- Oil exacerbated this crisis
- The US oil industry will survive with bailouts- Equity holders in trouble
- Levels to watch on the downside
The signs of demand destruction in the crude oil market began in January when news of the outbreak of Coronavirus in China caused the Chinese economy to grind to a halt. After falling to a low of $27.34 per barrel on the nearby NYMEX futures contract in the early hours of trading on March 9, the price held above the February 2016 low at $26.05. On March 17, as the virus continued to wreak havoc in markets across all asset classes, the support level at the 2016 low gave way, and the price of the energy commodity fell to below the $20 per barrel level at the end of last week, a price not seen since early 2002. As the virus made its way around the world, so did demand destruction for energy.
People around the globe are hunkering down in their homes. They are not driving to work, business activity has ground to a halt, and inventories have been climbing.
Production in the US, according to the Energy Information Administration, was at a record high of 13.1 million barrels per day for the week ending on March 13.
The United States Oil Fund (USO) moves higher and lower with the price of NYMEX crude oil futures. UCO and SCO are double leveraged products for the up and the downside but leverage in the current environment poses additional risks at this unprecedented time.
Oil exacerbated this crisis
If the Coronavirus was not enough, OPEC and Russia’s decision to abandon production quotas at its March 6 meeting rubbed salt into the wounds of markets. At the end of 2019, OPEC Plus-one increased its production cut from 1.2 million barrels per day to 1.7. Saudi Arabia threw in another 400,000 barrels bringing the total amount of the production reduction to 2.1 million barrels. The cartel agreed to meet in early March to assess the impact of its move on the price of the energy commodity.
The production cut in late 2019 was on the back of the trade war between the US and China. As it turned out, Coronavirus de-escalated the trade war with far more severe results. Saudi Arabia went into the early March OPEC summit advocating for a further 1.5 million barrel per day cut in production. The market anticipated the cartel to settle on a one-million-barrel reduction. Russia balked, and the meeting ended with no agreement. The cartel members and Russians abandoned all quotas when Saudi Arabia said it would ramp up output. The price of crude oil fell like a stone and reaching its lowest price since 2002.
As the monthly chart highlights, after putting in a bearish reversal in January, the price of crude oil fell in February. In March, OPEC’s decision to address demand destruction with increased production sent the price reeling to the downside. Last week, nearby NYMEX futures fell to a low of $19.46 per barrel, the lowest price since February 2002. The energy commodity closed the week at around the $23 per barrel level on the expiring April futures contract.
The prices of all assets would likely have moved significantly lower as the global economy has ground to a halt. Still, OPEC Plus-one’s decision to flood the market with crude oil certainty exacerbated the situation.
The US oil industry will survive with bailouts- Equity holders in trouble
One of the signs that crude oil was in trouble was the lack of performance in energy-related stocks as the stock market was rising to a series of new all-time highs in 2019 and in early 2020. While the energy sector lagged on the upside, it tanked when the rest of the market plunged.
The market caps of almost every energy-related company that trades on the stock market have evaporated. As the chart of the Select S&P Energy Sector SPDR (XLE) shows, XLE fell to a low of $22.88 per share last week. The ETF product that holds many of the top energy stocks traded to its lowest price since 2003.
Low interest rates over the past years encouraged many energy companies to build up high levels of debt. At the same time, efforts to support share prices led to share buybacks. With the price of crude oil below production cost, the number of bankruptcies in the energy sector, as well as most other businesses, will be staggering. The US government, and others around the world, will bail out companies that are critical for national security. However, equity holders are likely to see their investments wiped out.
Levels to watch on the downside
When it comes to NYMEX crude oil, $20 per barrel was a psychological level, which gave way late Friday. The next technical support stands at the 2002 low of $16.70 per barrel. In 1998, crude oil fell to $10.35 per barrel, and in 1986 to $9.75. With massive supplies coming from the oil cartel and Russia and US production at over 13 million barrels per day, the chances for a continuation of the price carnage are high as demand destruction continues. However, the price has declined to a level where the global output will decrease dramatically. On Friday, March 20, rig counts in North American dropped by 19 to 664 compared to 824 last year at this time. The number of rigs in operation will continue to plunge over the coming weeks and months.
The world has ground to a halt as scientists scramble for a vaccine, and health professionals try to deal with the mounting number of infections around the globe. The demand for energy will continue to fall in the current environment as, unfortunately, science progresses a lot slower than markets. On Thursday night and Friday, California and New York shut down everything but essential services.
Staying healthy is the primary focus. The price of crude oil will eventually come back, but it could make that move from a far lower level.
The United States Oil Fund LP (USO) was trading at $4.67 per share on Monday afternoon, down $0.27 (-5.47%). Year-to-date, USO has declined -61.12%, versus a -16.15% rise in the benchmark S&P 500 index during the same period.
About the Author: Andrew Hecht
Andrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.