Risk level: RED
RED: Severe (+/- 4%) ORANGE: High (+/- 3%) YELLOW: Elevated (+/- 2%) BLUE: Guarded (+/- 1%)
THE BOOSTER SHOT
-The dangers of over-reaction are high in times of crisis.
-Earnings week from global supermajors will tell us how bad things really are.
A change in the rules is necessary so that a negative price for US crude can never happen again. Some form of state intervention is needed to bridge the gap between supply and demand. The government could take an equity stake in some of the struggling oil players. Those are just some of the proposals coming from the now-struggling US energy sector. A price war between Saudi Arabia and Russia, two of the world’s leading energy producers, and a global pandemic defeated a once-dominant US shale industry and many of the players are begging for mercy. Just as $100 per barrel oil redefined the global energy sector by ushering in a giant new player in the United States, so too has $10 per barrel oil destroyed it. And some participants are pleading for a heavy state hand, a once-unthinkable prospect.
Brent crude oil prices ended the week down 23.6% to finish at $21.44 per barrel. Nearly all of that loss came on Tuesday, when US crude oil prices crashed below zero. Discounting the anomaly, oil performed reasonably well under the circumstances. The trade fluke, however, has triggered calls for massive changes in the way the market operates.
Diamond Offshore became the latest US company to enter bankruptcy proceedings, though it added it had enough capital to fund global operations.
“Through this process, we intend to restructure our balance sheet to achieve a more sustainable debt level to reposition the business for long-term success,” President and CEO Marc Edwards said in a statement.
His statement is somewhat reminiscent of American diplomat George Kennan’s call for a “a long-term patient but firm and vigilant” approach to Soviet containment. Nearly three quarters of a century after Kennan wrote those words in the pages of Foreign Affairs and Russia has expanded beyond its traditional belt of influence and pulled off a coup of sorts by taking a seat at the OPEC table to control parts of the global market. As demand evaporated in response to the new quarantine economy, the Kremlin balked on further market restraint among OPEC players, triggering a free-for-all in production. That double-whammy caused an exponential collapse in the price of oil and a systemic shift in not only the global economy, but potentially in the rules of the game.
In the foreign policy arena, a state feels threatened by uncertainty and is vulnerable to over-reaction when forced to adjust to systemic shock. An analogy is driving a car on an unknown road at night. Even if the driver anticipates an oncoming curve in the road correctly, the dangers of over-steering or under-steering normally become critical only when the curve is reached, not on the straight away. Over-steering in the US shale sector could cause a major upheaval for free-market principles.
Bloomberg News reported last week, after exchange house CME allowed the price for WTI to trade deep into negative territory, that the oil market is changed forever.
“We witnessed history,” Tamas Varga, an analyst at brokerage PVM, was quoted as saying. “For the sake of oil-market stability,” this “should not be allowed to happen again.”
Harold Hamm, the top official at US shale producer Continental Resources, called for a probe against CME, saying the WTI collapse smacked of “market manipulation or a flawed new computer model.” US trade regulators, however, seem to be suggesting it was more of a perfect storm than a case of cheating. And CME said the market indeed functioned as designed. If WTI for a brief moment in time was worthless, then so be it. Betting in markets by investing in certain assets is like predicting the future. Nobody, by its very nature, can predict a black-swan event, though when they do occur, there will be blood. And the wounded will beg for mercy.
This is not the Great Recession, where lending mechanisms triggered a collapse that caused a 7% reduction in US payrolls and a 4.2% contraction in US GDP. The US FTC reported that the crisis was avoidable and tied largely to the “Federal Reserve’s failure to stem the tide of toxic mortgages.” While the US federal response to the coronavirus was certainly flawed, there are few serious indicators that would suggest America alone – or any other nation for that matter – could prevent a global viral pandemic. With few medical options available to address the novel coronavirus, quarantines are among the best response. And with that comes the closure of large segments of the economy. Pain is inevitable. Some companies will survive and others will not. That too is inevitable in a free-market economy.
Resolve requires, as Kennan observed, patience. The economic downturn, however, has been so swift and so vast that patience is wearing thin. In Texas, a small group of companies are calling for state intervention in the shale oil patch. In Oklahoma, state regulators filed a briefing stating they can work to prevent “economic waste” and introduce a rationing system for shale producers. Rallying against OPEC for artificially inflating the price of crude oil over the last few years, Washington too is now thanking the production group for intervening to stabilize a lopsided market.
A fundamental component of a free market is the notion of liberty. An individual operating in a nation that indoctrinates liberty affords its constituents the right to do what they want with their property. That includes making foolish decisions. CME advised in early April that prices could be in negative territory, though some of the players who held their positions say it is unfair to lose. Calls for intervention after massive failures means calling for an infringement on the rights to property. Classic economic theory states that volatility over time reaches a state of equilibrium, with highs eventually compensating for the lows. In the United States, this sentiment prevailed until the Great Depression. Thereafter, market restrictions for the sake of social justice came into vogue with the ascent of Keynesian economics, which forecast that fear was a self-fulfilling economic phenomenon. The government, the Platonic “true pilot”, is best positioned to serve as a manager and thereby dampen the volatility that breeds income inequality, the logic holds.
The US energy sector, according to the American Petroleum Institute, supported some 10.3 million jobs in the United States and represented about 8% of total GDP in 2017. The average pay in the industry was some 85% above the average private sector salary that year. Those are good-paying jobs in an industry that has enjoyed unprecedented growth for more than a decade. US federal data, however, show that it was retail trade, finance and insurance, along with utilities, that were the leading contributors to US economic growth in the fourth quarter, not oil. The US Treasury Department has explained how struggling companies could get access to federal loans, suggesting even at one point that that an equity stake may be involved. That’s appealing to companies under the severe economic strain caused by oil prices at 10-year lows. It may not be appealing to those same companies looking to retake their liberty once the market recovers. The danger of over-steering, particularly in times of crisis, is very real.
It’s earnings week and the crude oil market is in for a rough ride, with the likes of BP, Exxon and Chevron all reporting first quarter figures. Russia’s Central Bank is working to right the economic ship, though GDP figures out Monday are expected to show a contraction. Consumer confidence in the United States is waning, and we’ll find out Tuesday if the mood is just as dark in the eurozone. We’ll get a clue as to just how full Cushing storage tanks are on Wednesday with the release of weekly figures from the United States. Quarterly US GDP data out this week will likely be damning. The US Federal Reserve also makes a rate decision this week, and WTI may possibly have company in negativity. European GDP and unemployment figures come out on Thursday. European and Asian markets may end the week on a quiet note amid Labor Day celebrations, but watch out Friday for more signs of US deterioration with the Baker Hughes rig count. As with last week, a Red alert is in place, with Brent crude oil expected to swing by at least +/- 4% on the week.