The Salutary Effects of Coronavirus-Stricken Energy Prices
While energy investment retrenches in the wake of COVID-19’s historic impact on oil and gas markets, consumers will benefit as economies reopen. Selective and patient investors should too.
As major central banks push key interest rates to sea level or underwater and national governments aggressively crank up fiscal spending to refloat economies dragged down by COVID-19, lower energy prices provide yet another form of massive stimulus for the vast majority of the world.
As coronavirus infection rates appear to have peaked in most of Asia, Europe and perhaps even the U.S., allowing for gradual re-opening of most of the world’s GDP, demand for transportation fuels should slowly start to recover from terribly depressed levels. The demand shock on oil prices was exacerbated by the recent oil price war that briefly broke out between Saudi Arabia and Russia, stoking market fears of rising supply amid the all-too-real sharp reduction in the global call on fuel.
News headlines have understandably focused on the nosedive in oil prices and especially the WTI crude May futures contract, which fell into negative territory for the first time ever last month, as well as on the historic agreement between the Saudi-led Organization of Petroleum Exporting Countries (OPEC), Russia and the U.S. to jointly start cutting their collective crude output from May 1.
But the big questions now are how fast supply is reduced, how fast demand recovers, and the outlook in the near- and longer-terms for investment–and investors–in the sector. There will, of course, be winners and losers among suppliers and consumers of conventional hydrocarbons.
Paying to Avoid Delivery of Black Gold
Toward the end of April, front-month WTI traded close to $13 a barrel, and the international benchmark, Brent, bobbed around $21/bbl, huge discounts from their respective five-year averages of about $55/bbl for WTI and near $60/bbl for Brent. Before the COVID-19 lockdowns crippled oil demand, global consumption was running around 100 million b/d. Since then, demand fell an estimated 29 million b/d year-on-year in April, and the International Energy Agency expects it to be down 26 million b/d in May from the year before.
In addition to the demand/supply dynamics, much of the recent WTI price action was driven by effectively full oil storage capacity at the main U.S. oil trading hub in Cushing, Oklahoma. That largely drove the WTI May front-month oil futures contract to -$40, a historic first in black gold, as investors caught on the wrong side of the trade paid to avoid delivery of the physical product. Don’t be surprised if the WTI June futures contract, which expires on May 19, also goes into negative territory. It’s worth noting that while storage costs are rising fast in Europe with inventory capacity at very tight levels, Brent bottomed on April 21 at $19.33/bbl.
Just how fast nearly full global oil and natural gas commercial and strategic inventories hit capacity, if indeed they do, depends on a number of variables. OPEC together with Russia are preparing to effectively take 10.7 million b/d offline (rather than 9.7 million b/d, given a higher production baseline in April.) The U.S. has agreed to “buy” 3 million b/d for deposit into its Strategic Petroleum Reserve, while China, India and South Korea will also divert smaller amounts into their own strategic reserves, according to the IEA. The U.S. and Canada, along with a few other smaller producers, will also presumably allow some 3.5 million b/d in combined output to go away via an economic shake-out of their higher break-even oil price, less productive operators in the current lower oil-price environment.
Importantly, though, the deal between OPEC and non-OPEC producers is essentially a “gentleman’s agreement” as it comes without enforcement mechanisms. Nonetheless, the IEA expects this price-induced “loss of supply combined with the OPEC+ cuts will shift the market into a deficit in the second half of 2020, ensuring an end to the build-up of stocks and a return to more normal market conditions.”
Crude Prices to Lag Consumption Rebound as Inventory Overhang Lingers
While higher-cost, short-cycle U.S. shale producers are cutting back fast, conventional major Western oil companies’ production declines will come more slowly, after reduced energy sector investment. Those capex declines are significant: global energy capex could fall to less than $300 billion this year from around $600 billion in 2019.
Still, working through the build in brimming global inventories to alleviate the downward pressure on oil prices may take at least a year or two. It depends on how much production comes down as well as on how fast economies normalize once the coronavirus is tackled by therapeutics and a vaccine, if it doesn’t first recede of its own accord as “herd immunity” develops.
As lockdown orders are lifted and people gradually get back to work and play, the call on transportation fuel will rise. All the monetary and fiscal stimulus will be joined by a giant boost in the form of lower-cost energy. Let’s say, for example, that global consumption recovers before too long to 100 million b/d again, but crude prices lag as the inventory overhang lingers. At $35/bbl, rather than $55/bbl, energy costs would fall about $730 billion a year, largely benefiting consumers worldwide.
And that’s a lot of consumers. Nearly all of Asia is a net oil importer. Moreover, although emerging market equities tend to trade with a positive correlation to oil prices, the only big net emerging market oil exporters are Russia, Saudi Arabia, a few other Persian Gulf states. Brazil and Mexico are effectively in net energy balance. In fact, after China, the U.S. is the world’s second-largest importer of oil, given that U.S. refineries are geared mainly for heavy, sour crude that’s produced largely in the Middle East and Canada. It’s followed by India, Japan, Korea and European nations.
Where Value in Energy Can be Tapped
For investors, opportunities may be found in the lower-cost, higher-margin producers, including Russian majors with costs in depreciating rubles (this year) but revenues in dollars. The premier European supermajors are financially sound with solid balance sheets, vertically integrated and boast plenty of exposure to natural gas. Beyond the COVID-19 dip, global consumption of the blue-burning fuel is growing as it’s far-cleaner burning than oil and coal, which natural gas has been steadily displacing in the U.S., Europe and elsewhere.
Select U.S. free-cash-flow positive upstream oil and gas producers and midstream infrastructure companies that sport low leverage may also offer true value, as declining shale output and less energy capex globally imply less oil and associated gas production near term. That should be supportive of oil and gas prices not far down the road, as bloated inventories normalize alongside supply and demand.