Smelly Sludge not Black Gold

Oil prices peaked 12-years ago. This week there was excitement amongst some financial commentators that prices had gone negative. Oil is a victim of the cyclical health crisis and the structural climate crisis. The lock-down may have accelerated the structural move away from oil dependence – at least to some extent. Emissions are down and we have adapted to life without the same levels of air and car travel and to lower levels of consumption. Investors and policy makers have a role to play in ensuring that the crisis is not wasted – there will be more scrutiny of carbon footprints, there may be an acceleration of public green investment. Negative oil prices didn’t last long but they reflect an over-supply and the oil industry will be structurally impacted by that.

Dancing on JR’s grave

There was a lot of excitement this week over the news that the price of oil turned negative. Well, actually it was the price of the oil futures contract that went below zero. I am not sure that if you turned up to an oil storage facility outside of Dallas, Texas and asked for a barrel of West Texas Intermediate, you would have been able to drive away in your pick-up truck with the “black gold” and a few extra dollars in the back pocket of your Wranglers. The dip in prices was “technical” and it didn’t last for long. The nearest oil future is now back up to $16. However, oil prices are low after having collapsed in recent weeks. The spot price for a barrel of North Sea Brent is currently $19.6 per/barrel. It was $69 in January and $60 the day the S&P peaked on the 19th of February. There have been only a few occasions in the past when prices have been lower. The magnitude of the oil price drop, in percentage terms, has been similar in the last month to that seen at the time of the Global Financial Crisis in 2008. The common fundamental theme? Global economic recession.

Market failure?

It is interesting when prices go below zero. It signifies a massive failing of the market mechanism that requires more than a simple supply and demand chart to understand. If markets are relatively un-incumbered, the situation won’t last long. That should be the case with oil, although the longer term fundamentals for oil prices are not encouraging. But in the short term if prices go negative it tells us that suppliers of oil have too much of it to sell on the open market in a manner consistent with normal frictional transaction costs. Demand for oil has collapsed as the global economy has gone into lock-down, massively curtailing transport and industrial activity. Any new oil that is produced needs to be stored or sold to consumers with their own storage. It seems there is little storage available. If you are long of oil and need to get rid of it or pay storage costs which might be increasing because of the lack of capacity, then you might be willing to give the oil away for nothing or pay someone to take it off your hands if that payment is less than what you would have paid for storage. Given that the oil market works on a forward basis there was clearly a massive oversupply of oil being traded on the dates covered by the April futures contract. I saw a rather amusing suggestion that environmentalists should pool their resources to basically pay to take a good chunk of oil out of the market permanently – climate action like you’ve never seen it before (although where they would store the oil remains a mute question).

Extreme supply and demand adjustments to the crisis

Companies maximise their profits when the market price for an additional unit of supply is equal to the marginal cost of producing that unit. When prices move below marginal costs, profits decline. When the average price of the output falls below the average cost of production, profits become negative. This is the case in the oil industry right now for a number of producers whose costs of production are higher than what they can receive for a barrel of oil. There is a minimum price, below which output tends to zero. The speed at which this happens depends on the financial position of the company (whether they have cash to tide them over or access to markets to raise liquidity), the cost of maintaining production facilities and the market outlook. Not every oil producer has the same cost of production – this differs massively from the Arabian oil fields, to North American shale to the Gulf of Mexico and to offshore North Seal wells. But there will be some already in a position where even the price implied by the April 2021 futures contract ($30.87 for WTI, $34.89 for Brent) is below the average cost of producing a barrel of oil. Moving to zero production is not easy as this reduces the longer-term viability of the oil fields and results in assets being stranded in the ground. Ultimately, this helps the market clear again as capacity is taken out such that prices will wise again once demand picks up, but it leaves some producers permanently out of the market. Currently this is probably a significant force in some oil producing areas given the lack of storage and transportation capacity – producers may have no choice but to keep it in the ground. The longer that situation persists, the more capacity will be lost. The cost of re-starting production will be too much for some. With huge sunk costs financed by borrowing, defaults again become an issue and banks and investors with exposure to the energy sector will likely take some losses.

Smelly sludge rather than black gold 

No wonder the energy sectors of bond and equity markets are struggling. The energy sector accounts for 9% of the US high yield market and currently displays a yield-to-worst of 16.6% with an average par-weighted price of 59.11 (relative to a par price of 100). This is distressed. The total return from that sector has been -33.8% year-to-date. In the S&P500, the oil and gas sector has delivered a negative total return of 47.2% since the beginning of the year. At the sovereign level, the picture is more mixed. In the emerging debt market, bonds issued by Gulf countries have tended to do quite well during the crisis, given the higher credit quality, but other oil dependent countries like Nigeria, Angola and Mexico have underperformed.

