Oil price cuts: There may be trouble ahead

The outlook for the world economy has moved into negative territory. The Coronavirus is stealing all of the headlines and the impact on multiple economic factors over the coming months is likely to be huge. The market sentiment is clearly evident as investors lose confidence in the global stock markets. Coordinated action from central banks is almost helpless when entire countries are placed on lockdown. People are not moving around, not doing business and as a result, almost all companies across industries will suffer disruption of some kind. Of course, there will be winners, there always is, online collaboration and communication technology will become ever more important and of course everyone is sitting by, on the edge of their seats, waiting for a pharmaceutical firm to bring a vaccine to the market.

Naturally, as Coronavirus turns into a global pandemic and slows the world down, the oil producers are anticipating by gearing up for a decline in demand…

Queue Saudi Arabia to make an aggressive move. Earlier this week they cut their crude prices by some 10% and increased production. Their retaliation comes after they had wanted to lead OPEC and Russia in making deeper cuts to oil production to stabilise the crude prices in reaction to the virus. But when Russia decided not to play ball then Saudi dealt their fatal blow.

A geopolitical battle between two heavyweights has far reaching impacts. Saudi’s cost of production is very low compared to other producing countries and they can stay in the game and still make money even with the tightened margins. Most other countries and companies cannot compete at this level, they have much greater production costs and simply cannot survive when oil drops below a certain threshold. Russia has a lifeline in that they have substantial financial reserves and could devalue their currency to maintain the cash flow through their economy. But the smaller producers will suffer and even more so those countries who support Saudi and Russia in drilling for oil.

Despite Saudi’s lower cost of production some analysts would still question their bold approach. Their economy is not immune to a price crash, they have gained a reputation of late for making risky decisions.

Hopes for an oil price recovery are reliant on finding a cure to the Coronavirus to stop it spreading…all unknowns. An ongoing price war will take a heavy toll on the producers and also governments, whose budgets are pegged on the price of crude. And even if Russia and Saudi did resolve their differences – the surplus of oil and decline in demand all points towards a future of low prices, for years potentially. Has instability become the new norm?

The economic fallout will take months to come to light but the US economy will undoubtedly suffer. Specifically, if we look at Texas where oil drives the majority of employment – last time there was a price crash 100,000 people lost their jobs. Many of the smaller oil producers with large debts are in trouble, even the medium sized firms that have large debts and they will have to cut spending on new production in order to survive. The larger firms should be able to ride the wave but there are most definitely troubled waters ahead.

All these factors point to a rise in credit defaults and bankruptcies in the coming months. It is vital that companies have access to key information and risk drivers on their trading portfolio. Credit Managers will need all the information and data at their fingertips to make vital credit decisions such as approving a new credit line, reducing the limit of a counterparty or requesting increased collateral cover.

There is undoubtedly trouble ahead but you must face the music and manage your credit risk efficiently!