Oil and the Black Swan – Saudi’s go nuclear

Oil and the Black Swan Shale

By David Nelson, CFA CMT

Investors have spent the last two weeks on a roller coaster as markets attempt to discount the coronavirus outbreak and potential damage to the global economy. With demand slowing it’s not surprising energy markets have been weak but Monday’s price action with crude looking to open down more than 20% in a single session is a Black Swan event for U.S. shale.

Saudi Energy Minister Prince Abdulaziz bin Salman and Russian Energy Minister Alexander Novak
While the world deals with COVID-19 and how-to best deal with the crisis OPEC was dealing with a crisis of their own. The Cartel now being referred to as OPEC+ was unable to come to an agreement on production cuts in the face of falling demand. Russia’s Alexander Novak told his counterpart Abdulaziz bin Salman that Russia will not cut oil production further. Although Russia is not a member of OPEC it has worked closely with Saudi Arabia. Russia believes the production cuts have been a gift to U.S. energy producers and is indicating it no longer wants to go down that path.

With no deal in place it begs the question what’s next for global energy producers and maybe more important what’s next for high yield debt markets U.S. energy producers depend on for capital?

Two of the world’s biggest energy producers Saudi Arabia and Russia are ready to start a price war. To put this in some context this wouldn’t be the first time Saudi Arabia took decisive action to push partners into compliance.

Oil Prices – 10 Year Chart
oil 10 year

In 2014, they collapsed oil prices in a six-month time frame essentially telling the world they wouldn’t be the swing producer ready to cut production to shore up prices.

In both 1997 and 1985 they took similar action to challenge Venezuela’s over-pumping and earlier to send a message that they were not going to hold up prices with production cuts on their own. Crude prices fell during both episodes 50% and 70% respectively.

Large scale shale production has pushed the United States closer to energy independence. Low prices are a clear benefit for most companies as energy costs touch almost every line item of the income statement. The U.S. consumer benefits directly and indirectly as the cost of manufacturing and transportation go down.

HYG – iShares High Yield Corporate Bond ETF – 5 Years
HYG 5 year

This dynamic of course depends on a functioning U.S. oil complex now caught in the path of a price war. About 11% of high yield (junk) bonds are energy producers and recently their corresponding CDS (credit default swap) spreads have been rising while their equity prices continue to fall. Credit default swaps are essentially insurance for the holders of debt to protect against a bond default. Spreads widening are an indication the cost of that insurance is rising.

RRC – Range Resources Credit Default Swaps vs Stock Price

Many bonds are hitting distressed levels where yields are more than 10% higher than U.S. treasuries. Large energy majors like Chevron (CVX) and EXXON (XOM) have the balance sheets to whether the storm but there are and will be others that simply won’t survive.

Behind the scenes it’s likely there are ongoing discussions between the Saudi’s and their Russian counterparts. In the meantime, a disruption in credit markets will only add to the pain being felt in equity markets worldwide.