Last week was an unprecedented one for oil markets, as US oil prices went – albeit temporarily – negative.
Price action last week in US WTI speaks to the lack of storage in US markets. While Brent-benchmarked crude prices may avoid going negative - that market does not face the same acute storage issues – prices have still collapsed towards cash costs in some markets. Given the COVID-19 induced demand shock and falling global storage, we expect continued volatility in all oil markets over the coming weeks.
We are arguably only near the beginning of the unprecedented demand shock – the International Energy Agency estimates a 23 million barrel-per-day (bpd) fall in demand this quarter compared with a year ago. So, things may get worse before they get better, with the spot market further hampered by a lack of storage in the US and some other markets.
However, as Chinese demand picks up and Europe and the US gradually get back to work after the initial lockdown phase, this should allow a recovery in oil demand, albeit one that’s gradual and uneven. This could be assisted by a ramp up in countries’ strategic reserves.
An unprecedented demand shock has been met with an unprecedented supply reaction.
On the voluntary side, OPEC+ has agreed to a cut of nearly 10 million bpd. While the actual change from first quarter production levels will be less than the headline number, there will still be a reduction of at least 7 million bpd. This is unprecedented action by the group – around four times the magnitude of the prior arrangement.
Perhaps more importantly, the involuntary production cuts are likely to be significant this year. Weekly data estimates from the US suggest around 900 thousand bpd of production has already come offline from its peak, while the IEA estimates non-OPEC production cuts could reach over 5 million bpd towards the end of this year. Recent price action may only exacerbate this trend.
A number of high-cost producers are at risk. In developed markets, the US shale industry and Canada are particularly at risk. Canada’s average marginal cost is US$25 per bbl, while the US energy secretary expects a drop in production of 2-3 million bpd by the end of 2020.
However, enforced production cuts will not just be a developed market phenomenon: countries in our universe such as Brazil, Colombia and even Russia are seeing forced production cuts as prices fall below cash costs in some fields. As the lowest cost producers, Gulf states should be the least affected, but with prices as low as they are we are seeing a postponement in capital expenditure in markets such as Qatar and UAE.
All of this means there could be a rebalancing in the oil market over the summer on the back of a gradual recovery in demand and material voluntary and involuntary reductions in oil production. For instance, the IEA estimates a stock draw of nearly 5m bpd in the second half of the year. This should help a gradual recovery in prices, albeit the scale of the inventory hangover will take many months to unwind.
There is of course significant uncertainty around this. We are in unchartered waters on both the demand and supply side. Of particular note:
We are still in the early stages of the pandemic. While lockdowns will start to be lifted, there are significant uncertainties around the extent to which economies can get back towards their potential output. Risks are in both directions, but likely skewed to the downside given the virus could re-emerge as restrictions on movement are lifted. If the economic recovery from COVID-19 is more modest and we see lockdowns reintroduced, say in China or Europe, this will put further downward pressure on oil demand, leading to lower prices persisting.
In addition, OPEC+ co-operation may disappoint. The organisation came under significant strain after negotiations failed in March. This time, the burden of production cutting is shared more widely through the group than previous production curtailments. Given a lack of compliance in the past, there are questions around how credible these pledged cuts are. However, the risks are somewhat mitigated by the Saudi Arabians having arguably cajoled others into more serious action through a) showing their threats to walk away are genuine and b) maintaining aggressive pricing in place through May, giving the rest of OPEC+ an incentive to play ball. Moreover, for Russia, a significant amount of the cuts are essentially enforced by lower prices.
Who will be the winners and losers?
Oil importers are clearly winners in this environment. The move lower in oil prices should help importers’ trade balances, all else being equal, supporting reserve accumulation and FX appreciation.
Countries such as Turkey, India and the Philippines should see significant improvements in their energy trade balances. It may also help fiscal balances in some markets where energy subsidies are still significant. For instance, Egypt has recently committed to removing subsidies by early summer. The Ecuadorians have also suggested they may use the lower oil price as an opportunity to lift fuel subsidies.
The main oil-sensitive currencies, such as the Russian ruble, Colombian peso and Mexican peso may come under further pressure, as well as some frontier currencies like the Nigerian naira. Sluggish growth in oil exporters should provide room for central bank policy action and allow rates to grind lower.
From a hard currency bond perspective, we can broadly categorise the more exposed oil exporters into investment grade or high yield:
- Most investment-grade oil exporters retain strong balance sheets that allow them to comfortably withstand a few months of weakness without undermining their balance sheets too much. Among these markets are the core investment-grade gulf producers and Russia.
- In high yield, a number of undiversified oil exporters face more acute liquidity and/or debt sustainability issues. This group includes vulnerable members of OPEC, such as Oman and Nigeria, which will also be hurt by production falls in line with commitments and will likely post very high fiscal deficits this year.
What’s our positioning?
Given these views we have modest oil exposure in our portfolios relative to their benchmarks.
In sovereign credit markets
- We prefer strong investment-grade balance sheets and low-cost oil producers who should be able to weather a sustained period of lower oil prices.
- In distressed high-yield names such as Angola and Ecuador, we think bond prices are now well below eventual recovery values as debt sustainability can largely be achieved through simple liquidity relief rather than large principal haircuts. Furthermore, both these countries have already made large strides to reduce fiscal breakeven oil prices with Angola targeting $35 in its latest budget.
- We’ve steered away from countries in the middle where we haven’t seen any fiscal reforms such as Nigeria and Oman. There, although bond prices are low they are not yet reflecting the degree of stress those economies will be facing with oil prices at these levels; fiscal breakeven for both sits close to $100/bbl currently.
In local currency bonds and local currencies
- We are generally short to neutral in oil-linked currencies with an underweight in the Colombian peso and a short in the Nigerian naira.
- With a weak oil sector adding to an already soft growth outlook from COVID-19 we are overweight local bonds in markets such as Russia and Colombia, where we see scope for further rate cuts.
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