Saudi Oil Price War and Coronavirus Deliver Double Attack

Saudi Oil Price War

With oil and stock markets already in a panic over the epidemic of virus fear that has gripped the world, Saudi Arabia declaring a price war on top of this was just too much.

We already had the weekend’s escalating coronavirus cases to deal with come Monday, but Saudi Arabia had a little extra surprise for the markets to add to all the turmoil. Oil prices were already painfully low for oil producers as it was, and Saudi Arabia tried to organize an agreement for producers to cut production to reduce supply and allow them and everyone else to make more money from this commodity.

Oil prices had been recovering in the fourth quarter of 2019, gaining about $11 a barrel from the low in October to the high on January 8 of this year. 2020 hasn’t been kind to oil though, and this was made worse by the coronavirus scare. Last Friday, West Texas Intermediate, or WTI, was off its January 8 high by $18 per barrel, a 30% decline, closing last week at $43.68 per barrel.

Russia, the world’s third biggest oil producer these days, failed to go along with Saudi Arabia’s plan to have everyone cut production. Russia is not a member of OPEC, and while OPEC used to dominate the oil business at one time, they only control a minority of daily production these days.

The U.S. leads the way now, with the Saudis being relegated to second place. Both Russia and the U.S. dance to their own beat, and although they do have a big stake in the oil business, they steer away from the restraint of trade tactics that OPEC is so famously fond of.

This is what we normally would call price fixing, on a scale that would have made John D. Rockefeller jealous. Price fixing is OPEC’s reason for being, and they ganged up on the world for decades to work together to keep the price of oil artificially high.

The emergence of non-OPEC oil producing giants have changed the landscape considerably, reducing the once powerful OPEC to a shadow of its former self. Sure, OPEC can cut production, and this does influence prices, but when countries like the United States and Russia refuse to go along with the act, OPEC’s attempts at market manipulation just end up cutting their sales and handing the production they cut over to their competitors to satisfy instead.

OPEC also isn’t as organized as they once were, which has served to further dilute their power. They now have to ask other countries to come along with their production goals, like Russia. Russia refused to play this game over the weekend, so Saudi Arabia chose to increase their production rather than limit it, with more of this promised.

The increased production from Saudi Arabia didn’t even amount to all that much, but oil futures markets scare as easily as the stock market does, and they are also prone to over-react. The Saudis are only increasing their production from 9.7 million barrels a day to 10 million, a mere 300,000 barrel per day addition.

They have promised to take this up to 11 million a day if necessary, but even if they do, a 1.3 million increase only amounts to a 1.6% supply shock, which isn’t much of a shock at all and should not have put the price of oil down by 38% at the worst of it. The math here is truly ridiculous.

The futures markets open for the week at 6PM ET, and by the time midnight hit, the price of WTI had fallen all the way to $27.30. The prices of futures contracts are not decided by the supply and demand of oil, they are governed by the supply and demand for these contracts, and demand slipped out the door on Sunday night for a time.

The response of the futures market does not have to be appropriate though, even though in the end these contracts do end up trading at the spot price as this is when there’s no time left to differentiate futures pricing with the actual market for oil. In the meantime, futures prices can take some real adventures, especially in the face of bad news.

Just like stocks can widely over-react to bad news, and the coronavirus scare has produced the biggest example of this of all time, the prices of oil futures contracts are prone to doing this as well. They also tend to calm themselves and realize their mistakes, and just 24 hours later, WTI has added over $5 of this back already.

This is not the first time that Saudi Arabia has tried to push around its competitors, sometimes to intimidate other OPEC members, and sometimes to push around other countries such as Russia this time and the United States during 2015-16. The last time the price of oil dropped this low was during that time, where Saudi Arabia tried to drive the American frackers out of business by declaring a price war on them.

In the end, it was Saudi Arabia that had to back off, and even though they say they can make a profit at $8 a barrel, oil is Saudi Arabia’s only cash cow, and their economy doesn’t do well at all with prices this low. Nonetheless, they are ready to go to battle again, although it’s a mystery why they expect a different outcome this time. Perhaps they don’t realize how more important oil is to them compared to Russia and the United States.

They aren’t just taking on the frackers this time, they are essentially taking on the Russian oligarchy, which not only are more organized, their government is even more committed to their success than the Americans are with their shale oil companies.

This Takes Over-Reaction to a New Level

The only way to describe the market reaction to this is by calling it an extreme over-reaction in the midst of a pretty big over-reaction already. The restrictions that the response to the coronavirus will affect oil demand, but nowhere near as much as the futures market is pricing in. When we add in the scare of this little increase in oil production, and it all adds up to a 48% drop in the price of oil from when the coronavirus scare really got off the ground down to the lows of Sunday night, you know how crazy oil traders can really get.

When oil bounced off of $27 and started to recover, this saw oil become incredibly bullish. Futures traders leverage WTI by a factor of 12, and if they had the guts to get in when this started to really move, they could have theoretically pocketed a couple of hundred percent gain in less than 24 hours just by hanging on this long.

