Last weekend, the cartel that controls global oil production met to discuss cutting production in light of the global dip in demand. Those negotiations failed, and now Saudi Arabia and Russia (the two largest producers of oil outside of the United States) are instead engaging in a "price war," ramping up production to their highest levels ever. The effect on the price of oil, already brought down by the lack of demand, was dramatic:

This price war obviously has implications for the Canadian economy and Canadian investors. Below is a brief explanation of the what, why and how of the current price war, and our outlook for Canadian investors.

Price War 101

What is OPEC? OPEC+?

OPEC stands for the Organization of Petroleum Exporting Countries. There are 14 member countries who represent the lion's share of global oil production and the vast majority of the world's proven reserves. OPEC+ includes all the OPEC member states plus 10 non-members, including Russia.

OPEC and OPEC+ operate as a cartel, meeting regularly to adjust their production levels and maintain stable prices. It isn't a perfect cartel, as member states don't always abide by the production levels agreed upon by OPEC, but it's powerful enough to meaningfully influence the global market. 

What is a price war?

A price war is a business competition in which suppliers of a product strategically lower prices, in hopes of lowering their competitor's margins to unsustainable levels. With oil, this means ramping up production to maximum levels despite falling demand, which causes the price of oil to fall well below levels at which some producers can profitably operate. For example, Canadian oil producers and American shale producers are taking a beating this week, because they are among the highest-cost producers of oil.

Why is there a price war now?

Coronavirus (COVID-19) has caused a global dip in the demand for oil, as people are far less eager to fly, go on cruises, drive to work, or engage in economic activity. Coordinating a drop in production to meet a drop in demand is one of the most difficult things a cartel can do, and this time OPEC+ failed to come to an agreement. Why those negotiations failed is unclear, but Russia does have a lot of incentives to undermine the pricing authority of OPEC and the power that gives to Saudi Arabia.

How Low Can Oil Prices Go?

Price wars, like other wars, emerge because of imperfect and incomplete information. If everyone knew how cheaply everyone else could produce oil, price wars would never happen because the outcome would be predetermined and obvious. This information problem gives each producer a huge incentive to hide their cards and obscure their cost of production. It also gives a huge advantage to sovereign producers, who don't have to disclose their audited financial statements like public companies do. 

There are therefore likely very few people inside Russia and Saudi Arabia who know each country's true cost of production. Rumours have swirled around Saudi Arabia's cost of production, with truly wild numbers like $9/barrel circulating, but those are estimates from outsiders. Saudi Arabia has absolutely no reason to correct those rumours, because being perceived as the world's cheapest large-scale oil producer is an extremely good thing.

A major reason this price war is happening now is that Saudi Arabia's cost of production might be higher than previously thought, and the Kingdom was forced to show its hand last year. The Saudi Aramco IPO required the first public, audited financial statements of the company, which are available here. These statements should be taken with a grain of salt, since a unique foreign deal of this size buys a little leeway with quantitative rigor.

Browsing through those financial statements does reveal some surprising information. Take a look at the Free Cash Flow:

In 2016, Saudi Aramco netted just US$1.6B in Free Cash Flow while the average price of Brent Crude was US$45.13. While Aramco might be able to produce oil for just $9 a barrel, it's hard to see how they can do it profitably.

Another aspect of Aramco and Saudi Arabia's cost of production that never gets talked about is the political aspect. Exporting oil is the backbone of the Saudi economy, and also the backbone of the Saudi political system and monarchy. If the country's oil reserves aren't reliably spinning off enormous cash flow, the royal family loses its biggest source of leverage and control internally. Why would competing factions within Saudi Arabia remain loyal when they aren't being showered in money anymore? Russia's political system is less tightly bound to oil production than Saudi Arabia's, but oil money is still an important source of political capital.

What price each country can produce oil at perhaps isn't the relevant question. The more important question is: how cheaply can they produce oil, and for how long, while still preserving their economic and political power.

Our Outlook

For the short term, we expect all energy producers to feel pain. The share prices of energy companies around the world are getting hit hard, and we don't expect that to let up until demand for oil rises and the price increases.

The intermediate term is very interesting. We're not sure that this price war can reach the depths that some expect, and we're aware that this was a rash decision in the first place. There's not a lot that needs to happen for this price war to stop, and a lot of incentives are in place for the world's largest oil producers to start colluding again. Should that happen, today's prices on energy stocks would present an attractive buying opportunity. Specifically, we're looking at:

Enbridge (ENB:TSX): which at current prices (C$42.96/share) pays a 7.5% dividend yield.

Chevron (CVX:NYSE): which at current prices ($83.03/share) pays a 6.2% dividend yield.

Suncor (SU:TSX): Backed by Warren Buffet, currently pays a 7.2% dividend yield.

For more information on this commentary or to discuss your portfolio, reach out to us at 604.643.0101.

Disclaimer: Canaccord Genuity Corp. is a member of the Investment Industry Regulatory Organization of Canada (IIROC) and Canadian Investor Protection Fund (CIPF). The comments and opinions expressed in this commentary are solely the work of the Cash Management Group and Andrew Johns.