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Energy ETFs Collapse As Oil Craters

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·6 min read
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Energy ETFs Collapse As Oil Craters
Energy ETFs Collapse As Oil Craters

Oil prices crashed by as much as 33.8% this morning and Sunday, their largest single-session decline since 1991, as Saudi Arabia indicated it would sharply increase production following last week’s failed talks with Russia.

The rout in oil sparked fear across financial markets, including U.S. stocks. The S&P 500 fell 7% early on Monday, triggering a market-wide circuit breaker that halted trading for 15 minutes. 

Prices for West Texas Intermediate (WTI) futures tumbled as much as $13.94, or 33.8%, to a low of $27.34. They were last trading down by 23.3% to $31.68. At the same time, Brent futures shed as much as $14.25, or 31.5%, to a low of $31.02. They were last trading with a loss of 22.7% at $35.

ETFs that track oil futures, like the United States Oil Fund LP (USO) and the United States Brent Oil Fund LP (BNO), sank the most on record. For oil itself, it was the worst single-day sell-off since U.S.-led forces began Operation Desert Storm to drive the Iraqi army out of Kuwait on Jan. 17, 1991.

In the past two months, oil prices have fallen by half and to their lowest levels since February 2016, when they briefly traded around $26.


Oil Prices Drops 50% In 2 Months

Talks Fall Apart

The stunning dive in oil prices comes as the coronavirus reduces oil demand by the greatest amount since the financial crisis. Initially contained to China, the virus was already taking a toll on demand, but as its spread worldwide, the hit to consumption could total millions of barrels per day.

Meanwhile, talks between the Organization of the Petroleum Exporting Countries (OPEC) and Russia broke down last week as the latter balked at Saudi Arabia’s plan to trim output by 1.5 million barrels per day to support prices.

According to sources, Russia believes the cuts—which would have come on top of 2.1 million barrels per day of existing production curbs—would hurt the country's oil industry and would give a free ride to America’s shale oil producers, who aren’t bound by any quotas.

Russia favored holding current production levels in place and then reevaluating the situation in June. Saudi Arabia threatened that if Russia didn’t join in the new cuts, the whole OPEC+ alliance would effectively be dissolved, and countries would be free to produce as much oil as they wish.

It looks as if Saudi Arabia has followed through on that threat, cutting prices on their crude dramatically over the weekend, signaling that a price war had begun.

Retesting The 2016 Lows

With Russia and OPEC nations free to pump oil without limits, millions of barrels per day of additional crude could hit the markets just as demand is plummeting. It’s a situation the likes of which the oil market hasn’t seen in decades. Even during the financial crisis, OPEC nations banded together to cut output by 4.2 million barrels per day.

It’s why some analysts are now calling for crude oil to potentially retest and perhaps even break below the $26 lows it saw in 2016.

That would be devastating for oil producers worldwide, including the American shale industry, which now pumps so much crude that the U.S. is the world’s largest producer. Russia and the Saudis hope these lower prices force shale producers to cut output dramatically, eventually rebalancing the market and leading to higher prices.

$86 Billion In Debt Looms

But even if an eventual rebound is inevitable, the pain in the interim could be extreme—even fatal—for many producers. Moody’s estimates that North American oil and gas producers have $86 billion of debt coming due in the next four years, with nearly two-thirds of that being high-yield debt.

With oil prices falling below breakeven levels, and natural gas prices trading at all-time inflation-adjusted lows, defaults in the energy patch could become widespread.

A similar situation caused a panic in junk bond markets in 2016, and investors fear history could repeat. The iShares iBoxx USD High Yield Corporate Bond ETF (HYG), which holds 10% of its portfolio in energy issues, was trading down by 5.6% on Monday.

HYG Sinks With Oil

 

Energy ETFs At Huge Risk

These deep fears also extended to the performance of energy ETFs.

The SPDR Energy Select Sector SPDR Fund (XLE) fell 15.4% on Monday, pushing the ETF below its lowest level of the financial crisis.

More targeted products, like the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and the VanEck Vectors Oil Services ETF (OIH), were down even more on Monday. XOP lost 26.8% and OIH shed 23.5%. 

Even with the energy sector trading at its highest yield on record—more than 5.5% for XLE—investors will be reluctant to wade into an area that is in free fall. Even when broader markets were hitting all-time highs, the energy sector was sharply underperforming amid concerns about long-term fossil fuel demand and growing considerations about environmental, social, and governance criteria.

Russia & Saudi Arabia Feel The Pinch

The U.S. energy sector isn’t the only place feeling the pinch of lower oil prices. Though they are widely regarded as some of the lowest-cost producers in the world, Saudi Arabia and Russia are also getting hit hard by oil’s retreat.

The iShares MSCI Saudi Arabia ETF (KSA) and the VanEck Vectors Russia ETF (RSX) were significantly impacted Monday, with declines of around 15% for each. Both countries rely heavily on revenues from oil sales to fund their budgets.

How It All Ends

How this all ends depends in large part on how developments with the coronavirus go. The demand side of the equation will likely work faster than the supply side. At some point, demand will bottom out and then recover. It could take a while if the virus pushes the global economy into a recession, but the world hasn’t weaned itself off fossil fuels yet, so oil demand will eventually grow again.

On the other hand, it may take some time for oil supply to roll over. Many producers have hedged their production at higher prices and will continue to pump full throttle to meet their debt obligations.

That won’t last forever. If oil prices stay below breakeven levels and the debt markets lock producers out, those spigots will eventually turn off, and production will decline.

Inevitably, bust will lead to boom. The questions are, where will the bottom be, and how long will it last?

Email Sumit Roy at sroy@etf.com or follow him on Twitter @sumitroy2

 

 

 

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