped both the new deal and the extension of the old deal. Consequently, oil exporters consider themselves free from any obligations under the former quotas after April 1, each OPEC country and Russia too can start increasing production since the existing deal has expired.


Initially, the reason for doubts of exporting countries was the numerous opinions expressed by experts that the reduction in volumes may not, in fact, affect prices at all since the market is not currently determined by an oversupply but oil prices are rather driven by different estimates of the demand. However, according to the most severe estimates made by Bloomberg and by IHS Markets, the reduction in fuel consumption in China and in other countries due to the emergency epidemic situation is ranging from 3.5 to 4.7 million bpd. The International Energy Agency (IEA) expected a decrease in oil demand by 90,000 bpd in the baseline scenario and by 730,000 bpd in the pessimistic scenario for the entire year of 2020, as the IEA wrote in the report released this Monday. According to their preliminary assessment for the 1Q2020, crude oil demand fell by 2.5 million bpd compared to the same period in 2019. This includes an estimated annual decline of 4.2 million bpd in February, of which 3.6 million bpd contraction was in China.


Despite the fact that all these figures are quite large in total, they do not exceed five % of the world's oil production. All this contrasts sharply with another "parallel" reality in the markets where oil prices have fallen by half in a couple of months. Perhaps this is why the oil policymakers, including oil dependant countries, whose incomes are heavily formed by fuel exports, chose to compete better with US sale producers and others for their market share. They may feel that a lack of demand could be rather a flimsy justification for the excessive speculative movements in prices and that leaving the markets to themselves for a while could be a wise solution. However, what is the only way to know how the market will behave without any artificial restrictions from the oil producers, and is the devil as black as he is painted? Just trying to see his face, of course. This is exactly what the emboldened oil exporters did when they did not take the deal, they provided to themselves and to everyone else, a real picture of the market.


It is quite possible that in the end they may turn out to be right. So when the market dust settles, oil prices could return to more adequate and higher levels. Nevertheless, at the moment they are, of course, pressured down strongly by messages that Saudi Aramco, the biggest state oil company in the region, reduced oil prices for importers in Europe, Asia and in the United States by the maximum amount in 20 years. On March 7, Saudi Aramco informed customers that it was reducing prices by $6-8 per barrel for those regions. So customers from North-Western Europe would be able to buy Arab light oil at a discount price of $8. Thus, if the Russian Urals is trading at a discount price of $2 against Brent, the Saudis lowered the bar by more than by $10.


Perhaps, the most surprising and not entirely logical decline was yesterday in the US stock markets when shares dropped after the fall in oil prices. It was clear that oil was not the only reason for this, as the day before China officially revealed the statistics on the decline in their exports by 17.2% and Italy decided to "block" the nation as it suspends traveling by individuals within the country except for health treatment reasons, work and urgent needs.. However, if the impact of oil is focused on, then low fuel prices are good for most non-oil companies. But it looks like the equity markets prefer to focus not on these potential benefits for the economy, but on the fact that once OPEC offered to lower quotas before, by as much as 1.5 million bpd, then it means that OPEC may have seen a yawning gap between the output and the demand that the Russians simply "did not see".


Just like a week ago, when the reaction to the urgent Federal Reserve (Fed) rate cut was considered as an extraordinary move by the Fed,that most likely predicted something terrible in the nearest future for the economy. Alas, a much simpler explanation which has turned out to be unpopular so far is that the Fed simply took advantage of the situation and lowered rates for the sake of refinancing the US government debt at a more advantageous conditions with the rate close to zero percent. That's the same with OPEC's decision not to act: the markets for some reason are not inclined to see the positive side of such decisions as for now, but this attitude to oil prices may change.


US President Donald Trump tweeted on Monday: "Saudi Arabia and Russia are arguing over the price and flow of oil. That, and the Fake News, is the reason for the market drop!" That was referred to the stock market. He also added in several minutes: "Good for the consumer, gasoline prices coming down!" In fact, these remarks of the US President quite logically follow his earlier calls last year for OPEC to stop artificially maintaining high oil prices and to abandon quotas. That's exactly what happened, so Donald Trump may be celebrating another victory ahead of the presidential election. But a more important point for stock market participants for the next several weeks is by how much - if this is the case - is the present collapse in oil prices underpinned by real problems of the world economy growth, and will oil prices help or prevent the stock market from finding out how low it can go, and could it happen sooner or later with these new developments in oil market.


Trump tries to support the market rise as he wrote: "So, last year 37,000 Americans died from the common Flu. It averages between 27,000 and 70,000 per year. Nothing is shut down, life & the economy go on. At this moment there are 546 confirmed cases of CoronaVirus, with 22 deaths. Think about that!" This seems to be one of the few adequate comments in everything related to virus hysteria regarding its possible impact on the financial results of companies, but obviously the markets still have a long way to go to realize this reality.


Disclaimer:

Analysis and opinions provided herein are intended solely for informational and educational purposes and don't represent a recommendation or investment advice by TeleTrade.

Indiscriminate reliance on illustrative or informational materials may lead to losses.

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