Is this capitulation?
Fixed income investments dropped like rocks on Wednesday as investors wondered if a trillion-dollar stimulus package will explode the deficit, causing rising interest rates, and also worried that debtors won’t be able to pay their bills. Even high-quality bond funds were crushed as investors squeezed through the exit doors.
The Dow fell below its closing level on the day President Trump took office, 18,927, before rebounding to finish the day at 18,898. Cruise ship stocks piled up on the rocks, and airline stocks crashed. But nothing, nothing matched the devastation in the oil field.
Just as the fears over Covid-19 were taking off, the Saudis and Russians got into a tiff over cutting oil production. The Sauds wanted to cut by another 1.5 million barrels per day, while the Russians didn’t want to cut at all.
When the two sides couldn’t come to an agreement, the Saudis informed the world they would start pumping all the oil they can. They intend to increase production from 9.5 million barrels per day to 13 million on April 1. This will add more than 3% to world capacity when we’re in the midst of a global economic recession.
The price of oil reached $64 on January 7. Yesterday it fell to $21, down more than 24%, before rebounding a touch to finish the day at $22.39, down almost 17%. At $21, oil was cheaper on an inflation-adjusted basis than the average price in 1972, or $3.39 per barrel, before the Arabian oil embargo.
Once the embargo happened, the price of oil jumped 300%. The shock sent waves of inflation through the U.S. economy for years.
Today, incredibly low oil prices will also ripple through the economy, and that’s part of the Saudi/Russian plan. They might be fighting each other, but both have an eye on the U.S. fracking industry.
OPEC, led by Saudi Arabia, and a group of producers led by Russia, have been holding down production since late 2016. They want oil prices to go higher. But Americans don’t play that game; they keep pumping all they can. The U.S. now produces more oil than any other nation, at least until April 1, and so it took market share from OPEC, Russia, and the other producers.
If the current fight over oil ends up putting a lot of U.S. fracking companies out of business, well, that’s a joyful side benefit to the Saudis and Russians.
But it will hurt here at home.
We’ll get the benefit of sub-$2 gasoline, and truckers, delivery companies, and anyone who counts fuel as a cost will get a bump in profits as the price of a key input drops. But many companies in the energy sector carry a lot of debt, which Harry has mentioned many times. It’s unlikely that their lenders will come to their rescue this time. Expect companies to shut down rigs, lay off workers, and go bankrupt.
The saving grace in the oil patch is that low prices eventually drive out enough production that prices rise again, there’s just no way to know how long that will take. If we get some therapeutic for the coronavirus, or a “flattening of the curve,” as people are describing it among those infected, then investors will start to price in a return to normal economic activity. If the Saudis and Russians call a truce in their market share war, that would also help. In the most positive scenario, we’d get both. In the worst case, we get neither.
If we don’t get relief, it’s going to be a long, dismal summer in Texas.