Oil prices dropped more than 25% on Monday which was the biggest one-day drop since 1991following a failure to make a deal at the Organization of the Petroleum Exporting Countries (OPEC) meeting and Saudi Arabia's move to boost production. Prior to the OPEC meeting, oil was trading between $42 and $47. Monday, it hit a low of $27 before closing around $31.
Expectations were for OPEC to agree to production cuts given the weakness in prices and further reductions in demand due to the coronavirus outbreak. Markets were shocked as the meeting ended with no agreement, and Saudi Arabia signaled it would boost production instead as it engages in a price war with Russia. Russia was not in favor of cutting production, as it wants to put US shale producers out of business. The U.S. is not part of OPEC and has been increasing oil production despite lower prices.
Like other cyclical assets, oil has been in a downtrend since late-2018, when it topped around $75. It bottomed in December 2018 but it failed to significantly rally like many other assets. Instead, it stayed range-bound between $45 and $65. Also unlike other assets, it was putting in lower highs and lower lows within this range. In hindsight, this was a clear indication that oil was under distribution and had more downside risk.
OPEC Meeting
Oil started this year near $60 per barrel. Supply remained strong, but demand was flagging as the global economy slowed. And this slowing intensified following the coronavirus outbreak and should persist in the coming month as countries take more aggressive efforts to combat the spread which basically entails reduced travel and economic activity.
As the lowest-cost producer with the most oil reserves, Saudi Arabia can pump as much as 12.5 million barrels per day. Currently, it's pumping between 9 and 9.5 million barrels per day but is signaling it will boost this amount to 10 million barrels per day. Basically, Saudi Arabia is looking to punish Russian and other countries that were unwilling to go along with its proposed cuts.
OPEC Members' Incentives
Additionally, OPEC's previously agreed-upon quotas expire in April, so member countries will be free to pump as much as possible. In some sense, OPEC's existence and discipline are remarkable. It's a testament to Saudi Arabia's power and leadership. It's in each OPEC countries' best interest to pump as much oil as possible to maximize revenue especially when oil prices are down. It's in their collective interest to pump the last oil as possible in order to maximize prices.
Russia prevented OPEC from reaching a deal in order to put higher-cost producers out of business so that in the long-term, supply will be lower. Saudi Arabia is looking to punish all oil producers by flexing its muscles and showing what countries have to lose by not following its lead.