The Crude Story of Oil

April 8, 2020 - John Osbon (6 mins to read)

Daily global oil demand was 100 million barrels per day in 2019 and was expected to be slightly more in 2020. In the new COVID economy, daily demand is difficult to determine although it is clearly significantly lower. Some say it is 77 million barrels per day. Some say it is much lower, questioning who is driving cars and who is riding in airplanes. Further, Saudi Arabia and Russia are in a price/volume tug of war. Energy-related equity prices are down significantly on low global demand, poor negotiations within OPEC and an uncertain future. Investors would be wise to be skeptical of the allure of high energy dividend yields or bargain prices. Let’s take a deeper look.

When Dominant Players Disagree

On March 8th, Saudi Arabia and Russia had a disagreement about production cuts. Saudi Arabia abruptly announced price cuts, triggering a huge price decline in oil. In addition, Saudi Arabia has boosted its output from about 9.0 million barrels per day to 13.0 million barrels per day to punish Russia for its stance. This event alone would have caused significant disruption for markets. The coronavirus has only made it worse.

The combined effect of coronavirus and the oil price war has sent the price of oil to a nearly 18-year low level. This week oil has been as low as $19 and as high as $33 per barrel. A barrel of oil is now cheaper than a pint of beer in Canada. Russia keeps changing its stance from pumping oil to agreeing to limit supply. We find out at 10am Thursday (today) if the Russians and Saudis will be cooperative. If it offers any insight into the future, the record of OPEC+ cooperation is poor.

The Long Term Oil Chart

Let’s start with a 15-year chart of oil prices to refresh everyone’s memory. We can see the famous $150 oil in 2008. We also know that the $20 price was a major new low this year.

Five indicators

People who track oil prices tend to focus on five indicators: current supply, available storage, current demand, contract flexibility, and degree of cooperation. 

  • Supply is relatively easy to predict and excessive right now due to production hikes by Saudi Arabia.
  • Storage is more or less easy to keep track of. Today it costs just about as much to store the oil as it does to give it away for free. Storage space is finite and nearly maxed out.
  • Demand is way down and will likely stay that way until the virus is thoroughly and completely eliminated.
  • Contract flexibility is case by case.
  • Cooperation is a vitally important issue. Producers, especially Saudi Arabia and Russia, are competing more than cooperating, raising uncertainty for all buyers and sellers.

Skepticism about cutting production and storage limitations

Analysts have said they are skeptical producers can commit to lasting large cuts in production. We expect any rises in oil prices to come under downward pressure again. “Even if a deal was to be reached, we believe the coordination required would lead to a delayed and gradual implementation,” Goldman Sachs analysts said. Citi analysts forecast a decline in global oil demand in the second quarter of 18-20 million barrels per day, which would trigger an increased growth in inventory to 1 billion barrels over two months. There isn’t enough room to store the stuff, experts say.

The US Strategic reserve is small compared to daily production and has room for just 170 million additional barrels. The US will store only US oil. There are 7400 tankers in the world with widely varying capacity. It is a difficult task to figure out how much oil is in transit to meet demand, how much is stored, and how many tankers are empty. No one ever thought we would need more storage with 100 million daily barrels per day of demand but apparently now we do.

All of this indicates consistently lower oil prices, perhaps below $20 per barrel. 

Virus is an afterthought to producers

Saudi Arabia is the Group of 20 Chair for the year. They may propose a coordinated cut for all nations including the United States and Canada. President Trump is opposed to any US production cut.

“We need every producer to come in to agree to a cut and have the cuts enforced. That is a tall order in the limited time we have before the world runs out of crude oil storage.” Viktor Shum of Markit said. Analysts have predicted the storage ceiling will be reached in May or June. That’s when oil prices could face heavy selling pressure again.

With no real signs that Saudi Arabia and Russia have agreed to put aside their differences, it’s going to be a rocky road ahead. “I imagine it will be a brutal, unadulterated market fight and the weak producers will have to shut their production, in particular in the U.S. shale oil sector.” Shum added. Analysts suggest that even a cut in output by 15 million barrels per day would not be enough to help remove the current glut estimated at 35 million barrels per day. $20 oil seems more than likely under that scenario.

Previous oil price drops

We witnessed the exact same pattern in the previous downturn of the energy sector, when the price of oil collapsed from $100 in mid-2014 to $26 in early 2016 due to the booming U.S. shale oil production. Instead of reducing its output, Saudi Arabia maximized its output in order to drive many shale oil producers to bankruptcy. As soon as Saudi Arabia achieved that goal, it then established deep production cuts, along with the other OPEC members, and thus led the oil price to double in less than 12 months. A similar pattern is expected in the ongoing downturn. In the near future we expect oil prices to stay depressed due to the demand destruction. Past energy recessions were not triggered by demand destruction but rather oversupply. Notably, it is the first time that U.S. shale oil producers have attempted to contact OPEC and agree on production cuts. While the outcome of these negotiations is uncertain, it is evident that the current depressed oil prices are unsustainable for all the producers worldwide and hence an agreement on production cuts will come sooner or later.

Risk Management

While many consumers benefit from lower oil prices, there are serious repercussions for energy investors. With big losses for oil-producing companies and countries come significant declines in the industry’s capital investment, production cuts, stock price declines, and eventual dividend cuts.

For decades, Exxon has dominated markets as one of the top ten largest and most profitable businesses in US and global markets. Its market cap peaked around $430 billion in 2014. Today it’s trading with just a $174 billion market cap and is at significant risk for cutting its dividend. Exxon has never cut its dividend.

Instead of low oil prices creating a tailwind for consumers and businesses via lower energy costs, it has created significant equity and job losses. Even once the virus is under control, the economics of oil could be compromised for years. We feel that it’s time to re-evaluate even the most consistently held core investments. Investors have relied on blue chip energy stocks like Exxon for income for decades. Energy is not the only investment sector with structural issues. Please message us to learn more about how we are positioning clients to invest through this crisis.

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