Market Crash, Coronavirus, Oil Price Collapse, Where Do We Go?

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Senior Fellow - Economy

This was a really awful black Monday by any historical yardstick. On March 9, global equities plunged, triggering circuit breakers even in the most liquid markets. At market close, the S&P 500 index had lost 19% from its recent peak (19 February). This steep decline was set off by a collapse of crude oil markets, as the news of Saudi Arabia and Russia launching a war for global market share reached trading desks. Even more spectacular than the equity market crash, crude oil quotes fell by more than 30%, WTI dipping as low as $30/bbl. Less noticed but nevertheless quite revealing of the market sentiment, US government bonds rallied spectacularly, with the 10-year yields falling from 1% to 0.4%, as institutional investors rushed for safety. Even though a rebound took place the next day, high market volatility is warranted for some time, as shown by another sell-off on Thursday 12. These developments raise three questions:

1/ What triggered the joint sell-off of crude oil and equities?

2/ How will the oil price war end?

3/ Should we fear a doom loop between real economies hit by the coronavirus outbreak and the financial markets?

The root of the sell-off is a no brainer

Starting with the cause of the sell-off, there is no doubt that it is the ongoing coronavirus outbreak. Only two weeks ago, the coronavirus disease (COVID-19) seemed limited to China and some neighboring countries, with dramatic short-term consequences for the Chinese economy and large global ripple effects, but a pandemic was only a probability. With the number of cases suddenly rising in Italy, cases appearing in the US from coast to coast, the probability has become a reality, triggering a sell-off: markets have now priced in a global recession. The next big uncertainty markets have to cope with is the effectiveness of government strategies to contain and eventually curb the epidemic.

Only two weeks ago, the coronavirus disease (COVID-19) seemed limited to China and some neighboring countries, with dramatic short-term consequences for the Chinese economy and large global ripple effects, but a pandemic was only a probability.

While China, Japan, South Korea and Taiwan, although after delays and hesitations, seem to have designed and implemented effective strategies against the virus, the same cannot be said of the United States and Europe, where the number of cases is growing exponentially, and where, rightly or wrongly, policy makers appear reluctant to take the bold decisions that their Asian counterparts took. Italian authorities were taken off guard by the rapid rate of the outbreak, before deciding to follow the Chinese strategy and lock down the whole country. In the US, President Trump keeps downplaying the severity of the pandemic, despite the warnings of the Center for Disease Control and Prevention.

Markets are calling for effective political leadership and coordination

For investors in risky assets such as equities or corporate bonds, the question is not whether the global economy will take a hit –this is now a given– or when –it is happening right now, which is the first cause of the oil price fall— but the depth and duration of the downturn caused by the outbreak. Although there are still many unknowns about the new coronavirus (SARS-CoV-2), such as its "true" lethality (estimate span from 1% to 3%-plus) or its seasonal nature (one hopes it is indeed seasonal, although this means it could come back with a revenge next winter), the main uncertainties around the depth and duration of the crisis are stemming from governments’ reactions in key constituencies such as the US and Europe. Once clear and credible strategies are implemented, which would require a higher level of coordination than what we have seen so far, risk assets markets are likely to stabilize even if the news flow from the pandemic remains bleak for some time. In other words, markets are looking for true leadership.

Despite lower demand, Russia and Saudi Arabia open the oil taps

Talking about leadership, the behaviour of the giant oil producers that are Saudi Arabia (KSA) and Russia is another big source of uncertainty. Because of the coronavirus crisis and its large knockdown impact on China (see Coronavirus: Preparing for the pandemic), global crude oil demand has plummeted, which would require significant output cuts to clear the market. While Saudi Arabia, the de facto leader of OPEC because of its swing producer¹ capacity, was calling for such cuts, Russia turned a deaf ear. According to the Financial Times², Igor Sechin, ruler of oil giant Rosneft and close ally of Vladimir Putin, thought that letting prices fall was a once in a decade opportunity to ger rid of US shale oil producers, which have marginal production costs around $40/bbl and are highly leveraged.

The fly in the ointment was that Saudi Arabia would also be on the losing side. Perhaps the Sechin-Putin tandem bet that young crown prince Bin Salman, already struggling to raise capital by floating Aramco, would bulge. In the event, MBS called the Russian bluff, announced Saudi Arabia would increase production and cut prices. On Sunday 8 March, a full-fledged price war had started.

A remake of the 1986 Saudi U-turn ?

In the event, MBS called the Russian bluff, announced Saudi Arabia would increase production and cut prices. On Sunday 8 March, a full-fledged price war had started.

