Ramifications of the Oil Price Collapse

Context in terms of prior oil market events, i.e., why this shock is so much faster and deeper.
Big price movements typically shift wealth from consumers to producers, or vice versa, but are relatively balanced macroeconomically. The current event is pure wealth destruction, as consumers cannot leverage low prices due to the lockdowns in place. This is bringing permanent damage to balance sheets as well as industry demand, even if all else stabilizes. The fallout from this oil shock will be with us for a while.

Effects of the oil shock beyond the energy sector.
All balance sheets are indirectly or directly linked to energy. US capex is likely to drop by 25-30% in the energy sector, so that will shrink demand for US manufacturing, which will have a weaker recovery than global manufacturing. The other challenge in the US will be to the financiers of the energy industry, given that defaults will likely rise as the industry consolidates.

In relative terms, which countries will be the winners and losers.
The losers are likely to be oil producers across the board, particularly those with weak balance sheets, as well as those within the extended oil value chain. Ultimate winners are probably going to be the survivors, if large parts of the energy sector shut down. Marginal players are more at risk than key players (e.g., Saudi Arabia, Russia), which have low production costs and maximum scale that will enable them to weather the downturn and capture market share on the rebound.

How we got to $-37 oil, and whether we should expect to see more negative pricing.
That was a perfect storm. In typical times, there is always someone out there ready to buy the crude contract, typically a crude marketer or a refiner. What was interesting last week was that, given that storage was expected to be full, physical buyers did not show up, which led to a no-bids situation. The second contributor was that in the days/weeks prior to the contract rollover, there had been a big increase in oil ETF demand, prompting the ETF to purchase and support the spot oil price; they then had to sell those contracts to roll over into June contracts. We’re not expecting negative prices again.

The outlook for oil, including near-term and long-term prices.
This will be a challenging time for the oil market, especially within the next 2-3 months. We see an inventory overhang of 600-800 mmbbls end of June, which is close to tank top across the world. The real challenge is to quantify the structural impact of COVID-19 on long-term demand. We need three things in order to see >$45/bbl oil again: (1) market balance, (2) surplus inventories to normalize, and (3) full return of OPEC + production. We expect oil prices to remain depressed through July; assuming that economic activities return this summer, we could see more of a demand/supply balance and head toward ~$30/bbl by year-end.

How we should think about our investments across the energy sector.
There are very few winners, but the relative losers will be those with high levels of debt, high production costs, and inflexible capital expenditure commitments. Energy Equipment and Service companies have been the hardest hit in this crisis (and had already been suffering from overcapacity).

What to look at when evaluating these companies.
We are looking for those companies that are cheap when we take into account the current crisis as well as the impacts of the longer-term secular decline in energy driven by the energy transition and the move toward a lower-carbon future. Holdings must have the balance sheet and liquidity to withstand the current low prices and survive into the next stage of the cycle. They must also be attractively valued when factoring in the current headwinds facing the energy market. Valuation must compare favourably to intrinsic value when all negative factors are taken into account.

How bad the crisis will be for shale E&Ps.
Most shale producers require a significant amount of spending to maintain production. With capex in North America being down 40-50% post-Q1, expect a dramatic drop in oil output. Some producers are even shutting down volume. This implies production will naturally fall, likely by 15-20%, by December. Once things settle a bit, US shale producers will have less production than when the crisis started, and their ability to finance and grow will be impacted also. On the other hand, US natural gas prices could improve medium-term. With lower oil production, this could lead to a tighter market for natural gas.

The impact on credits.
While companies are responding to today’s crisis in a similar fashion to that of five years ago, generally their available options are fewer or less impactful. Going into this cycle, Integrateds and E&Ps were fairly lean, so there is simply less fat to cut. We now see 2020 capex falling roughly 24% to $140bn. Dissecting that, Integrated capex will be down roughly 16% while E&P spending will decline 43%. During the last cycle, E&Ps cut their dividends by 37% and Integrateds showed little movement. So dividends could be a source for needed cash flow flexibility for E&Ps, and some will act decisively.

The ability of companies to access the capital markets.
Capital markets were incredibly accommodative to E&Ps last cycle, issuing roughly $30bn of equity to bolster balance sheets in 2015-2016. Of that amount, only ~$4bn was raised by Investment Grade-rated companies. The remainder was by High Yield E&Ps, and we just don’t see the equity markets stepping up again, except perhaps for the largest E&Ps. Also, we don’t believe the debt markets will be there to bridge either a cash flow gap or fund refinancing needs this cycle, again except for the strongest companies. We expect market access to remain challenged.

Other sources of liquidity that can be tapped.
Investment Grade E&Ps benefit from unsecured credit facilities and traditionally a maximum debt-to-capital covenant. Conversely, most High Yield E&P bank facilities are secured, with the borrowing capacity limited to the value of oil and gas reserves. Reserves are generally revalued in early spring and again in the fall. With today’s forward curve at $25-30/bbl, High Yield E&P borrowing capacity could be reduced by as much as 40-50% versus pre-crisis levels.

How we are investing given liquidity constraints.
We have stress-tested the sector across a variety of oil prices. Many E&Ps are well-hedged for 2020, which will soften the impact of today’s prices, but that is not the case for 2021. The crisis is exposing weak balance sheets, poor assets, and an external funding reliance. It’s critical to understand those companies that are most at risk as well as those for which opportunities may lie on the eventual upswing. It’s best to stay with solid balance sheets, strong liquidity profiles, and high-quality assets given all the uncertain outcomes before us.