The global economy and the energy sector have suffered two huge shocks recently: the first was the implications that COVID-19 would have on the global economy – specifically oil demand – which had kicked off a decline in crude prices over the last several months. The second shock was the dismantling of OPEC+ and Saudi Arabia’s partnership to stabilize oil prices. The Saudi’s not only wanted to cut oil production further to support prices, but also refused to go at it alone. Therefore, when Russia refused to share a higher burden, the Saudi’s decided instead to flood an already-weakening market with supply, drastically increasing crude price discounts to customers well into the summer, forcing barrels to market and displacing others, like Russia in Europe. Russia announced they would also ramp up production, and so a price war began. While the disagreement may have been inevitable given an artificially supported crude price founded on market-share losses, emotions and ego played a role, along with Russia’s additional desire to retaliate against US sanctions from last December – which shut down the almost-complete Nord Stream gas pipeline – and to “sweat out” US shale producers in an effort to regain market-share.
Simultaneous demand and price shocks haven’t hit oil markets since 1998, when the Saudi’s increased production going into the Ruble/Asian economic crisis. Any cooperation between OPEC and Russia (OPEC+) that had been in place since 2016 appears to have been set back, but not lost forever. The Russians claim open-ness to discussions, and while the Saudi’s do not appear similarly constructive, subsequent pain from current prices and any US persuasion could likely bring them back to the table, in our view.
As we stated in our update on March 9th, given the algorithmic trading nature of markets, we expected oil prices to likely test and overshoot the 2016 lows ($26), and were therefore, unsurprised to recently see WTI touch $20 barrel, more than 20% below the February 2016 bottom1. Despite the market overly discounting the fallout there are some positives among the rubble – namely the rapid adjustment of US E&Ps to much lower oil prices, after the already announced drastic capex cuts, and dropping rigs and fracking crews in time with the oil price. We believe this is reflective of their newly-announced/increased dividends they’re looking to protect, along with investor intolerance for deficit spending and a lack of capital market funding.
This recent reaction sharply contrasts with the 2015 downturn when the E&Ps dug in – cutting costs, growing production, and battling for market share with the Saudi’s – all of which, resulted in the 2017 OPEC+ production cuts that just expired. Given the unavailable capital markets, recent investor calls for capital discipline and free cash generation, along with newfound dividend protection, have made US E&Ps much more responsive to prices than in the past.
According to our internal research estimates, we believe the oil markets will start healing in late-2020, assuming US COVID-19 infections are decelerating by mid-year, with inventories falling as non-OPEC production drops over 1mb/d in 2021 (versus a 1.3mb/d rise in ’20)2, and demand rises strongly off the low ’20 base, powered by global government stimulus. However, we feel the stock market starts to discount that recovery, either in late ‘20 or in early ’21.
Supply & Demand Impact
The effects of COVID-19 on global oil demand are difficult to predict, evidenced by the large dispersion of sell-side analysts’ supply & demand projections. While the supply picture has definitely changed, putting near-term pressure on the market, we do see demand growth returning over the long-term.
With capital markets having abandoned the energy industry, we believe market over-supply declines the longer the market holds at these lower oil price levels, while US production declines accelerate and global reinvestment falls. As a result, we believe US supply should be less resilient than in the previous 2014 – 2016 price war, when production took 7-8 months to roll over, and even then, the declines were still marginal. US E&Ps will likely be tested, as the marginal supplier should prices stay in the low-$30’s, forcing those less-well positioned players to adapt more quickly than in prior years.
Ultimately, the impact of COVID-19 makes the supply and demand picture more difficult to ascertain, especially with recessionary concerns and Saudi Arabia deciding not to support oil prices, which some argue, might just be a negotiating tactic with Russia.
As we look ahead, our analysis indicates that $30/barrel oil is not sustainable for anyone. As COVID-19 fears subside, we expect demand to eventually come back, as in all other oil price cycles when supply has overwhelmed demand, but in this case, comes back more strongly due to extreme government stimulus, in our view.
While we have seen oil prices head to $25 barrel in the near- term – close to the cash costs of even the best E&Ps – we believe this paves the way for oil prices to climb higher over the next 12 to 24 months, as demand returns and the US supply begins to roll. All of this potentially sets a similar stage to the attractive buying opportunity seen in 2016, in our view.
We are continually reassessing the situation and the potential impact to our portfolios and will position ourselves as new information becomes known. In the meantime, we continue to remain true to our investment strategies and put our clients first.
1 Note: WTI oil prices bottomed on February 12, 2016
2 Source: Jennison estimates
Source for price data: Bloomberg
Data as of 03/27/2020
mb/d = million barrels per day