In contrast with Russia, always reluctant to cut production because its declining yet still large population needs oil dollars to protect its living standards, KSA, which has a rising but still comparatively small population and owns very large external assets, can afford cutting production to beef up prices. This was the strategy followed by then oil minister Yamani in the early eighties, when rising non-OPEC producers threatened to cut market prices. Doing so, KSA was losing market shares year after year, until King Fahd fired Sheikh Yamani and made a U-turn, increasing output from 5 to 10 mb/d, making crude price collapse. Although that was not his purpose, King Fahd helped Paul Volker, then Fed chairman, to win the war against inflation, and kicked started the global economy. According to some analysts, the fall of oil price created the conditions for the collapse of the Soviet Union, suddenly starved of petrodollars.

Are we witnessing a remake of 1986? The common point is the fight for market share between two big producers, then OPEC vs. NOPEC, now KSA vs. Russia. Yet, the world is very different from what it was back then. First, US shale oil producers have become the dominant swing producer, making the game more complex. Second, because inflation has vanished, central banks are at, or close to the bottom of the feasible range of policy rates. Therefore, the collapse in energy prices, which will cut consumer prices, will not be fully compensated by lower policy rates, which, in turn, will increase real interest rates at the expense of the real economy. In other words, lower energy prices are not necessarily good news for the global economy. Besides, the market reaction to the new oil war was quite negative: because shale oil producers are highly indebted, the high yield segment of the bond market suffered heavy losses, reinforcing the downward pressure on equities. This shows how important is the oil war.

Russia, Saudi Arabia, shale producers, who’s going to blink first?

Russia has sound public finances, being one of the rare countries to run a budget surplus (1.5% of GDP in 2019), its government is almost not indebted (15% of GDP) and has built a hefty stabilisation fund for rainy days thanks to oil royalties. Yet, both the economy at large and public finances are highly dependent on oil income. Excluding energy, the current account and the government balance are in deep deficit, -8.6% of GDP in 2018 for the former and -6.2% for the latter. A 30% oil price drop would impact government balances and, more importantly, reduce households’ income, a politically sensitive topic.

Saudi Arabia is in a more precarious situation, at first sight. The government has a large budget deficit –more than 6% of GDP in 2019— dug by the rising social needs of the country, and its economy is even more dependent on oil than is Russia. Yet, KSA has accumulated colossal external assets –its international investment position stands among the highest in the world ($685bn or 92% of GDP in 2018) which provides the kingdom with a significant room for tactical maneuver. To restore KSA market power, Saudi Aramco has just been asked by MBS to prop production up to 13mb/d, still lower than US output (15mb/d) but significantly higher than Russia’s (10.8mb/d).

By embarking into a market share war, they take the risk to bleed their domestic economies.

At this stage, it is hard to predict which of the two giants will blink first. By embarking into a market share war, they take the risk to bleed their domestic economies. In the end, domestic politics will have the last word.

A Pyrrhic victory for the winner?

Yet, one thing is sure: the short term victim of the oil war will be US shale oil: in contrast with Russia and Saudi Arabia where oil policy is decided by governments, US companies adapt their production to market conditions in real time. Below $40/bbl, a large number of smaller shale oil producers will go bankrupt and those having deep enough pockets to hibernate until better times will shut wells down. As a result, oil output will most likely plummet. Anyway, with demand falling and Russia/Saudi Arabia raising output, something has to give.

In the longer term, things could be very different. Russia and Saudi Arabia will temporarily dominate the market even if waging their market share war implies losses of hundreds of billions of dollars. On the other hand, shale oil producers will be decimated, but the industry will remain vibrant thanks to technological innovation and abundant capital, and will come back with a revenge as soon as prices pick up.

Where do we go from there?

The financial market crash is obviously bad news for savers, mostly those invested in government bonds. In addition, falling equity prices increase the cost of capital for companies. That banks’ share prices have plummeted more than other sectors, because the quality of their assets is deteriorating, adds insult to injury in regions such as Europe where bank lending is the main funding channel for real economies.

Governments can and should alleviate the pain by allowing companies to soften debt servicing and allowing banks to take more risks on their balance sheets, temporarily at least. Central banks must be absolutely clear on their commitment to provide liquidity "whatever it takes" –in that matter, doubts are as harmful as facts. All this is well understood by authorities, and I see no reason why they would not behave. In the event, measures already announced in Italy, France, Germany and the UK, decisions announced by the European Central Bank on Thursday 12 March, are all based on these sound principles. Economic policies, whether macro or more targeted can and must limit the damages caused by the outbreak and make sure that long term consequences will be as small as possible. Yet, they cannot turn water in wine.

In the end, the key question for the financial markets remains the quality of official actions to check the outbreak and curb the ‘new case’ curves as soon as possible. If you trust governments’ capacity to decide timely and implement the right policies effectively, then this could be a good time to invest.

¹By swing producer, one means a producer that has the power to influence global oil markets by cutting or raising production.
²See David Sheppard, Financial Times, 10 March 2019: Russia is digging in for a long battle in the oil price war.

Copyright: SPENCER PLATT / GETTY IMAGES NORTH AMERICA / AFP