Multi-Asset

OPEC+ Disagreement Blows More Bad News for Risk Appetite

In a surprising move, Saudi Arabia decided to flood the market by boosting oil production by 25% after failing to reach a deal with Russia to address the sudden drop in oil demand induced by the coronavirus.
March 2020
  • Failure of Organization of the Petroleum Exporting Countries (OPEC+) members to curtail supply has triggered a price war as Saudi Arabia is boosting oil production by 25%. The flooding of oil has sent oil prices to critically low sub $30/bbl levels where many producers are losing money.
  • This is bad news for Canada on both the economic and stock-market fronts as the country still heavily relies on oil. However we expect a smaller negative impact than during the 2014-15 oil-price shock as the reliance on energy has diminished over the years.
  • Energy capex in Canada and the U.S. is expected to contract in coming months, but consumers will enjoy lower gasoline prices and mortgages rates, which help offset the drag. However, Canada’s regional growth divide will be amplified as oil-producing provinces face increasing headwinds whereas other provinces will get a tailwind.
  • Energy stocks will continue to struggle vs the broad market until someone blinks and cuts oil production aggressively, which might take a few months. Asia EM stocks, led by China and India, will benefit from lower oil prices and should continue outperform Canadian stocks.

In a surprising move, Saudi Arabia decided to flood the market by boosting oil production by 25% after failing to reach a deal with Russia to address the sudden drop in oil demand induced by the coronavirus. Western Texas Intermediate (WTI) oil prices reached an intra-day low of $27.34/bbl on Monday before reverting in the low $30s. This was the steepest daily fall since 1991 (Figure 1). Meanwhile, the price of Canadian crude oil (Western Canada Select) collapsed to just $17.80/bbl. We believe the Kremlin triggered a risky price war to rebalance global oil markets by forcing less profitable U.S. shale producers out of the market (Source: Bloomberg). The move is risky not only for Russia as every OPEC+ member crucially depends on oil revenues to finance public spending. The coronavirus-induced demand contraction will likely linger a few more weeks before we see sustained rebound in prices, but the price war could endure longer unless OPEC+ and Russia negotiate a truce to limit oil supply.

Figure 1: Intra-Day WTI Prices Feeling the Saudi Oil Flood

OPEC Disagreements - Figure 1 - Intra-Day WTI Prices Feeling the Saudi Oil Flood

Source: Bloomberg, BMO Global Asset Management

What does it mean for Canada?

Bad news, of course, but not quite as bad as it would have been back in 2014 when energy extraction was twice as large a share of GDP and when a third of Canada’s capex was energy-related (Figure 2). Leaving aside the highly uncertain magnitude of the coronavirus drag, the lower energy foot print in the economy is the main reason the reason why we expect a milder impact now. For Alberta’s economy, this is another dose of bad news and we would not be surprised to see the province experience another recession throughout the summer if oil prices remain at depressed levels.

Figure 2: Energy Still Matters for Canada, but now half of what it was in 2014

OPEC Disagreements - Figure 2 - Energy Still Matters for Canada chart

Source: Bloomberg, BMO Global Asset Management. Note: Includes support activities.

Similarly, the weight of the energy sector within the S&P/TSX Composite Index has shrunk steadily and now accounts for less than 6% of the S&P/TSX Composite Index (excluding pipelines). The days of $150/bbl oil are long gone and the secular trend of decarbonisation is here to stay. For energy companies, the underperformance is not new but the recent selling pressure has intensified (Figure 3).

Figure 3: Energy Sector (ZEO) Steadily Underperforming the Broad Market (ZCN)

OPEC Disagreements - Figure 3 - Energy Sector Steadily Underperforming the Broad Market chart

Source: Bloomberg, BMO Global Asset Management.

Elsewhere in the country, lower oil prices will bring households a welcomed break at gas stations along with significantly lower mortgage rates. This will be highly stimulative for the already hot provinces of Ontario, B-C and Quebec, especially as we expect interest rates to be much slower to normalize than investor risk appetite. We expect the Bank of Canada, along with the Fed, to aggressively cut rates in coming weeks unless we get signs of containment of the virus. An emergency rate cut by the BoC would not surprise us if the outlook deteriorates further.

What does it mean for the U.S.?

In a major strategic shift, the U.S. turned a net exporter of oil in recent weeks after aggressively ramping up production since the great financial crisis (Figure 4). However, the all-out price war is likely to set the U.S. back to a net importer. Still, the U.S. is now the third largest oil-producing country in the world, behind Russia and Saudi Arabia, and oil affects its economy in a more comparable way to Canada. We expect U.S. energy capex to fall significantly in coming months, which is likely to offset the benefits that lower gasoline prices and record low mortgage rates will bring to consumers.

Figure 4: U.S. Production Ramps up with Drill-Baby-Drill Strategic Policy (1k barrel per day)

OPEC Disagreements - Figure 4 - US Production Ramps up chart

Source: Bloomberg, BMO Global Asset Management.

What does it mean for the rest of the world?

For the heavy oil importers like Europe, Japan, China and India, lower oil prices are a clear positive to their outlook. It will help them cushion against the negative impact of the transitory demand and supply disruptions caused by the coronavirus. Meanwhile, oil-producing EM countries like Brazil and Mexico are likely to face increased pressure on their local economies and currencies as external revenues from oil exports remain weak.

Implications for Asset Allocation

In recent weeks, we tactically over-weighted EM stocks, funded by Canadian stocks. While we did not expect oil prices to collapse this much and thereby violently hurt the loonie and energy stocks, nor did we expect stock prices to tumble by nearly 20% in a few days, we believed China had managed to contain the spreading of the coronavirus faster than expected. Moreover, we think the Chinese fiscal and monetary measures, coupled with the Phase-One trade deal, will make EM stocks outperform the TSX. EM equities are also heavily weighted to the Asia region (70%), which is largely oil-importing and therefore can benefit from a plunge in oil prices.

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