Adding to fears caused by the spread of COVID-19, over the weekend of March 6 OPEC failed to agree on production cuts, sending oil prices down as much as 33% on Monday. By the end of trading, the S&P 500 was down 225.81, or 7.6%. The coronavirus has created a drop in demand for oil, so Saudi Arabia has pushed OPEC members to cut production to keep prices stable. Russia, which is not an OPEC member, had recently cooperated in trimming production to counter US growth, but refused this time and insisted US shale producers should share in the pain.
The Saudi plan was to trim production by 1.5 million barrels per day, or 1.5% of world supply, with the Saudis reducing by 1.0 million barrels, as long as the other producers trim the rest. When Russia rebuffed the offer, the Saudis notified buyers on Saturday that they would offer deep discounts on their oil sales for April.
Up to now Saudi Arabia has absorbed most of the cuts to offset rising production in the US. Russia, for its part, was tired of seeing growth curtailed and would rather impair the US shale industry. They have built up a $570 billion fund to help them ride out an oil revenue deprivation.
Saudi Arabia and Russia have had a tenuous relationship concerning oil production since 2016. Despite both having enormous reserves, the two sides were unable to reach agreements previously due to differences in strategic interests. In the past, Russia has sided with Iran, a Shiite nation, currently fighting for dominance in the Middle East with Saudi Arabia, a Sunni nation. Even though lower oil prices hurt the Saudi economy, they felt the pain would be more severe in Russia and Iran. Eventually, when oil prices fell below $30/barrel, Russia and Saudi Arabia joined forces and agreed to production cuts.
While lower oil prices have historically been positive for global growth, today’s slump may contribute to the headwinds currently facing the global economy. Producers in developed markets, like the US, could see dramatic cuts in revenues should prices remain low for an extended period. As their revenues decline, lenders could see defaults rise and cut into their profits. Additionally, demand has slowed due to COVID-19. Since fears are cutting into discretionary spending, it is unlikely that consumers will respond to lower energy costs by spending more now.
For investors, a price war in oil only adds to the stress caused by the coronavirus. While the report of new cases in China has decelerated, the spread outside the country has increased. Over the weekend, the World Health Organization reported that the number of confirmed cases around the globe rose above 100,000. According to the CDC, there have been 423 Americans diagnosed with the virus, with 26 confirmed deaths. Of those deaths, 22 are linked to Washington state.
The current drop in the markets brings back memories of October 2008, but the two situations are completely different. In 2008, the Great Recession was caused by an asset price collapse due to excessive lending in the housing market. Today, there is a supply and demand shock caused by the coronavirus. Historically, asset price collapses have led to the most severe recessions, while pandemics have been short-lived. Today’s wrinkle of lower oil prices has served to stoke investor fears. Only time will tell if this wrinkle has longer-term effects.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Rick Cloutier, CFA is the Chief Investment Strategist for Washington Trust Bank with over 25 years of portfolio management and investment experience. He is responsible for directing the portfolio management, research, and trading activities for the bank’s multi-asset class strategies. He is also responsible for overseeing the client portfolio manager team and portfolio analytics team. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, the Journal of Business Management and Economics, and the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University.