In reality, the traders that know what they are doing would never have held their positions through all this, since there were several hills and valleys that would have scared them far more than the Saudis did. This actually ends up adding to the amount of opportunity during a move like this, as their moving between long and short a few times can capture even bigger gains than staying in when executed properly.

It is still underpriced at $32 a barrel though, and you don’t have to know a thing about the oil market to know this. You do need the skill of looking at what has changed and comparing it to the magnitude of the price change, and having an idea of how bad news can drive trading over the precipice for a while certainly doesn’t hurt.

For traders, the bigger the move, the better, and there is no such thing as a move too large whether it does it on the long side or the short side. Future traders with any sense would not have dared hold a leveraged position over the weekend, the only time the futures market closes, other than a one-hour break every evening. You can’t do this with leverage and if you were on the wrong side of this one, this would be even worse than the stories you hear about rogue energy traders losing billions.

A 33% drop at a leverage of 12 wouldn’t just see your position closed with your losing the whole amount, you would also owe three times more than your investment to your broker. Making 400% over the weekend sure would have been nice though. Jumping off of a building may be pretty exhilarating though but not a very sensible idea unless you actually do have a death wish with your trading.

Trading oil is a tough gig though due to its high volatility at the best of times, and this is much more than what would qualify as just being high. It can actually be easier to trade, and the big problem is whatever lack of discipline a good trader gets really tested. When the numbers are a lot bigger, it’s actually not no easy to continue to trade well, especially in not getting out early enough, which is even earlier with something like this than normal due to the greater risk involved that needs to be managed.

The spotlight is on oil much more than it normally is, and futures traders who don’t normally trade oil owe it to themselves to start paying attention now, to look to pick up their share of all the money thrown on the floor due to madness, with traders scurrying to pick it up since. There’s still plenty of money left on the floor to be claimed.

As far as the stock market goes, it already had to deal with the still growing coronavirus case count outside China without this oil news that shocked even though it wasn’t all that shocking in reality.

It wasn’t all oil that wreaked the havoc we saw Monday, as the coronavirus likely played a big role as well. We need to understand what is going on with this virus though to be in a position to even know what to do here. This requires us to start by looking at China’s experience.

We Know How this Virus Will End, if We Are Paying Attention

China’s numbers have evolved from 4,500 cases a day that we later learned were understated, to 19 now. China is where this all started, and their playing out of this virus is more evolved there, and has now evolved virtually into nothingness. This does give us a very good idea about how this will end up playing out in other countries, where their outbreaks have been of a shorter duration and need more time to get to where China is now.

There is no good reason why this virus won’t evolve in other countries in the same way that it has in China, and while China’s level of restriction certainly helped contain it, and this can limit expansion, it doesn’t affect decline. The downward move we have seen in China is the end-of-life experience for this virus, a life that also will come to an end for this virus elsewhere as well, and in a comparable way.

South Korea used to have numbers that were growing very quickly, and they are in second place in the virus longevity category, so they should be the next to peak and decline. That’s already happened and their numbers are on the way down now, and have been well passed by Italy.

These are important things to note if you are looking to predict either the price movement of oil or stocks, or even if you wish to free yourself a bit at least from the hysteria that has actually become a pandemic. Both of these markets overreact to news perceived as bad, and this story plays every day, so we’ve seen a whole lot of overselling and it may not be over yet.

Having to deal with both virus fears and crashing oil prices was bound to smash an already beat up stock market, and that’s exactly what happened. Futures trading on all three major U.S. stock indexes hit the 5% limit down curb early in the session, and were sent home for the night as we awaited the opening of the market in New York.

With only 2% more until another curb, and with panic in the streets, this was hit in the first few minutes. At the end of the day, after another real roller coaster, the Dow lost over 2,000 points and saw its biggest one-day loss since the financial crisis.

We have another over-reaction with stocks to add to all the other over-reactions we’ve had over the last three weeks, and this further sets up the opportunity to ride this back up once we get there. Whether or not you are profiting from this huge decline in stocks, now at the doorstep of the bear’s den, you definitely want to get on the whole lot of love that is coming soon.

There are no good or bad big moves, there are only good and bad ideas about how to play them. Few investors have any idea of how glorious these times should be for them, and it’s not only because the moves are so big, it is especially because this is all so well telegraphed to even make it nearly fool proof.

The trend lately with stocks have been one side wrestling control for a while, which we especially saw last week. The bears won the day Monday, but the bulls are no doubt pawing the ground in eagerness and getting ready to charge. The stock market is only part-time scared now, so you can’t exactly do this with your eyes closed.

Oil also continues to look very good on the long side, and although investors don’t really trade futures much, they can still get in on this in a lesser way with slightly leveraged or even unleveraged ETF. You have to know when to hold them and know when to fold them though, as always.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.