If the depressed oil prices remain, expect a wash-out in the U.S. energy sector … but also look for great buying opportunities
There are going to be bodies … and there will be opportunities.
The drama surrounding Saudi Arabia, Russia, and the price of oil is a fascinating look at geopolitics, the interconnected nature of our world today, and egos.
It also happens to be setting up a buying opportunity in select U.S. energy stocks …
As you’re aware, markets plunged on Monday in the wake of OPEC infighting and a resulting 31% decline in the price of Brent crude on Sunday.
Today, let’s dive into what was behind this, the impact on the U.S. energy sector, and what to expect going forward. Over the next few weeks/months, we could see some “blood in the streets” but also some great buying opportunities.
Let’s jump in.
***The Saudi Arabia/Russia spat sends oil prices spiraling
Let’s begin with what tanked oil prices over the weekend.
Last week, members of the Organization of the Petroleum Exporting Countries (OPEC), met in Vienna to discuss what to do about the coronavirus’ impact on lowered global demand for oil.
Now, to be clear, Russia is not an OPEC member, but Russian officials were invited to the meeting. That’s because three years ago, Russia entered into a deal to coordinate its production levels alongside OPEC.
At the meeting, Saudi Arabia, OPEC’s leader, recommended the member-countries cut their oil production by roughly 1 million barrels per day. Saudi Arabia suggested Russia should make the most dramatic cut of around 500,000 barrels a day.
The goal of these cuts would be to keep oil prices higher — a way to offset the reduced demand we’ve seen since the coronavirus has everyone hunkering down. For example, China’s refineries cut their oil imports by roughly 20% last month.
The Russians didn’t like this plan.
Why? Well, it’s not 100% clear, but the common belief is Russia wants prices to remain low — as a way to kill the U.S. shale industry.
Another theory is the move is part of a calculated plan to steal market share from the Saudis. Whatever the reason, Russia didn’t go along with the plan.
Saudi Arabia was offended and decided to slash its prices regardless, therein launching a price-war with Russia. The price-per-barrel fell by roughly $11, which was the largest one-day drop since the U.S. invaded Iraq in 1991.
As of yesterday, Saudi Arabian Oil Co. (run by the state) said it would boost production to 12.3 million barrels a day in April. That’s about 300,000 barrels a day above the company’s previous maximum sustained capacity.
What that means is Saudi Arabia will be tapping its inventories to flood the market. Specifically, the massive discounts are targeting some of Russia’s core markets in China and Northern Europe.
One senior Saudi official said the move “… was the Saudi declaration of war against Putin.”
And as I write Wednesday morning, the latest news it that Saudi Aramco has said it will now increase its “maximum sustainable” production capacity to 13 million barrels per day (from yesterday’s 12.3 million).
CNN reports the Saudis are “digging in for a war of attrition.”
***This price war might backfire against the Saudis
As to “why?” let’s turn to master income investor, Neil George. Given the fat yields that often accompany oil and MLP investments, Neil knows the energy sector inside and out.
In his update to Profitable Investing subscribers yesterday, he noted that the Saudi production move may end up hurting the kingdom. From Neil:
Saudi Arabia is in trouble with this, as it needs every penny to pay the vast number of folks on the dole for the family to keep its seat of power.
Russia has an economy that, post-US sanctions, is a whole lot more independent, and it has the ability to ratchet down the ruble to offset lower U.S. dollar prices for crude.
The Wall Street Journal echoed Neil’s thoughts yesterday:
Russia is better prepared to weather low oil prices than in the past. Oil now accounts for less than a third of budget revenue. The country has also accumulated massive reserves. The Russian finance ministry said Monday that it could withstand 10 years of prices at $25 to $30 a barrel.
Regardless of who blinks first between Saudi Arabia and Russia, the U.S. shale industry is caught in the middle.
***U.S. shale is getting squeezed, and some of the smaller players may not survive
Back to Neil on how the pricing war is impacting U.S. shale producers:
… the pricing of crude will cause pullbacks in U.S. producers, particularly in shale markets. Companies are cutting crews and idling rigs. And they are working to just keep the wells pumping at their lowest levels to keep them open on a maintenance basis.
In fact, the pullback threatens the U.S.’s status as an oil exporter.
From Bloomberg:
The U.S. only in recent months began exporting more petroleum than it imports, a shift fueled by record shale production in fields such as the Permian Basin.
Now, amid the worst price rout in nearly three decades, American drillers are facing a million-barrel drop in production that could curb U.S. exports and set back the country’s march toward energy independence …
If shale output were to fall by 1 million barrels a day this year, as BloombergNEF estimates, that could be enough to take the U.S. from net exporter back to net importer.
Some of the smaller U.S. players may not survive such market conditions. On Monday, some debt-heavy U.S. shale producers saw their bonds crushed as investors feared for their survival.
To make sure we’re on the same page, shale fracking is a highly-capital-intensive business. Given this, many shale producers have loaded up on debt to finance their operations. But with oil prices having plummeted — and threatening to remain low for a while — certain U.S. shale producers won’t be able to generate enough revenues to meet their debt obligations and stay in business.
An article in MarketWatch this week quoted a fixed income specialist who said, “there is a certain subset of energy companies like Chesapeake that will not survive.”
From MarketWatch:
But the session’s most actively traded speculative or “junk” bonds came from shale producer Oasis Petroleum Inc. US:OAS, which saw the average price of its most-active bonds that mature 2022 plunge to $31.70 on Monday, from $74 on Friday.
Deutsche Bank noted that even before Monday’s market rout in oil, about two-thirds of high-yield exploration and production companies were trading at distressed levels. Worse, Deutsche’s earlier 2020 forecast of a 15% high-yield default rate will probably now “go materially higher above that.”
***Looking further out, we’ll see some U.S. energy companies emerge from the shakeout, and present great buying opportunities
The S&P 500 index’s energy sector index fell about 20% on Monday. And as of yesterday, the sector had lost about a quarter of its value over the prior three days — that marks the worth three-day stretch on record.
Many individual stocks were crushed. For example, on Monday, Diamondback Energy, Apache, and Marathon Oil Corp. all suffered stock losses that topped 40%.
And more may be coming …
If oil prices don’t post a sustained rebound, we’re going to see the higher-cost producers getting squeezed, some of them eventually closing their doors. Better-run, lower-cost producers will survive, potentially buying some of the liquidated assets from the higher-cost producers, therein gaining size and share.
Yet, as often happens in situations like this, the entire sector will go on sale — even those companies that are fundamentally stronger. And that’s going to present great buying opportunities.
Neil will certainly be looking for opportunities within the U.S. energy sector. To follow along as a Profitable Investing subscriber, click here.
Bottom line, expect some pain to come but then opportunities to arise.
We’ll continue to keep you up to speed.
Have a good evening,
Jeff Remsburg
