Oil slides into uncharted waters

In this month’s video Ritu Vohora, Investment Director, looks at oil’s tumultuous ride in the wake of the COVID-19 pandemic, which has prompted the most profound impact on energy demand in 70 years alongside oversupplied markets. This unprecedented situation will shape the energy sector for years to come, with consequences for the wider industry and its transition to clean energy.

 

The COVID-19 pandemic is inflicting tragic human costs worldwide, and impacting economic activity. PMIs fell in the US, Europe and China, while US jobless claims topped more than 30 million in just six weeks – driving the unemployment rate to the worst level since the Great Depression. The IMF is projecting the global economy will contract sharply by 3% in 2020.

Despite the grim data, markets responded positively to encouraging signs of fewer new virus cases, hopes of a vaccine and gradual steps towards lifting lockdowns. Markets have also been driven by liquidity support from global central banks.

The US was the best performing region, as both the Dow Jones and S&P500 posted their best month since 1987 – the latter climbing almost 12.8% in April. All regions rallied over the month, with the MSCI AC World index jumping 10.8%, in US dollar terms, having recovered almost 30% from March lows. Japan was the weakest region over the month. A risk-on rally was driven by cyclicals, led by consumer discretionary stocks and technology titans.

Energy is the worst performing asset class year-to-date, down more than 60%, with the worst phase of the sell-off in late April. Brent crude, the international benchmark, fell from about $70 a barrel in January, to an 18-year low below $20.

The oil and gas sector has suffered a tumultuous start to 2020 in the wake of the COVID-19 pandemic, with near-term demand disruptions alongside oversupplied markets.

With global economies in lockdown and travel bans, the demand destruction has been unprecedented, with global demand for oil falling 30%. The International Energy Agency has estimated that oil demand in April 2020 was 29 million barrels/day lower than a year ago, falling to a level last seen in 1995.

Despite the demand shock, we hadn’t seen a supply reaction. The consistent increase in the oil supply since the advent of fracking, has meant supply has been running ahead of demand for some time. OPEC and its allies have had many attempts to curtail production, but their attempts have been unsuccessful. Furthermore, a mistimed market share war between Saudi Arabia and Russia, further compounded oversupply.

The imbalance of oversupply and plummeting demand, is causing a storage crisis as facilities reach maximum capacity. On 20th April, US WTI crude prices fell below zero for the first time in history, with the contract for May delivery falling to negative $40 at one point. Producers were paying buyers to take oil off their hands – the cost of storage exceeded the economic value of oil. While prices could return to sub-zero levels for the June contract, the system is incentivised to prevent this happening again, by reconfiguring and building extra storage capacity.

Low oil prices are forcing a supply correction. Over the past week, prices have rebounded, partly due to agreed production cuts of around 10% by OPEC members and its allies, effective from May. US shale producers have also scaled back activity as prices have fallen.

Short-term supply cuts, however, cannot drive rebalancing alone. The pandemic has prompted the most profound impact on energy demand in 70 years. Its full impact remains unknown, but the pace of easing lockdowns is crucial – economic activity needs to pick up again for a more stable oil price to return.

This unprecedented situation will shape the energy sector for years to come, with consequences for the wider industry and its transition to clean energy. Global CO2 emissions are set for the largest reduction on record. But sustainability calls for continuous efforts and commitment.

It will be interesting to see the attitude of the oil majors to energy transition, as the world normalises. Plummeting prices have forced many large companies to slash their capital budgets and even dividends. Shell is the first ‘supermajor’ to cut its dividend – its first time since WWII. This is not a short-term measure but a ‘reset’ of policy, as it shifts to become a net-zero emissions business by 2050. BP’s chief executive has staked his tenure on a promise to set the company on a path to “net zero” emissions and Total is also prioritizing clean energy.

Well-capitalised oil majors will likely come out of this crisis stronger, as production consolidates to a smaller group of companies. The US shale industry has been over-capitalised and has struggled to sustainably generate positive free cashflow – consolidation and bankruptcies could drive radical change. As a result, shale output is expected to decline steeply over the next two years.

Global crude inventories and oil prices will be volatile in the months ahead, but the fact that energy stocks are, so far, looking through the noise is reassuring. While there will be some permanent demand destruction, there are signs that the worst might be coming to an end, as China and parts of Europe and North America begin easing restrictions. As global lockdowns ease, we move to a more managed oil market, through OPEC+ cuts and significant falls in US shale production. However, supply chain issues are likely to remain prominent as long as the coronavirus pandemic continues to spread.


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