Party like its 1995

Oil is a victim of the economic shock. The demand curve has become - in the short-run at least - totally inelastic to price because it itself has been moved to the left as a result of the forced reduction in economic activity. Data show that global oil demand already fell considerably in February and this will have worsened in March and April. The International Energy Agency has recently estimated that demand in April would be 29mn barrels a day lower than in April last year – a 30% drop with almost all of that coming in the last three months. This has taken global oil demand back to 1995 levels. Supply will respond – the IEA estimates a 12mn b/d drop in global output in May as a result of the OPEC+ deal to cut production and as a result of the economic dynamics described above – some producers won’t be able to afford to keep on producing. At this stage it is impossible to say where the market will clear. Much depends on how quickly global growth resumes and how quickly demand for services like air transportation return to normal. That may not be quick. Or maybe, demand moves back up while supply is still being curtailed, which would make sense given the amount of the stuff in storage. There is a chance that prices could spike higher under some scenarios. Although the oil market remains in contango – futures prices are higher than spot – the actual levels don’t suggest much market confidence in a rapid return to higher oil prices.

Permanently lower?

The outlook for the oil market is challenging in the short-term. The longer term is challenging too. Carbon transition is the biggest issue for oil producers. It suggests a secular decline in demand. It poses challenges around how to deal with the reserves/assets producers already own and how companies will adapt their businesses. The IEA report from April mentions how oil producers have had their capacity to invest curtailed by the crisis and the increased cost of capital and this will delay their development of alternative energy sources. It will be interesting to see how demand does recover from here. Consumer preferences for goods and services that have a direct or indirect oil input may have changed irrevocably. The obvious is air travel but also day to day consumer spending patterns have been forced to change during lock-down and may not return to normal, with implications for things like packaging, some petrochemical based consumer products and transportation of goods. Responsible investors are also likely to be more focussed on the carbon intensity of business activities and investment portfolios to try and build on whatever progress towards lower emissions growth has been made during this period of forced economic inactivity. The planet is breathing more easily these last few weeks, there will be a huge desire to try and keep that going for longer.

Clearer skies

The drop in demand for oil this year is greater than even the most optimistic climate change activists could have hoped for. The Responsible Investment team at AXA-IM estimate that there has been a sharp fall in global greenhouse gas emissions as a result of the crisis and they could be down as much as 5% this year compared to 2019. In reality, it is unlikely to stay that weak and but it needs to if the world is going to meet its greenhouse emissions and climate temperate targets. Hopefully the current crisis has given the world the opportunity to stop short of going back to the levels of oil demand and carbon emissions that prevailed before the pandemic -  there have been clear changes in consumer and business preferences and additional change should and could be encouraged by policy makers. In addition, as my colleague Gilles Moec has suggested, governments could accelerate their own climate change policies by using the some of the fiscal spending that they are now in the game for, to support green infrastructure and alternative energy developments. Moving more quickly to a change in the energy mix would be a great outcome from this period where, let’s face it, most of us have coped quite well with a lifestyle that is less demanding on the environment.

Extremes of supply and demand

Negative oil prices are a bit like negative bond yields and negative interest rates. They point to dysfunctional markets. They point to an excess of supply over demand – clear in the case of oil where the demand curve has collapsed. In the case of interest rates the price is set by central banks but it reflects that they can supply as much money as the economy needs and essentially pay the markets to absorb that money in the hope that it finds its way into asset prices and spending. For government bonds the negative yield reflects something a bit more nuanced, it is the price of “safety”. Governments have “safety” in abundance (especially when they have a close relationship with a willing central bank) and so can “sell” it to an investment community that is willing to pay for that “safety” – that is the bond contract. The negative yield is just the inverse of a very high price that investors are willing to pay to have their capital protected by investing it in safe assets with that safety trading at such a premium today meaning that investors are willing to give away income in return.

Don’t waste a good crisis

The investment outlook is always determined by the “cyclical” and the “structural” and how they come together. We continue to define the cyclical outlook being dependent on the evolution of COVID-19, the subsequent progress of releasing lock-downs and the shape and veracity of a global GDP recovery. Yet, structural themes come out of that cyclical recovery pattern and oil, climate change, consumer spending patterns and how governments manage their balance sheets are just some of many. These will provide the rationale for investment decisions in years to come. Equity investors are searching for how spending and investment patterns will change and which companies will benefit. Bond investors worry about whether corporates can manage their cash through the recovery process and whether some of the sovereign stresses in Europe will have a potential negative credit impact. It will keep all of us busy for years to come and make the profession of investment as exciting and intellectually demanding as it has ever been. In the meantime, let’s hope we see more signs of recovery from the illness in the coming weeks, let’s hope we see progress on pharmaceutical solutions and let’s hope political recriminations in all forms don’t stop us from building on some of the good things that have come out of this horrendous crisis.