We're in Uncharted Territory for Oil

The meeting in Vienna last week among OPEC members and their non-OPEC allies, OPEC plus, was intended to help nations reach an agreement on production cuts to extend past the current end date of April 1.

OPEC plus is currently operating on a reduction of 2.1 million barrels per day in oil production, and that lasts until April 1. OPEC proposed Thursday in Vienna to extend that cut by 1.5 million barrels per day and have it run until the end of 2020.

Oil prices had already fallen 20% since the start of the year, encouraging oil producers to push for more production cuts. The concern is the spread of the coronavirus will drive down the price further as economic activity, and in turn, oil demand, slows around the globe.

But Russia was not on board.

The Saudis' response to Russia's stance was to cut its price to Chinese customers, and plan to increase production by as much as 2 million barrels per day.

That fallout then led to oil's massive 30% nosedive. And on Monday, oil's decline was literal fuel to the stock market fire.

A market already suffering from news of the further spread of COVID-19 dropped 7.79% in one day and a total of 19.3% since Feb. 12.

Since Monday's losses, both oil and the stock market have recovered a bit. Oil is sitting at around $33 a barrel, and stocks rallied at open.

Now as a whole, the oil sector has already been in a difficult position - this OPEC plus news simply makes it worse. The Saudi-Russian oil war has all the earmarks of a standoff.

Unless there's a resolution, we will be retesting the market lows that we experienced in 2015 and 2016, when oil dipped below $30 per barrel.

We're also going to see a ripple effect through the economy that's going to have a parallel impact to the COVID-19 problems we already have...[mmpazkzone name="in-story" network="9794" site="307044" id="137008" type="4"]

What Could Happen After April

We may not get a decision on production cuts before April 1. Russia's Minister of Energy Alexander Novak told CNN that his country would make its own decision about production on that date.

And we don't know exactly what the consequences will be for the global economy if Russia decides not to go along with the proposed cuts.

Russia can in fact make its own decisions, along with all of the participating nations, which includes every member of OPEC, Russia, and any producer outside of OPEC who was involved in the OPEC plus agreements previously.

Most of the OPEC member countries as well as the OPEC plus and non-OPEC nations are dependent upon the production and export of oil to maintain some semblance of balance in their central budgets.

Each one of these nations is in deficit, and those deficits are going to be expanding as we move forward after April 1.

Of course, the United States and the shale producers in this country have no say whatsoever, nor do they participate in the OPEC or OPEC plus meetings. So they're by and large a sidebar participant here.

However, the protracted decline in oil prices is going to begin creating serious difficulties in the American oil patch. As a result of all this, we're likely going to be seeing massive waves of mergers and acquisitions in the United States. As most American operators languish, there will be selective companies where current low-cost drilling and completed infrastructure in choice basins translate into M&A targets.

This trouble comes at a time when oil is already in a difficult position. The global spread of COVID-19 is currently adding more pressure to the industry.

We're dealing with preliminary estimates, but the best estimates that I've seen indicate that over the last quarter, we actually had a decline in demand of 2.7 million barrels of oil per day worldwide because of the COVID-19 virus.

Now I regard such figures to be very problematic. To have figures of any consequence, you need lead time of at least three to six months.

But the current market isn't going to wait for that. It's going to trade on emotion.

Absent a move by Moscow to reverse direction and return to the table, the oil mess will continue with prices trading in the low $30-a-barrel range. The recovery will happen in due course. But for the immediate term, this will be a low-price market.

Exacerbating this in terms of oil price is that one of the problems that energy and oil have specifically is once you get into unknown territory, traders tend to use future contracts to overemphasize the trend they see developing in the market. And the trend after April 1 is clearly going to be going down, which means the traders will accentuate that and will have another overreaction of prices well below where the market would support them.

As for solutions to this - there are no short-term answers right now.

The problem is that supply exceeds demand. Now ultimately, if things stabilize and economic development starts improving, then we can see demand kick in.

We're likely to see a marginal increase in demand once we get to the end of 2020, but that's going to be dwarfed by the rise of supply. And the problem we have after April 1 is that every nation that produces any significant amount of oil is now going to have the right - and in some cases, the obligation - to simply open the taps and run the risk of being flooded with an amount of supply that can't be absorbed by the market.

And the longer this disagreement continues, the OPEC plus deal may be in significant jeopardy. We've already seen in the past that members of OPEC itself have not always been on the same page when it comes to policy.

Everybody in OPEC recognizes that if push comes to shove, the Saudis will use their tremendous volume to continue balancing production inside OPEC. So if other nations don't cut production, the Saudis are likely to cut their production as a consequence.

That's because there's now a caveat these days that didn't exist last year or the year before. The Saudis must maintain a high price of oil so that the Saudi-Aramco IPO doesn't fall through the floor. Saudi Arabia's state-run oil business went public on Dec. 5, 2019.

The Saudis now have a vested interest in maintaining the overall value of the Aramco stock in international markets, and that's essentially done by the overall valuation of the oil reserves in the ground that Aramco has in Saudi Arabia.

So the Saudis are somewhat limited in going with increased production without shooting themselves in the foot.

As we inch closer to April, the main factor to watch is whether these countries will be able to reach an agreement to avoid a situation that neither the oil sector nor the overall markets can withstand, given the added COVID-19 panic. I'll be sure to keep a close eye on the situation in order to bring you all the latest updates and developments.

In the meantime, click here to check out my colleague Shah Gilani's coronavirus roadmap to learn how to navigate each of the potential pathways the virus could take markets down. You don't want to miss it...

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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