Authored by Tom Nelson, Head of Natural resources, James Webb, Analyst
10 March 2020
The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole.
Oil's double trouble
February provided an early warning that the spread of the coronavirus (COVID-19) in China was impacting oil and fuel demand in the country, which accounts for more than 10% of global demand. First came a wave of ‘force majeure’ pleas relating to supply contracts, predominantly for liquified natural gas (LNG). Then listed oil & gas majors, such as Total and BP, warned of a hit to global demand in the order of 500,000 barrels per day (bl/d). Finally, the OPEC+ countries announced the conclusions of their Joint Technical Committee (JTC) meeting, which advised the group to make a further 600,000 bl/d cut in March to keep markets balanced.
That advice has seemingly been thrown aside and replaced with geopolitical posturing and a race for market share. Having failed to reach a new accord on Friday, the OPEC+ countries ripped up the current agreement, which expires in April. Saudi Arabia, OPEC’s biggest producer, immediately discounted its crude and talked of increasing production. Brent crude prices dropped from about US$50/bl to US$35/bl, falling with a severity that eclipsed the declines at any point of the 2008/9 Global Financial Crisis or the 2014 oil-price drop. As a reminder, Brent was trading at US$68/bl in early January this year.
The concern for oil is now two-fold, with both a supply and demand dimension. This is highly unusual. Oil shocks are usually supply or demand driven — rarely, if ever, have they been both. On the demand side, demand has been very weak in the first quarter due to the coronavirus, sufficient for the International Energy Agency to predict average year-on-year demand will slightly contract in 2020. Now that the virus has spread beyond China’s borders, the consensus view that this will be a 3-6 month issue could be far too optimistic. On the supply side, the OPEC+ rift could return between 1-2 million barrels of crude supply to the market in the coming months. This oil wouldn’t have a use in today’s market, only finding a home in storage, and so could extend the depression of prices.
However, oil prices are the great enabler of market equilibrium and we have been here before. In 2014, the oil price started a descent from US$115/bl to US$46/bl. In 2016, it sunk to US$27/bl, having recovered to US$68/bl after the prior collapse. On both occasions, the lows were very temporary.
Given this recent history, there is a temptation to assume that the market has overreacted and that prices cannot stay down for long. At US$35/bl, the oil price is unsustainably low for a large cross-section of oil & gas producers. However, demand data could yet deteriorate from here, and we will be watching the second-quarter forecasts very carefully. Furthermore, the market’s confidence in OPEC’s ability to manage the supply/demand equilibrium — which was already fragile — is unlikely to recover fully. That said, if the political strongmen of Saudi Arabia and Russia can agree a constructive way forward, oil could recover very quickly. On the other hand, those relying on demand recovering or US shale production capitulating may have a longer and more arduous wait.
One other point needs to be emphasised. We do not believe that this collapse in oil prices threatens the energy transition or slows the shift to a low-carbon economy. Oil is not generally used to generate electricity, and electric vehicle sales are driven more by regulation and technology advances than by operating-cost arbitrage. While the impact to gas prices for power may be more nuanced, renewable-energy technologies are highly cost competitive and their costs continue to decline. It will be interesting to see how the oil majors allocate capital to ‘old’ and ‘new’ energies in the light of this commodity price move. It could be that lower but stable returns from renewable energy projects look more attractive than ever.