24 Apr 2020
The US oil benchmark West Texas Intermediate (WTI) price has turned negative for the first time in history, marking another significant footnote in this coronavirus (COVID-19) pandemic. While specific technical factors were behind that move, global crude prices remain under pressure as the industry contends with a glut of supply and very weak demand trends.
In times such as these, there can be a tendency to become very short termist, so it is important to put this recent price action into context. After all, it was less than four months ago that Iranian major general Qasem Soleimani was killed by US forces. At the time, Brent crude was around US$70 per barrel (bl) (with WTI around US$65/bl) and some market participants said this could spark a rally in prices to above US$100/bl. In early March, prices had fallen closer to US$50/bl as signs of demand destruction caused by COVID-19 began to emerge, and another leg lower to US$30/bl followed an unsuccessful OPEC+ (OPEC and allies including Russia) meeting that ended with a market share war between Russia and Saudi Arabia. It has been an exceptionally volatile year in a consistently volatile commodity.
The biggest dislocation of all was clearly the extraordinary price action seen at the beginning of this week. With coronavirus having significantly reduced demand for products such as gasoline and jet fuel, which are predominantly made by refiners based in the US, these refiners have significantly reduced their purchases of crude oil, which has resulted in massive over-supply at land-locked Cushing, Oklahoma – the main trading hub in the US.
Estimates that storage would reach capacity prompted concern that holders of May contracts – each one equates to 1,000 barrels – would have to take physical delivery of oil, given there was little demand from buyers to simply roll the contracts over, as typically occurs. Therefore, these holders essentially became forced sellers, paying other market participants to take the oil off their hands as the 21 April cut off for the May contracts approached.
Prices for Brent crude, the international benchmark, have proved more stable as it is delivered waterborne and therefore can be shipped and stored globally. Nevertheless, the Brent contract for June also fell significantly on 21 April and fell below $20/bl for the first time since 2001.
Looking at forward prices out to 2023, the market anticipates oil will trade between US$40/bl-US$50/bl, which is important from an investor’s standpoint because this is the price producers are able to sell in to, or hedge. Notwithstanding considerable near-term uncertainty, with oil currently at these extreme levels, as demand comes back following some sort of economic recovery, the physical market should tighten once again, and prices should begin to move higher.
Yet, this demand is currently nowhere to be seen. Less than two weeks ago, OPEC+ agreed an unprecedented cut of 10 million barrels per day (mb/d), effective 1 May 2020. The deal – which involved President Trump as he sought to protect US shale producers in this election year – was supposed to put a floor on oil prices by ending a price war that had led to the sharpest one-day decline in prices since the first Gulf War in the early 1990s.
While significant – equating to about a 10% reduction to global oil output and more than twice the reduction agreed in response to the 2008 oil price slump – it doesn’t appear to be enough. Current estimates of the reduction in demand due to COVID-19 restrictions on movement is between 20-30mb/d, and therefore this much celebrated deal is not sufficient to balance markets in the short-run. We therefore expect weakness in oil prices to persist until the COVID-19 lockdown begins to be lifted, and, crucially, oil demand beings to return, particularly in the US.
In the short run, it is difficult to provide any expectations for oil prices for a number of reasons. In particular, a key issue is that the financial market for oil is considerably bigger than the physical oil market. This means that speculation and financial positioning can – certainly in the short-run – influence oil prices more than fundamentals and result in technical anomalies such as the WTI May pricing during periods of extreme duress. Secondly, we believe the impact and subsequent recovery in oil prices is contingent on the duration and response to COVID-19, which is very difficult to predict. Therefore, we anticipate the animal spirits of traders will dominate in the near-term.
Over the longer-term, we expect crude prices to recover strongly as demand returns after COVID-19. In addition, the OPEC+ agreed cuts, while insufficient at present, are subject to review in December 2021, so this length of cut should help producers reduce inventories to ‘normal’ levels and thereby support prices.
While weaker oil prices are clearly sub-optimal for oil equities, the moves in equity prices in the aftermath of ‘spot’ WTI turning negative – certainly in the context of the past couple of months – were relatively limited. This is because companies will generally sell their production well ahead of next week’s physical delivery date – either a month ahead or further down the curve by hedging. For context, energy equities – using the MSCI ACWI Energy NR index as a proxy – fell only 1.8% on Monday, and 1% the following day.
At Ninety One, we have and continue to allocate capital to higher quality energy companies that we believe are best placed to generate free cash flow and returns in a variety of market conditions. In our Global Energy strategy this leads us to a portfolio which is overweight selected European oil majors, renewable energy and environmental companies, independent US oil refiners and a small number of independent oil & gas producers. The strategy is underweight US shale, oilfield service companies and US oil majors.
The oil majors are not without their difficulties at the moment, with the traditional diversifier – refining – not providing any support to profitability due to enormously reduced demand for transportation fuels, and we are paying close attention to dividend sustainability, in particular. We note that Equinor became the first European oil major to cut its dividend which was announced this morning. The US shale industry is in severe peril, with the sector struggling to generate positive cash flow even at significantly higher prices than today. Avoiding exposure to US shale is a long-standing position, based on our view that the business models of companies in this sector are unsustainable. The sector saw a swathe of bankruptcies during the 2015 oil price rout, and there are likely to be significant casualties of the current market backdrop.
While our stock selection is driven from the bottom-up, we believe that the current oil prices are unsustainably low over the medium term. This reaffirms our view that holding quality energy companies that can survive an unknown period of low oil prices can potentially result in outperformance through the cycle and as prices recover.
Importantly, we do not believe that this collapse in oil prices specifically threatens the Energy Transition, or slows down the shift to a low-carbon economy, as oil is not generally used to generate electricity and electric vehicle sales are driven more by regulatory influences and technological advances than operating cost arbitrage.
While the impact to gas prices for power may be more nuanced, renewable energy technologies are cost competitive and costs continue to decline. It will be very interesting going forward to see how the oil majors allocate capital to ‘old’ and ‘new’ energies respectively 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.
From here, the biggest driver of any recovery will be demand. However, this remains very difficult to forecast – both in terms of timing and quantity. There is no clarity on what exactly ‘normal’ economic activity looks like in a post-COVID-19 world, with the obvious implications for oil demand. We believe lower oil prices should bolster consumer incomes globally, which would support a rebound in economic activity once the lockdowns are lifted, but the medium-term impact on transportation and broad-based oil demand is open to debate.
To wrap up, we expect some form of normality to return to the oil market by the end of 2021, which should see prices moving back up to the $35-$50/bl range, which is above the futures curve. For context, the average price in the years from 2015-2019 was in the high US$50s/bl, and – despite all of the near-term headlines – oil is still averaging over US$40/bl so far this year. But investors must be patient because near-term prices could go lower – and either way, we believe that a well-diversified portfolio of energy sector equities will prove to be a better way to gain exposure to this recovery.
All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.