The Art of the Price War
The coronavirus preys on the old and frail. Price wars kill off the weak too, in a corporate sense. Both scourges are ravaging the global oil and gas business, with little visibility on how or when things will be resolved.
Market death. That’s what happens to weak companies that succumb to low product prices. The Russians know this, which is why they pulled the “plus” out of the OPEC+ last week. By breaking rank from the price-protecting cartel, they signaled intent to take down their nemesis: the American oil and gas industry.
I can envisage Vladimir Putin opening his desk drawer and pulling out his specially embossed copy of Sun Tzu’s The Art of War. Turning to the dog-eared page, he reminds himself of a key lesson: “You can be sure of succeeding in your attacks if you only attack places which are undefended.”
Those are poignant words. The Russians, like the Chinese general from the 5th century BCE, understand the word “undefended.” Also versed in The Art of War are the Saudis, who are veterans of many price clashes.
Undefended oil producers—anywhere in the world—are those with pre-existing health conditions: high costs, too much debt and no access to capital. Unresponsive management and lack of innovation expose additional weakness. Corporate ventilators won’t protect these companies much when the price of a barrel is under $US 40, let alone sub-30.
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The negative impact of the coronavirus on the global economy, hence energy consumption, had already infected oil markets. As of last Friday, the price of a barrel was down over 30% since the beginning of the year, trading in the low-$40 range. By week’s end the necessary vaccine was clear: OPEC+, the original 10 cartel members plus four others, including Russia, had to shut in more of their production to stop the price slide.
That’s when the cherished Russian copy of The Art of War was pulled out of the drawer. Prop up prices? Are you kidding, OPEC? What a great opportunity to bankrupt half the defenseless North American oil and gas industry and take back market share.
The Saudis, reportedly angered by the Russian move, pulled their own quotation out of Tzu’s battle notes: “In the midst of chaos, there is also opportunity.”
So now, instead of offering any production cuts, two of the three largest oil-producing countries are flooding the market. Already, a barrel of oil is selling for less than a bottle of black-market hand sanitizer.
This is the second time a price war has been declared in less than five years. But this time, market death will hit companies with pre-existing conditions much harder. Access to capital, which has been the corporate oxygen of the past, is now shut off. Equity financings are gone. And banks have already been slashing their exposure to vulnerable debt. Price hedges offer short-term protection for producers, but no more than a cheap respiratory mask if the price war lasts more than a couple of quarters.
Disintegration of OPEC was a long time coming. The Russians were tired of making American—and Canadian—oil producers stronger. For Putin, an axe to grind over punishing U.S. sanctions made the idea of assaulting Western oil interests even sweeter.
The broader geopolitics are important: to Russia, this price war is more than just about regaining market share for oil; it’s about assaulting the Western economy, especially America’s.
For Canadian producers, there is good news and bad. On the positive side, the industry is battle-hardened. Over the past five years, innovative companies have already learned to endure some of the lowest prices in the world. But on the downside, there are many that are battle-weary, weakened and lacking a lifeline to capital.
On average, Canadian producers break even pumping oil if the price of a West Texas barrel is somewhere in the high-$US 30 range. But that’s an average break-even threshold for an industry with a wide variation in costs; that means at that level about half the companies can’t pay their bills and half are treading water.
How do companies survive a price war? Wash hands of debt, don’t shake hands on bad deals, and keep your distance from high-cost assets. For those that didn’t take such precautions after the 2015/16 price war, this one is likely to be deadly.
But there is good news from Sun Tzu. Paraphrased from the original Chinese writing, he notes that “There is no instance of a nation benefitting from prolonged warfare.” Hopefully, that page in the book is also dog-eared, and gets turned to.