Russia and Saudi Arabia have fallen out of love and their spat has translated into a world oil crisis.
The two countries had been willing partners for several years in managing oil production in such a way as to keep prices at profitable levels.
Although Russia was never a member of OPEC, the world’s third-largest producer had gone along with the cartel’s policies for years, deeming them to be in the country’s self-interest. Until now.
The coronavirus has dramatically reduced the world’s demand for oil, as factories have been idled and air travel slashed. Saudi Arabia wanted to cut production to maintain the supply-demand balance and to keep oil prices stable. Russia said no thanks.
The Saudi response was to announce a major increase in production, which caused the price of oil to plunge to levels not seen since the financial crisis. That will cause short-term pain to the Saudis but will likely hurt their major competitors more. Here’s what the situation looks like now.
Russia. According to most analysts, the Saudi move places Russia in a difficult position. Oil and gas revenue represent a large chunk of the country’s budget. If the oil price remains low for an extended period, the Russian economy will take a big hit and President Vladimir Putin will hard-pressed to respond.
United States. The U.S. has become the world’s largest producer, thanks to the magic of fracking, which has released vast quantities of shale oil and gas. But many shale producers are small, overleveraged operators. A sustained drop in the oil price could push some of them into bankruptcy – a result that both the Saudis and the Russians would welcome.
Canada. Despite all our woes with pipelines, Canada is still the fourth-largest oil producer in the world, according to the U.S. Energy Information Administration. But we labour under a unique handicap – most of our production is landlocked, reducing us to having only one major export market, the U.S. As a result, our producers are forced to sell at a deep discount. As of March 11, a barrel of Western Canadian Select was selling for US$20.19. That was a discount of 39 per cent from the price of West Texas Intermediate.
Few, if any, oil companies can make a profit at those prices. Small wonder the S&P/TSX Capped Energy Index was down 60 per cent year-to-date as of March 12. The stocks of some companies have fared even worse. Things didn’t get any better on Monday, when the S&P/TSX Composite index lost 9.9 per cent and the S&P/TSX Capped Energy Index fell 18 per cent.
There is no evidence that things will improve soon. The coronavirus is likely to suppress world demand for months to come, perhaps even longer depending on its intensity. Saudi Arabia is not likely to back off, unless President Donald Trump puts the squeeze on his “good ally” Prince Mohammed bin Salman in an effort to save the U.S. shale oil industry.
So, if you own Canadian oil stocks, what should you expect?
The biggest will survive. Companies like Suncor (TSX, NYSE: SU) and Canadian Natural Resources (TSX, NYSE: CNQ) have seen their share prices hit hard. Suncor was down 39 per cent year to date as of the time of writing. Canadian Natural Resources was off 52 per cent. However, these companies should have the financial staying power to ride out this particular story.
Those with stretched balance sheets are vulnerable. With oil prices so low, revenue is going to fall off a cliff. Companies that are heavily leveraged are going to struggle to survive and some will not succeed.
Dividends will be cut. Expect wide-scale dividend cuts if this situation continues. The payouts of some companies are not sustainable in the current climate. Earlier this month, Vermilion Energy (TSX, NYSE: VET) announced a 50 per cent cut in its monthly dividend to $0.115 per share. Even at that drastically reduced level, the stock will yield an absurdly high 28.9 per cent at the current price, suggesting that investors believe there is more pain to come.
Consolidation looks inevitable. There are a lot of quality assets available right now for peanuts. The bargains are almost certainly going to look even better in the coming weeks. Expect to see a spate of mergers and acquisitions in the energy sector as cash-strapped companies seek more financially stable partners.
One black swan is enough to destabilize an industry. Two is destructive. Three could be a death knell.
That’s the number the Canadian oil sector has to cope with: the coronavirus crisis, the unexpected price war, and the Liberal Government’s chaotic energy policy. No wonder Albertans are on the verge of rebellion.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters.