Welcome to the oil price shock of 2020

by Shaun Richards

Today is one where we are mulling how something which in isolation is good news has led to so much financial market distress overnight and this morning. So much so that for once comparisons with 2008 and the credit crunch have some credibility.

And I felt a rush like a rolling bolt of thunder
Spinning my head around and taking my body under
Oh, what a night ( The Four Seasons)

Just as people were getting ready for markets to be impacted by the lock down of Lombardy and other regions in Italy there was a Mexican stand-off in the oil market. This came on top of what seemed at the time large falls on Friday where depending on which oil benchmark you looked at the fall was either 9% or 10%.Then there was this.

DUBAI, March 8 (Reuters) – Saudi Arabia, the world’s top oil exporter, plans to raise its crude oil production significantly above 10 million barrels per day (bpd) in April, after the collapse of the OPEC supply cut agreement with Russia, two sources told Reuters on Sunday.

State oil giant Aramco will boost its crude output after the current OPEC+ cut deal expires at the end of March, the sources said.

Whilst they are playing a game of who blinks first the oil price has collapsed. From Platts Oil

New York — Crude futures tumbled roughly 30% on the open Sunday evening, following news that Saudi Aramco cut its Official Selling Prices for April delivery. ICE front-month Brent fell $14.25 on the open to $31.02/b, before climbing back to trade around $35.22/b at 2238 GMT. NYMEX front-month crude futures fell $11.28 to $30/b on the open, before rising to trade at around $32.00/b.

The Real Economy

Let us get straight to the positive impact of this because in the madness so many are missing it.

We find that a 10 percent increase in global oil inflation increases, on average, domestic inflation by about 0.4
percentage point on impact, with the effect vanishing after two years and being similar between advanced and developing economies. We also find that the effect is asymmetric, with positive oil price shocks having a larger effect than negative ones. ( IMF 2017 Working Paper )

There is plenty of food for thought in the reduced relative impact of lower oil prices for those who believe they are passed on with less enthusiasm and sometimes not passed on at all. But if the IMF are right we will see a reduction in inflation of around 0.6% should oil prices remain here.

As to the impact on economic growth the literature has got rather confused as this from the Bank of Spain in 2016 shows.

Although our findings point to a negative influence from oil price increases on economic growth, this phenomenon is far from being stable and has gone through different phases over time. Further research is necessary to fathom this complex relationship.

Let me give you an example of how it will work which is via higher real wages. Of course central bankers do not want to tell us that because they are trying to raise inflation and are hoping people will not spot that lower real wages will likely be a consequence. To be fair to the IMF it does manage to give us a good laugh.

The impact of oil price shocks, however,
has declined over time due in large part to a better conduct of monetary policy.

That does give us the next link in the story but before we get there let me give you two major problems right now which have links. The first is that the oil price Mexican stand-off has a silent player which is the US shale oil industry. As I have pointed out before it runs on a cash flow business model which has just seen likely future flows of cash drop by a third.

Now we get to the second impact which is on credit markets. Here is WordOil on this and remember this is from Thursday.

NEW YORK (Bloomberg) –Troubled oil and gas companies may have a hard time persuading their bankers to keep extending credit as the outlook darkens for energy, potentially leading to more bankruptcies in the already-beleaguered sector.

Lenders evaluate the value of oil reserves used as collateral for bank loans twice a year, a process that’s not likely to go well amid weak commodity prices, falling demand, shuttered capital markets and fears of coronavirus dampening global growth. Banks may cut their lending to cash-starved energy companies by 10% to 20% this spring, according to investors and analysts.

That will all have got a lot worse on Friday and accelerated today. I think you can all see the problem for the shale oil producers but the issue is now so large it will pose a risk to some of those who have lent them the money.

US oil/junk bonds: busts to show folly of last reboot ( FT Energy )

I am not sure where the FT is going with this bit though.

There will be no shortage of capital standing ready to recapitalise the energy sector….

Perhaps they have a pair of glasses like the ones worn by Zaphod Beeblebrox in The Hitch Hikers Guide to the Galaxy. Meanwhile back in the real world there was this before the latest falls.

More than one-third of high-yield energy debt is trading at distressed levels. Oil and gas producers with bonds trading with double-digit yields include California Resources Corp., Range Resources Corp., Southwestern Energy Co., Antero Resources Corp., Comstock Resources Inc., Extraction Oil & Gas Inc. and Oasis Petroleum Inc. ( World Oil)

Central Banks

As the oil price news arrived central bankers will have been getting text messages to come into work early. Let me explain why. Firstly we know that some credit markets were already stressed and that the US Federal Reserve had been fiddling while Rome burns as people sang along with Aloe Blacc.

I need a dollar, dollar a dollar is what I need
hey hey
Well I need a dollar, dollar a dollar is what I need
hey hey
And I said I need dollar dollar, a dollar is what I need.

Whoever decided to taper the fortnightly Repo operations to US $20 billion had enough issues when US $70 billion was requested on Thursday, now I guess he or she is not answering the phone. Anyway the role of a central bank in a crisis like this is to be lender of last resort and splash the cash. At the same time it should be doing emergency investigations to discover the true state of affairs in terms of solvency.

This is because some funds and maybe even banks must have been hit hard by this and may go under. Anyone long oil has obvious problems and if that is combined with oil lending it must look dreadful. If anyone has geared positions we could be facing another Long-Term Capital Management. Meanwhile in unrelated news has anyone mentioned the derivatives book of Deutsche Bank lately?

The spectre of more interest-rate cuts hangs over us like a sword of damocles. I type that because I think they will make things worse rather than better and central banks would be better employed with the liquidity issues above. They are much less glamorous but are certainly more effective in this type of crisis. Frankly I think further interest-rate cuts will only make things worse.

Comment

I have covered a lot of ground today but let me move onto home turf. We can also look at things via bond yields and it feels like ages ago that I marked your cards when it was only last Thursday! Anyway we have been on this case for years.

Treasury 10-Year Note Yield Slides Below 0.5% for First Time ( @DiMartinoBooth)

Yes it was only early last week that we noted a record low as it went below 1%. Meanwhile that was last night and this is now.

Overnight the US 10-year traded 0.33%, under 0.44% now. The longbond traded down to 0.70% overnight. The bond futures were up over 12 points. Now trading 0.85%. Note how “gappy” this chart is. Liquidity is an issue. ( @biancoresearch )

This really matters and not in the way you may be thinking. The obvious move is that if you are long bonds you have again done really well and congratulations. Also there is basically no yield these days as for example, my home country the UK has seen a negative Gilt yield this morning around the two-year maturity.

But the real hammer on the nail will not be in price ( interest-rates) it will be in quantity as some places will be unable to lend today. Some of it will be predictable ( oil) but in these situations there is usually something as well from left field. So let me end this part Hill Street Blues style.

Let’s be careful out there

Podcast

I have not mentioned stock markets today but I was on the case of bank shares in my weekly podcast. Because at these yields and interest-rates they lack a business model.