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How Corona & sharp fall in crude oil prices may trigger global equity sell-off

All oil exporting countries have high dependency on oil prices for budgeted revenue, Average breakeven oil price to balance the budget for OPEC members is about $80 per barrel while current market price is about $30.


Gulf countries have high per capita income and big sovereign wealth funds to reduce dependency on oil, Because of global slowdown and now coronavirus have badly affected economy of these countries.


Let's understand how sustainable low oil prices will trigger biggest ever asset sell-off globally-


Oil is a major source of global energy, Oil consumption is a sign of growth. Baring United Kingdom, largest global economy is the top oil consumer of the world. United States and china consumes 20 ml and 13.5 ml barrels of oil per day


From aviation to other means of transportation, from industries to to other sectors major source of energy is oil and petroleum products.


“Fall in oil consumption is leading indicator of slowdown (recession) in global economy”


  • You must have heard about negative crude oil prices for May delivery. That was primarily on account of shortage of storage of oil.

  • Because of corona entire world (All the major economy) is under locked down and thus closed and very limited economic activity is going on. However

  • Due to geopolitical situation and nature of the industry oil extraction and production is continue

  • On one side oil consumption has down drastically but oil production does not reduce with the same pace resulting into shortage of storage of oil.

  • But story of oil is not so simple, CORONA is just an occasion for falling crude oil prices. It starts with geopolitics and fight for the real power


Let’s understand in detail-


Top oil consuming countries-















End of OPEC’s monopoly?


  • Decade ago global economy was booming, crude oil was supplier’s market and United States, china, India was biggest consumer and importer.

  • These countries were heavily dependent on middle-east for oil supplies.

  • Over a period United States heavily invested in Shale gas and oil with the discovery of shale oil in the U.S.A and advances in drilling techniques, America has re-emerged as a top producer of oil

  • In 2019 US become the largest oil producer in the world, Though OPEC countries together produces 42% of world crude oil

  • OPEC still have pricing power and drive the prices but somehow with low cost extraction, USA limited the OPEC cartel by ramping up production whenever OPEC cut its output.


Net oil Import by United states-


Top oil producers -













How it changed the oil world –


  • United states become the net oil exporter at the same time second largest economy china evidencing economic slowdown thus lower crude oil consumption.

  • Overall global scenario with focus on environment protection and sustainable energy long term crude oil prices started to fall down and sustained at much lower level (50 to 60 USD)

Crude oil prices (WTI)-



Long term average crude oil prices-



How oil prices affect the middle-east economy-


  • Oil is a major source of revenue for middle-east countries and other OPEC member They make their budget by forecasting long term crude oil prices

  • On an average oil and allied products contributes > 40% of OPEC GDP and > 65% of budget revenue

  • Substantial reduction in crude oil prices badly hurt OPES member’s capex plan

  • In a short span ( 2014-2019) almost all the middle-east country turn from budget surplus to deficit economy

With lower oil prices and United States independence on oil import. The decade old Geopolitical tussle among Russia Saudi Arabia (OPEC) and the United States went to the next level.


OPEC’s dilemma and counter action-


  • Earlier united states and all major economy wanted low oil prices however USA heavily invested in this sector (mostly borrowed money) to build the capacity

  • Now OPEC are not agree to cut the production while demand is cool across the globe. OPEC countries want US shale producer to go bankrupt with low oil prices

  • Meanwhile Saudi Arabia says, they can afford oil at $30 a barrel, but they would have to sell more crude to soften the hit to its revenue.


Now rather reducing oil production they are increasing it to meet their budget requirement. It seems that there is a disparity among OPEC members.


Russia, a largest Non OPEC oil producer with 11% market share (equivalent to Saudi Arabia) does not want to cut the production. Entire story is reverse now.


  • Saudi Arabia (OPEC) don’t want to cut oil prices to punish debt laden US oil companies, But they don’t other option but to cut crude oil production.

  • Russia says they can produce and sell oil for 25-30 USD for next 5-6 years


Amid all this geopolitical problem COVID19 appear as last nail in the coffin-


  • About 40% of the world’s population is currently advised to stay at home to limit the spread of COVID-19

  • Because of shutdown rapid increase in layoffs and unemployment observe specially from service industries

  • Government’s fiscal and monetary responses in on the social side thus will have limited impact on oil demand given the significant restrictions on travel.

