Markets had one of their worst days in decades on Monday, with the opening being so bad that it immediately triggered a suspension in trading on the New York Stock Exchange, known as a Market-Wide Circuit Breaker. This circuit breaker is tripped when the S&P 500 index drops by 7% in one day.
When the closing bell rang, the Dow Jones Industrial averaged had suffered its second worst trading day of the last 25 years, with the -7.8% drop on the day only bested by the -7.9% day at the height of financial crisis on October 15, 2008.
Even with that carnage, oil had an even worse Monday – crashing by a whopping 34%. That’s the largest drop since the 1991 war with Iraq started.
This enormous drop in oil price is the result of a spat between Saudi Arabia and Russia that started last Friday. It’s a new upset that is adding even more uncertainty into an already jittery market.
But the real repercussions here at home go far beyond just the promise of lower prices at the gas station.
Those repercussions will be much more sinister.
There’s one sector in particular you need to avoid and even short or buy puts on – and it’s NOT in the energy complex…
Things Aren’t the Way They Used to Be – but the Saudi’s Haven’t Noticed
But first, we need to take a little walk down memory lane. See, by the 1970s, the Soviet Union’s development of oil deposits in Western Siberia put the country squarely at the top of global oil producers.
In second place was the United States. But the Texas oil fields that had helped us win World War II were getting long in the tooth, and production began tapering off. By the mid-1980s, U.S. oil production was in long-term decline.
At the same time, Saudi Arabia nationalized its oil industry in 1980 and embarked on an ambitious program to increase oil production.
This chart shows what happened next:
Just as U.S. production was gently falling, the Soviet Union crumbled – and its oil production collapsed with it.
The Saudis took advantage, and until the mid-2000s, were the largest oil producer in the world.
This gave them unprecedented power over the price of oil, and the global economy in general. The OPEC oil cartel, which in theory has no leader, almost always did what the Saudis wanted it to. Anyone who didn’t listen would soon face a massive dip in oil prices, as Saudi Arabia opened the spigots to punish them.
Looking at what happened this past Friday, I get the sense that some in Saudi Arabia think that is still the world they live in.
And that’s the huge Reality Gap in the oil market right now…
Saudi Arabia is Out to Get Russia’s Oil Industry – and Ours
On Friday, Saudi Arabia and its OPEC followers met in Vienna with Russia and some other oil producers. The goal was to decide on how to keep oil prices up, even as the spreading Covid-19 epidemic was cutting down on global oil demand.
As they have for years now, Saudi Arabia and OPEC wanted everyone to agree to cut production to meet the fall in demand. This would keep prices up, and if everyone stuck to the plan, no one would get an unfair advantage.
And as most oil-producing countries rely on oil revenues for almost all their budgets, keeping oil prices high is a matter of life or death.
However, Russia wanted no part of this. The Russian economy is already unhealthy, and with unrest, elections, and a planned change to the constitution coming up, President Putin is eager to get as much money as possible to shore up his position.
The Saudis responded as if it was 1993 and cut their production dramatically. This hurts every oil producing country, whether it’s Russia or one of the OPEC states.
But at least in theory, Saudi Arabia can extract its oil cheaper than anyone in the world. So they lose less than anyone else. And so they could withstand a prolonged price war.
Again, that’s the theory, and no doubt what the Saudi royals believe.
But we know what the reality is, because we’ve seen it before.
In 2015 and 2016, the Saudis saw that U.S. oil production was soaring, and was about to catch up to theirs. Combined with the renewed competition from Russia, this would push Saudi Arabia down to the status of a sharing power in the oil markets.
So the royals decided to open the spigots, flood the markets with their oil, and drive down prices. Then as now, their goal was to drive U.S. shale drillers – many whom are small to medium-sized companies – out of the market. Oh yeah, and they’d also get to punish the Russians so they would be more likely to do what the Saudi’s want in the future.
Instead, the U.S. shale oil boom was forced to innovate (technically and financially) and grew exponentially, while the Russians shrugged it off. And the Saudis were left with egg on their face – and a budget deficit in the billions.
Much the same is going to happen this time. Saudi Arabia can’t afford to play this game for too long, because the whole country is propped up solely on oil revenues. Without them, the police and military don’t get paid, and the very unpopular royals won’t be able to suppress protests anymore.
That will change their minds long before Russia is cowed to come back to the negotiating table.
But here in the States, this crazy and petulant move by the Saudis will have two serious side effects, even if it’s short lived.
One we just discussed – but the other could be even more dangerous…
This One Industry Will Get Hit by Coronavirus AND Low Oil Prices
American shale oil and gas companies are fast operators, using ever-improving state-of-the-art technology to drill quickly and efficiently.
But the fact remains that drilling for shale oil isn’t cheap. So these companies operate on a lot of debt. In fact, energy companies now account for the majority of the U.S. high-yield (or “junk”) bond market. The Financial Times reports that a whopping $84 billion of shale oil debt comes due in the next three years.
With oil prices crashing at record speed on Monday, we’re about to see a number of oil producers have to dip into their reserves to make their payments on that debt.
The worst-managed ones won’t make it.
Traders have already taken note, with Energy Select Sector SPDR Fund (XLE) down almost 19% on Monday.
That’s close to triple the Dow’s fall.
Now, oil prices and stock prices in general are not correlated. But the effects of Saudi Arabia’s move won’t end at some delayed or missed payments in U.S. oil fields and lower prices at the gas station. Lots of people may be thinking that right now, that oil prices simply don’t matter to most stocks. And logically that makes sense when oil and stocks are trading in “normal” times.
The thinking goes that when crude oil prices drop, the losses by the big integrated oil companies like XOM and COP and oil service providers like SLB and HAL will be offset by cheaper goods that are made with crude oil as a feedstock (like plastics) and increased consumer spending thanks to lower prices at the gas pump.
The reality is that this oil price drop, when combined with the uncertainty from the coronavirus outbreak and low interest rates, is going to hit another sector very hard…
All these missed payments from shale operators, a potential wave of defaults in the high-yield bond market as a result, will hit banks at the same time as lowered interest rates and other companies struggling because of trade disruptions from the coronavirus.
Together, that’s a recipe for financial stocks to start tumbling.
Now, at the beginning of the year I told you about the troubles facing cash-strapped shale oil producers, and recommended you go short on Whiting Petroleum Corp. (WLL). If you took that trade, please submit a comment below this article to tell me how you did – you should have made out like a bandit, as the stock is down some 88% since then! Let me know in the comments section if you shorted WLL stock or bought puts as I recommended.
And now, other financially unsound shale drillers will go the same way.
Once they start defaulting on their junk bond loans, financial stocks that are already under pressure from businesses struggling with the coronavirus outbreak and low interest rates will get hit.
The question quickly becomes this: Which banks will be hit worst? Morgan Stanley Research issued a note with that exact information in this handy graphic (Note EOP = End of Period):Here’s how a subset of those banks have faired since the market top on February 12:
You can see that combo of diving interest rates and exposure to shale oil debt has tanked these stocks, with the worst of them getting hit with almost 50% losses.
And the three banks with 10% or more of their debt in shale oil producers are not out of the woods yet. If oil prices have an extended stay below $40 per barrel, BOK Financial (BOKF), Cullen/Frost Bankers (CFR), and Cadence BanCorp (CADE) will find their stock prices continuing to drop like a rock. Use any quick up in price to sell these short or buy 3 month puts.
Great trading and God bless you,
D.R. Barton, Jr.
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