There are decades where nothing happens, and weeks where decades happen


What Happened ( skip to next section if you are a “market pro”)

  • Last Monday (20/4) the WTI oil price fell to an all-time low of -37.63 $/b, the first time ever in negative territory, after a -400% fall

  • Brent also sank below $16 a barrel, its lowest level since mid-1999. Yet, it proved its resilience thanks to its global tradeability - unlike the WTI, it can be globally shipped to areas of higher demand

  • All of this came on top of a horrible two months for oil with Brent and WTI already falling by 30% in early March compared to January prices, after the Saudi-Russian “price war” & the first Covid effects

  • The week closed on a better note, with WTI hovering around 16 $/b & Brent at 21$/b - a level already called “the new normal” by commentators & the respondents to our online survey

  • The key drivers for the rebound were a stabilization in speculative market positions and a well-timed tweet from President Donald Trump, who fueled Middle East tensions. The President pledged he would order the US navy to “shoot down and destroy” any Iranian vessels if they posed a threat to American ships, with immediate repercussion for trade through the Strait of Hormuz, the key oil shipping node

  • Overall, in real terms oil has never been this cheap since the 1973 oil crisis. Just as a reminder, WTI was trading at more than $60 a barrel in early January!

Why It Happened

  • The driver of these swings and what brought oil futures into negative territory is primarily misplaced fundamentals alongside a healthy dose of animal spirits

  • Let’s turn to the fundamentals first, starting from the demand shock. From March onwards, oil markets have been in the middle of the perfect storm. As the COVID-19 pandemic has worsened, it has shut down a significant part of the global economy. This, in turn, has led to an estimated -30% decline in energy demand, to around 77mbpd (Rystad Energy) or 70mbpd (International Energy Agency). While demand for oil has stopped suddenly, oil supply can't stop so easily. Capping wells is very expensive, and often causes lasting damage. All the while, economic predictions that modeled for a so-called “V-shaped” recovery are seeming less and less plausible by the day

  • On the supply side, Russia and China started a price war on oil around the same time (see last weekend’s editorial) that had already wiped out about 30% from the price of crude in March. Last week the historic OPEC+ agreement pushed by President Trump to cut an estimated 20mn barrels per day in global production raised spirits for a short while, but serious concerns soon emerged about the timing of the cuts and remaining hopes were completely dashed on Monday

  • What happened on Monday? First (i), people realized that the decline in demand is still significantly higher than the cuts in supply. (ii) Given the fact that these cuts would only start from May onwards, many producers (especially Saudi Arabia) have sought to flood the markets as much as possible before then, putting further pressure on prices. Third (iii), the closing of many speculative positions accelerated the price fall to the known record lows. And most importantly (iv), there was a storage crisis in the US WTI market for the May futures

  • The storage crisis: as with any product, the business of oil isn’t a “once-and-done”. It must be produced, shipped, processed, and then the refined product must be shipped and retailed. What happened on April 20th was a bottleneck in that process. Production surged ahead of pipeline shipping capacity (because of the drastic demand fall), leaving some producers with nowhere to put their crude. On Monday, traders realized that the main US facility located in Cushing, Oklahoma (population 7,500) and which has 13% of US storage, was running out of future leased storage capacity for the month of May. This resulted in a mad dash to offload these futures, which led to their prices crashing.

Where Next?

For Markets

  • While the May contract may settle close to zero, prices for future months are at the moment “relatively normal” (to quote a trader contacted by Energen)

  • We are now in “contango” market structure, namely when the price of futures is higher than the current spot price. Commodity markets are essentially hoping that as economies open up following the peak of the pandemic, oil demand will thus rapidly rise, while supply will remain lower than before. It is also based on this assumption, that the energy sector has actually outperformed the S&P 500 by about 9% from March 16th to April 22nd

  • However, do not expect a short term bonanza. The above reasoning rests on several assumptions, all of which are very unclear at the moment. First of all, in the short term demand will stay weak, and storage has almost reached full capacity. This will likely create substantial volatility with more downward spikes until supply equals demand

  • The EIA estimated the total U.S. working storage capacity at 653mn barrels. Net stocks held at refineries and tank farms were at about 323mn barrels as of the week ended on April 10th, taking up 57% of storage capacity. R. Yawger, director of energy futures at Mizuho Securities, in a note on Tuesday said that “at the current rate of increase, storage in the U.S. would fill in 7 to 8 weeks,” also supported by a similar analysis from Duff & Phelps. Therefore, while especially for global storage capacity data is murky, according to those in the know it is expected to run out between late May and early June

  • And no, don’t expect storage in oil tankers to solve the problem as firstly many have already been leased out by the Saudis, and secondly, they are already holding record storage (about 160mb, the previous record was 100mb in 2008). Furthermore, the cost of leasing has already increased ten-fold from about $20,000 per day to more than $200,000, which is an unsustainable option for most in the medium-term

  • Moving on to the pandemic itself, it seems likely that despite a summer respite, there will probably be a second wave in late autumn, unless a miracle vaccine is found beforehand (unlikely). Second of all, even if economies restart, they won’t function at full capacity as consumers are likely to be wary of restarting normal spending habits, so a V-shaped recovery is more of a hope than anything else at this point.

For Companies

  • As seen before, the equities of Oil majors aren’t doing too bad and are in fact part of a mid-crisis bull market. But more fundamental problems remain

  • First of all, small US players will be prone to bankruptcies

  • An analysis of more than 90 companies in the US Integrated Oil & Gas companies and related sub-industries shows that 67% of these firms have total liabilities in excess of equity. This is already not a positive number, but with oil prices about 80% below the price that prevailed at the beginning of the year, the ability of these companies to meet debt payments or pay suppliers is further brought into question. The smart view is that unless there is a rapid radical change – such as a very significant rise in energy prices or a large-scale Federal bailout – much of the US energy sector is going to pursue restructuring or get purchased by a stronger hand

  • The question of the Federal bailout will be complicated in the US, as it will certainly be a priority of the Trump Administration (the sector is strongest in Republican-controlled states) but Democrat-controlled Congress will likely attach many constraints, most notably ending the significant subsidies that the industry receives every year

  • Industrially, if the “new normal” (of low demand & prices) will stay, expect many assets shutdowns. And as production cannot be easily restarted (both up- & down-stream), many assets will never come back

  • Specifically in the US, gasoline demand dropped by nearly 60% (to levels last seen in 1967) - far more than diesel, used in road freight (at -20%). This shock already changed the refiners’ economics. Only the fittest, namely refiners able to change their product mix, will stay open & likely survive

  • Taking a more macro view, oil companies are some of the most important players of dividends across financial markets worldwide, providing vital income streams to pension funds and millions of smaller investors. The longer this crisis continues, the more energy companies will be forced to cut dividends and end share buybacks, ultimately creating a recessive spiral that harms investors and market confidence alike.

A Few Lessons Learned

  1. Invest in connecting your supply to the global market, or be ready to pay the price of long-term downsides

  2. Historically price cuts were aimed at killing green alternatives, yet they ended up hurting oil more than its competitors with investment in renewables proved being more resilient, even in Texas. This is perhaps the end of a century-long narrative: (at least today) green is not only ethically better, but also financially over-performing

  3. An aggressive tweet can really move global markets, especially if you are the President of the United States. Yet, price effects are never long-lived

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