  • The outlook for global economic growth is highly uncertain

  • Around the world billions of people are affected by one of the worst health crises of the past century.

  • The global economy is under pressure in ways not seen since the Great Depression in the 1930s; According to one report countries like USA, Europe, India, and China are turning away shipments because of storage glut.

  • Even assuming that travel restrictions are eased in the second half of the year, global oil demand in 2020 may fall by 9.3 million barrels a day (mb/d) versus 2019, erasing almost a decade of growth


Bigger question is what will Happen with Middle East countries-


Oil rent-


  • Oil rents are the difference between the value of crude oil production at world prices and total costs of production

  • The volatility of worldwide oil prices results in large fluctuations in the percentage of GDP because of the economy’s reliance upon the petroleum sector

  • Oil rent simply indicates economy’s dependency on oil and allied products


#Source- Above numbers are the latest available data extracted from US energy information, World Bank and OPEC websites


Decoding the numbers-


  • Baring Iran average breakeven crude price of OPEC members is about $80 which is more than double the current market price.

  • Oil rent for all the OPEC members are very high however countries shaded in red color will be most affected on because of high fiscal deficit and low sovereign fund to balance the budget.

  • Countries in green shad will also affect but they have big sovereign funds and room for further borrowing

  • There is serious risk of social unrest in countries like Iran, Iraq, Nigeria and Venezuela


Details of various sovereign funds-



Most Middle East countries have big sovereign fund to reduce dependency on oil prices.

  • Presently there are news in the domain that presently all the Middle East based sovereign funds are busy in identifying bargain and buying assets.

  • If oil price sustained at much lower level for long time than there will be huge budget deficit, Government will have limited options viz.


  1. To increase oil prices domestically, But this will not give bridge the gap

  2. To stop social benefits- This will be unpopular measure and may result in unrest in the country

  3. To withdraw money from sovereign funds to balance the budget, Iran government had already withdrawn 1 bn. euro to fight with corona.


These funds have major investment across all the asset class like real estate debt and global equity, private equities, startup funding and venture capital funding.

If it triggers not just global equity will see major outflow it will badly affect startup funding as these funds are major investor to soft bank and other VCs


Which will affect the most-


Iraq-


  • The problem starts from here- With > 80% of budget revenue comes from oil

  • Almost 10% workforce is employed in this industry

  • But unlike other middle east countries Iraq govt. do not have any sovereign fund to support the public

  • Only solution is to cut the nation’s budget and stop some social benefit with immediate effect this can cause big social unrest in the country.


Other gulf countries-


  • Kuwait is also exposed to oil very much

  • Dubai is not UAE, It’s one of the city for entire country story is not different


Saudi Arabia-


  • Oil is almost 87% of budget revenue, This sector contributed about 50% of the nation’s GDP

  • Largest exporter of oil has instructed states to cut budget by 30%

  • Saudi’s king’s plan of diversifying to other areas to reduce dependence on oil will be badly hurt with low oil prices

  • They will have to hold all capex in other segment to balance the budget

  • Increase in oil prices domestically and increase in taxes is the long term solution to sustain Though they have sovereign wealth fund of 500 bn USD that they have to deploy in oil industry

  • Saudi king run major social benefits, If they withdraw these benefits social unrest may be there in country

Russia-

  • Deep reductions in demand from Russia’s largest customers China and the European Union.

  • Half of the total export of Russia comes from oil thus it become more painful

  • Russia is in full-fledged fight mode, with 500 bn USD in foreign currency and 175 bn USD of sovereign fund Russia says they can survive oil prices between $25 and $30 per barrel for up to a decade

  • Still 1 mn job i.e. 1.5% of Russian workforce are at risk


Conclusion-


Corona is the last nail in the coffin for OPEC members. It will not only affect their plan to de-risk from oil but they have to deploy more money to manage from corona. Iran has seen its worst time in the century.


  • If oil prices does not increases and sustained at above $50-60 they have to withdrew from sovereign fund that will trigger the global equity sell-off, Not just equity but world can see big outflow from real estate to debt market

  • For countries like Iran, Iraq road is even tougher, there is a high chance of political uncertainty or social unrest



Regards,

Gourav Gupta


For any queries you can reach out to me at gourav@equialpha.com

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©2019 by Equialpha Wealth Advisers