- The destruction of crude oil demand caused by COVID-19 is expected to be the most severe on record, creating concerns about where to store all the unused oil
- Recent discussions around globally coordinated production cuts can help balance the market in the medium term but will not be big enough to completely offset the historic hit to demand
- Short-term risks are still biased lower
- Over the next 12 to 18 months, the opportunity to invest in an oil price rebound looks more compelling in individual equities and credits than in crude itself
Amid the economic shock of the COVID-19 outbreak, oil prices plunged, with the price of crude down over 60% year-to-date to around USD25/bbl for Brent, a multi-decade low. Demand is severely depressed (the transportation sector alone generates 65% of global crude demand) and supply levels were excessive even before the virus outbreak.
What’s the outlook for oil markets over the next 12 to 18 months? We expect that a global recession has begun, but no one can confidently predict its depth and duration. Acknowledging this basic uncertainty, we think spot oil prices are unlikely to sustain levels above USD30/bbl through mid-fall without significant output reductions from OPEC and other major producers globally. Oil could move as low as USD10/bbl before a rebound begins—which futures markets suggest may be some time this winter. We note that the price for Dec20 Brent crude oil futures, which expire in October, are currently trading at USD38/bbl—nearly 20% above front month prices.
In this article we consider the various factors—macroeconomic and oil market-specific—that will likely be driving oil markets, explain which data points we are tracking that might signal the timing of an oil price rebound, why we are skeptical of the short-term impact a globally coordinated supply cut may have, and explore potential investment opportunities.
Oil’s unprecedented plummet
Recessions, commodities and equities
Economic data will soon begin to reflect the current demand shock. Expectations for GDP, employment and inflation are all set to decline at a record-setting pace over the coming months. Crude oil data operates on a slightly different trajectory. The movement of physical oil takes time and the expected inventory builds that are currently pushing prices lower have yet to show up in the high frequency data. Until the market can better understand the size and duration of the inventory builds, oil prices will remain under pressure.
In this context we note that recessions play out differently in equity and commodity markets. Looking back at the last six recessions, equities tended to bottom about five months before the ends of recessions as markets discounted the turn in economic data before it actually happened. However, commodities tend to trough around the same time the recession ends. In other words, equity investors are more forward-looking, making them willing to buy early, while commodity investors need to see the proof before they buy.
Crude reality: Excess supply, shrinking demand
As economic activity is effectively frozen in much of the global economy, an unprecedented decline in demand in the second quarter implies that full-year demand for oil could contract nearly three times faster than it did during the global financial crisis. In just two weeks in March, global air traffic declined by about 40% and traffic congestion levels fell about 75%. Train travel has also fallen sharply. The market currently estimates that demand could drop by nearly 20 million barrels per day (mb/d)—a 20% decline—in April alone. For the full year, demand is likely to plummet between 3mb/d and 5mb/d— the largest slump on record.
The supply picture is not much better. Following the breakdown in negotiations among OPEC+ countries in early March that aimed to reduce global oil supplies, Saudi Arabia and Russia ignited an all-out price war to gain market share—and then kept pumping oil. At the same time, U.S. oil production is unlikely to see material declines for three to six months.
Given the large imbalance between supply and demand, inventories are expected to build by an estimated 1 billion to 1.5 billion barrels—as much as a 50% increase in existing stocks. Where will that oil be stored? Spare commercial storage capacity is estimated at around 1.5 billion barrels. As a result, traditional crude oil storage capacity may be filled as early as the third quarter of 2020.
Oil prices are low—and likely to get lower
By any measure, oil prices are quite low, but they may need to decline toward USD10/bbl to be far enough below marginal production costs of already producing fields to force the shutdown of those fields. Around 7 mb/d of global oil supply, roughly 7% of the total, currently has short-run marginal costs of more than USD10/bbl.
Already we see signs of distress in the market. Some grades of benchmark WTI and Brent crude recently dipped temporarily into negative territory (reflecting quality or transportation issues), which meant producers had to pay end users to take product off their hands.
Potential supply cuts
Crude recently staged its biggest rally on record after reports that President Trump was attempting to negotiate an agreement between the Russians and the Saudis to curb production. The number mentioned was 10 million barrels, which is basically 100% of current production from Saudi Arabia or Russia; said another way, this is implausible between OPEC and Russia alone. This is difficult to get to with global coordination. Even with 1 million barrels of cuts from OPEC, Russia, the United States, and the rest of non-OPEC plus going back on commitments to increase production after the OPEC+ deal fell apart only gets you to around 8 million barrels of day of production. The current base case is for 14 million barrels of demand destruction in April alone. Even after the recent rebound in spot prices, the market is pricing in builds of 1.4 million barrels per day versus around 2.5 million barrels per day in build when oil was at its lows.
Investment opportunities: Equity and credit vs. crude and crude ETFs
Over the next 12 to 18 months, the opportunity to invest in an oil price rebound looks more compelling in individual equities and credits as opposed to crude itself. Crude and crude ETFs will likely underperform crude-linked assets given the current shape of the oil futures curve, with prices today lower than prices in the future. To express a bullish view on oil one year forward, an investor would have to pay nearly a 25% premium to buy that one-year contract relative to spot prices.
Expecting 25% returns over the next year?? The market is already there
In the equity market, we favor large-cap energy companies that were conservatively managed even before the recent market turmoil. That means companies that have cut production quickly, halted stock buybacks to boost free cash flow, and partially hedged their exposure to the price of crude.
Among credits, we prefer producers with modest leverage (less than 3X net levered, for example) with a substantially de-risked balance sheet and ample access to liquidity. These companies are responding to the regime shift in oil prices with plans to cut capex, reduce operating expenses and delay dividend payments. In some cases, they are adding new revolving lines of credit. Broadly they aim to improve free cash flow resilience and bolster liquidity. For companies that we view as strong credits, their long-duration bonds are essentially a way to own a senior secured preferred on the company. We see this as an attractive way to invest in a rebound in oil prices over the medium term.
What signals might call a turning point in crude oil prices?
There are a few key indicators on both the demand and supply side which will help us identify when the market imbalances are starting to mend.
On demand, we are specifically watching traffic congestion, which has likely fallen by over 75% in many major American cities. Simply getting back to work should help support demand as U.S. gasoline consumption accounts for roughly 10% of global oil demand. Additionally, low prices often encourage governments to buy crude for their strategic petroleum reserves. With roughly 350 million barrels of spare capacity, this will be an important source of demand. Lastly, the overall monetary and fiscal stimulus will eventually lead to a bounce back in demand for oil. The demand surge in 2021 could be unparalleled.
On the supply side, we’re keeping an eye on diplomatic efforts between the United States, Russia and Saudi Arabia to strike a production deal. Discussions have begun, but the size of any reduction must be double digits and sustained for quarters not moths if they are to have a meaningful impact. Additionally, low oil prices will continue to slow drilling activity. We are following global production levels with a particular focus on U.S. oil production. The number of active U.S. oil rigs tells us how quickly producers are responding by taking production offline. Currently, that number is at 624 rigs. At its lowest level during the 2015 to 16 oil price crash, it reached 316 rigs.
Seeing the indicators turn more positive are key for a price recovery in crude oil, but we reiterate that there are still investment opportunities in both the equity and credit markets that can be accessed today to take advantage in the potentially long-term recovery of crude oil prices.