The overnight futures markets were a stunning sight to behold this weekend.
On Sunday night, the Brent and West Texas Intermediate crude oil futures markets were down more than 30% at their lowest point. That is the wildest price move for crude since the first Gulf War in 1991.
Crude oil is still, by far, the most important commodity in the world. Prior to the coronavirus slowdown, the world consumed roughly 100 million barrels of oil per day.
For a commodity of such widespread use and importance to shed over 30% of its value — in less than 24 hours — is almost unthinkable. On Monday, March 9, as of this writing, crude is still down 23%.
So what in the world happened?
On Friday in Vienna, a new “oil war” broke out between Saudi Arabia and Russia. And while the Saudis and the Russians are gunning for each other in this new oil war, the real target for both is the U.S. shale industry.
This time, they might actually succeed, too. In the Saudi-Russian oil war of 2020, much of the U.S. shale industry could actually be wiped out, with only a small handful of hardy players remaining.
It started out as a fairly normal OPEC meeting.
On Friday, oil ministers from the Organization of Petroleum Exporting Countries (OPEC) got together to discuss the need for production cuts in light of the coronavirus slowdown. Travel cancellations and business disruptions have lowered oil demand at the margins; OPEC wanted production cuts to match this reality.
Saudi Arabia, led by Mohammad bin Salman, the arrogant 34-year-old crown prince known by his initials, MbS, wanted a production cut of 1.5 million barrels per day, and they demanded that Russia participate. That’s when a fight broke out.
Russia is not an official member of OPEC, but as a major oil producer, Russia usually plays along and coordinates with OPEC decisions.
Not this time. Vladimir Putin said “nyet” to the Crown Prince, and made clear that Russia would not participate in any cuts. This made Saudi Arabia angry; Russia was clearly refusing to play ball. Next thing you know, an oil war broke out, in which both sides decided to sell their oil aggressively.
So crude oil futures plummeted over the weekend — falling 30% in overnight trading — on the prospect of Saudi Arabia and Russia pumping flat out as they fight for market share.
And again, a big part of the logic here, and a big reason Saudi Arabia and Russia have started a new oil war in the first place, is the opportunity to vaporize the U.S. shale industry as collateral damage.
Saudi Arabia has gone after the U.S. oil industry at least twice before. In 1986, the Saudis opened up the taps and flooded the market with oil in an effort to drown the U.S. energy patch. That effort largely worked. The domestic U.S. oil industry grew deeply fearful of Saudi oil power after that.
A few decades later, in late 2014, the Saudis tried it again.
With the price of West Texas crude oil above $90 a barrel in 2014, the Saudis announced their intention to open the taps, with the hope of putting U.S. shale producers permanently out of business. Over the next 18 months or so, the crude oil price plummeted into the $20s. It didn’t kill U.S. shale producers, though.
So why might a new “oil war” extinguish U.S. shale producers in 2020 when the same idea failed in 2014? Because in 2014, the U.S. shale industry had two things that are no longer available today: Ample financing and investor optimism.
Five years ago, it was almost impossible to kill the U.S. shale industry because financing was so readily available, and because operations could easily change hands rather than disappear.
If a shale outfit was facing trouble in the 2015 period, it could raise investor capital or do a new round of financing. And even if that particular shale company went under, a distressed buyer with cash on hand could buy the wells and keep the oil flowing.
So a big feature of the “hard-to-kill” U.S. shale business was a steady flow of financial lubrication that kept the wells in production, coupled with investor enthusiasm for shale plays in general.
But fast forward to 2020 and investors have fallen out of love with shale. Wall Street has grown tired of pumping hundreds of billions into the shale patch without a decent return on equity.
Worse still, credit markets are no longer friendly to U.S. shale producers — investor optimism has departed from the space — and industry debt loads are close to maxed out.
All of this means that, if Saudi Arabia and Russia succeed in driving the oil price down to $20 a barrel, or even back into the teens, they might successfully decimate the U.S. shale industry this time.
That would set up the conditions for a severe and inflationary shortage of crude oil later on, but that’s a different story. In the meantime, the energy sector is in for a world of hurt, and this could go on for a while.
If you are tempted to buy energy stocks because they are cheap, you should probably resist the temptation, as conditions are now right to make them “value traps” — the term when supposedly cheap assets continue to fall sharply in value.
(What’s the difference between a stock that is down 90% and a stock that’s down 80% and falls again by half? There isn’t a difference, it’s the same thing — except the second one is a value trap.)
With all of that said, there will be some very interesting opportunities on the other side of this. The oil wars of 2020 will have a whole roster of intriguing side-effects.