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Why would falling oil prices induce an equity rout?
U.S. shale production vs. Saudi Arabia’s “long game”
Falling oil prices ordinarily would not cause a significant sell-off in the equity market. However, post 2008 financial repression have induced yield-starved investors to pour massive funding into energy companies (who are high-yield debt issuers) and increased market risk exposure to energy companies (therefore transmitted oil price sensitivity to broader financial markets).
Federal Reserve’s accommodative monetary policies indirectly made the U.S. shale revolution a reality, but such change to the world oil market also threatened Saudi Arabia. Saudi officials blame U.S. producers as a source of overproduction that upset the status quo, and they should suffer the negative consequence instead of demanding Saudi Arabia to maintain price level by cutting production.
Saudi Foreign Minister Adel al-Jubeir pushed back against this narrative during a January 19 interview with CNN’s Wolf Blitzer. He claimed that Saudi Arabia didn’t want to cut production because it’s worried about the consequences of what he believes would be an artificial price increase.
“The oil price is determined by supply and demand in the market, and there was an oversupply in the market because of overproduction in a number of countries that led to a drop in the price,” al-Jubeir told Blitzer.
He added that a cut in production would effectively bail out the countries allegedly responsible for the price drop while only delaying the current, supposedly market-driven drop in price: “Saudi Arabia refused to cut its production in order not [to] support high producers, since that would have set a stage for a drop in prices and volume down the road … What we’re seeing now is the market price.”
In short, he’s saying that if Saudi Arabia cuts production, it will be just as guilty of price manipulation as all the countries that overproduced and got the world into this situation in the first place.
Thus, Saudi Arabia implemented its policy to maintain production level (thus sustaining the oil supply glut) in hopes of making U.S. shale operations unsustainable (Saudi producers’ break-even price level is significantly lower at a projected $12 per barrel).
Saudi Arabia’s strategy is by no means secret – it was outlined by none other than oil minister Ali al-Nami himself:
Any idea that Saudi Arabia was about to abandon its effort to turn the oil market on its head was dashed earlier this month when the country’s top energy official said it would do something few other industry players want to do right now: invest.
The oil price collapse over the past 16 months has forced the world’s biggest energy companies to cut hundreds of billions of dollars in future spending to bolster their balance sheets. But Ali al-Naimi — oil minister and architect of the Saudi strategy to maintain output and keep prices low to hobble its rivals — voiced a commitment to press on with investments in exploration, production and refining.
It reinforced the idea that however much Riyadh’s revenues have been shrunk — by an oil price that has more than halved — the kingdom has a higher pain threshold than everybody else. And it will press ahead with its long-term plan to undermine rivals and secure its market share
Equity investors react as U.S. energy companies feel the squeeze
As oil prices decline further, equity investors raised probability of default in the energy sector. This wasn’t in theory – investors actively pulled money out of energy stocks and companies that provide peripheral services to energy exploration activities. Some market participants also raised alarms that oil would serve as a contagion transmission mechanism to spread weak growth into healthier sectors. This (and China worries) helped pushed equity indices to current levels.
Monetary policy – the source of the U.S. oil boom
That did not happen.
Instead, classical market concept of simple supply vs. demand took U.S. producers (and investors) by surprise – the overproduction and Saudi Arabia’s reluctance to “play along” in maintaining oil prices resulted in the steep price decline, punishing shale producers and investors alike.
Next article01 20 2016 | by Victor Xing | Economics