In a worrying development for coronavirus-hit financial markets, oil markets are now in crisis. The accord between OPEC (led by Saudi Arabia) and Russia has broken down with Russia not accepting OPEC's proposal for production cuts in the face of falling demand due to the coronavirus slowdown. The accord between OPEC and Russia has operated since 2016 when a bruising battle occurred to try and eliminate the marginal US shale oil producers.

Saudi Arabia is playing a game of Russian Roulette. With Russia having double-the-cost of production of Saudi Arabia's (at USD $9 a barrel) and double the sovereign wealth funds and foreign reserves of Russia, the economic pressure on Russia will be immense; currency pressure, government revenue pressure, political pressure. Just up from the production cost curve from Russia are the US shale oil producers (at USD $23 a barrel). The US shale oil producers carry significant corporate debt at the fringe and below investment grade level and are currently the largest oil producers behind Saudi Arabia and Russian. The US political environment is incredibly different to 2016, and the US oil industry's resurgent is a point of national political pride, a position which is unlikely to go unchecked by the Trump Administration.

The move to increase oil production in a declining oil demand world (which has been compounded by COVID 19 reduction in demand) is fairly unprecedented. In fact, you have to go back to the 1930's for such a situation. Brent Crude closed last week at USD $45.27 having already fallen over 9% for the week. At the time of writing it was trading at USD $32.00, a fall of 29% over a single weekend. This has occurred with the Saudi's offering significant discounts to customers in Europe, Asia and the US corresponding with indications that it will lift daily production from 9,7 million barrels per day to over 12 million barrels per day (despite seemingly weak demand).

The move by Saudi Arabia is potentially more troublesome than the COVID 19 crisis. It is a high stakes move by both the Saudi's and Russia. Russia did not agree to OPEC's proposal to cut production as it sees an opportunity to inflict pain on the US shale oil producers, who are large volume but marginal producers at USD $45 a barrel. The Russians want to take back market share from the US shale oil producers. For the Saudi's and Crown Prince Mohammed bin Salman (MBS), the counter-attack is high risk. The Saudi's have been somewhat reconciled to the US shale oil economy. Russia on the other hand is a key ally to the Saudi's principal enemy in Iran and has rejected OPEC's supply/demand strategy. The Saudi's seek to make Russia heel (and likely don't mind if US shale oil producers fail).

Ordinarily we could expect that the Saudi's to have consulted the US. However, with Mohammed bin Salman controlling government and his actions being somewhat erratic, these actions coincide with further power consolidation over the weekend, and other ill fated strategies such as Yemen, the Jamal Khashoggi assassination and the blockade of Qatar. The cost to Russian oil producers, principally controlled by government is likely to approach USD $175 million a day and cause huge economic pain to the Russian economy. It is the equivalent of economic shock-and-awe by the Saudi's timed for maximum economic carnage. In conjunction with COVID 19 it adds a further front of market dislocation.

The recent financial turmoil has been roiling in its rapidity and severity. With the oil price down 29%, equity markets broadly down 20% and the Australian 10 Year Bond Rate down to 0.62%, the data points are jarring in the short term. That said however, unlike previous financial market corrections leading to recession, the underlying landscape is not nearly as hostile and toxic - in fact, the US is at a strong starting position.

The COVID 19 news flow will invariably lead short-term markets for the next month as US testing and data gets to where it needs to. Oil will cause significant problems for Russia, the US oil industry but also Iran, Canada, UAE and Iraq (but the large oil importers are beneficiaries like China and Japan). We expect money market liquidity to continue to be supported by the Federal Reserve and our own Reserve Bank. This will combine with further quantitative easing actions and government spending. Markets will invariably continue to overshoot on the downside but monetary and fiscal policy will grow in its support. Against this balanced assessment, we remain constructive on market risk assets over the medium term but see news flow driving the short-term downside.

For further readings on the Pandemic impact on Global Economy, please click one of the links below:

• The spread of coronavirus outside China has rattled equity markets, but what is the impact for the Australian economy?

• Panic, Pandemic and Effective Investment Strategy

Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.

For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.