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Oil Shock Adds to Rising Risk

Brent crude prices fell by more than 20% from Friday’s close of US$45.27 after Saudi Arabia announced price cuts and output increase. This led to substantial losses in equities and energy credit that were already weak from COVID-19 contagion. At the time of writing, Brent at US$33 is the lowest since 2004, with the exception of a few weeks in early 2016.

 

Market reaction

Coupled with weak sentiment from the global spread of COVID-19 cases with more than 100 countries reporting cases as the total tally crossed 100,000, equity markets fell sharply this morning, with Hong Kong, Japan and Australia opening 3-9% lower. Equity index futures in the US and Europe dipped more than 4%.

 

The US 10 year Treasury Yield fell below 0.5%, the lowest level seen in history. As of this morning, Fed Funds futures are now pricing in 70bps of rate cuts by the end of March.

 

Oil shock increases risks of economic and geopolitical instability

On Friday, OPEC+ talks to cut output broke down after Russia refused to take part in the cut. Over the weekend, Saudi Arabia effectively declared a price war with Russia to fight for market share. Saudi Arabia announced US$6-8 per barrel price cuts across most of the world. In addition, it would immediately increase output by 300K immediately to 10 million barrels per day, with further increase to 12 million possible if needed.

 

Unlike Saudi Arabia’s 2015 ramp up in output to pressure US shale producers, this round comes when global demand is even weaker due to COVID-19. The breakdown in OPEC-Russia cooperation also appears more permanent than previous episodes.

 

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The collapse in oil prices may have many market implications:

  • Sovereign default risks are likely higher for exporters that are already under pressure, such as Argentina.
  • Corporate defaults, especially among US high yield issuers in the energy industry, are likely to rise.
  • In Asia, producers (Malaysia, Indonesia) and refiners (Singapore, Thailand) are likely to come under fiscal pressure.
  • Importers like China and India may be net beneficiaries.
  • Airlines and the transportation industry may benefit from low oil prices, but this may not be enough to help weak revenues.

 

In any case, global inventories are likely to build significantly no matter what OPEC+ decides and this could weigh heavily on prices into 2021. Brent crude oil looks like it could fall below US$30 sooner, rather than later, with no clear end in sight for a new price range.

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