CRUDE AWAKENING – DISCUSSING THE OIL PRICE DECLINE AND ITS LONG-TERM IMPLICATIONS
In recent weeks we have regularly discussed both the short and long-term effects of the ongoing coronavirus crisis on the global economy and financial markets. One of its most profound impacts in the short term has been on oil prices which have plummeted due to the decline in demand from the economic impact of the steps governments around the world have taken in an attempt to bring the spread of the virus under control.
This sharp fall in demand coincided with an increase in supply after Saudi Arabia and Russia were unable to reach an agreement on production cuts at the beginning of March. And oil prices have received renewed attention this week due to further extreme volatility and after the May West Texas Intermediate (WTI) future traded with a negative price on Monday.
This latest leg lower for oil comes just over a week since Saudi Arabia and Russia returned to the negotiating table, agreeing along with other members of the OPEC+ group, to reduce oil supply in an attempt to support prices. The deal, however, proved to be a weak one, especially in the short term, as the 10 million barrels per day cut in supply fell well short of the expected impact on demand from the coronavirus crisis.
However, the negative pricing for the WTI May future is as much down to technical factors as it is to do with economic ones. WTI futures are for physical delivery only to landlocked Cushing, Oklahoma, where storage is currently extremely limited. This meant that existing holders of the May future, which expired on Tuesday, were so desperate to offload their contracts due to the potential cost of moving and storing their oil, that they were prepared to pay people to take them off their hands. By contrast, the equivalent Brent crude future, which can be settled in cash, expires next week and currently trades at $21 per barrel.
The coronavirus outbreak has some potentially significant implications for the oil and gas sector. In the short-term, the sector is currently faced with a huge imbalance between demand and supply, as outlined above. Oil that does not find a buyer needs to go into storage which is increasingly limited and therefore increasingly expensive, and rising inventory levels have historically been correlated with a decline in prices. Inventory levels are currently expected to continue to build in the coming months, unless the OPEC+ group is able to reach a stronger deal on production cuts or the demand lost from the coronavirus outbreak returns more quickly than expected.
In an environment where oil prices remain under pressure into the second half of the year, we would expect the financial impact on the sector to be significant, with a number of weaker, more highly leveraged companies in the space facing bankruptcy. For the stronger names, those with the most diversified operations, lower costs of production and the strongest balance sheets, the focus is less on whether they will survive and more on whether they will be able to maintain their dividend through this most challenging of periods.
There will also be an unplanned supply response, as oil producers decide to shut-in oil fields due to the difficulty in finding storage for their oil. This is a difficult decision for a company to take because restarting an oil field that has been shut-in is a complex and expensive process and therefore some fields that have been shut-in will never return to operation. In normal circumstances, producers would be prepared to operate fields at a loss, but such are the storage constraints that shut-ins are becoming necessary.
These shut-ins, which are estimated to reach between one to two million barrels per day within the coming months, will not be able to significantly offset the short-term demand hit from Covid-19, but may help to rebalance the market after demand has begun to normalise.
The crisis may also support efforts to decarbonise the energy sector, with investments in oil assets likely to be structurally lower going forward, not least because the availability of financing to the sector may have been permanently impaired, creating a significant barrier to entry. There is also the potential that some of the lost demand for oil and its associated products never returns post-crisis if people travel less and work from home more. Additionally, the oil majors have used the crisis not to row back on plans to decarbonise their own businesses but in some cases doubling down on them, with Shell, for example, last week setting out its ambition to become a net zero emissions company by 2050.
Judging what all this means for the oil price over the medium to long term is fraught with difficulties. However, current prices are currently below industry cash costs which historically has provided a floor from which a recovery occurs within a number of quarters. Assuming demand begins to normalise from the second half of the year, planned and unplanned reductions in supply will help to rebalance the market and may support prices through the end of 2020 and into 2021. Indeed, the Brent crude futures curve indicates that the market is forecasting a recovery in price to almost $40 per barrel by the end of 2021.
The impact on oil prices from decarbonisation efforts is also not clear. The electrification of the global economy through the rapid growth and declining cost of renewable energy sources will reduce the global demand for oil over time. However, one must consider the speed at which demand falls against the speed of the decline in supply, with the latter potentially accelerated by the current crisis.
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