Energy investors have had to struggle with two significant headwinds for oil, with ripple impacts across the economy and multiple markets. The price war between Saudi Arabia and Russia and the drastic reduction in demand due to COVID-19 social restrictions have seen the price of WTI drop over 75% since the start of the year.1 Unlike previous oil price events (as seen in 2014–2016, when consumers benefited from a glut in oil supplies), the combination of pressure from both supply and demand produced a situation that has very few beneficiaries. This is particularly impactful for consumers, who typically benefit from lower oil and gas prices. In a social distancing world, the lower demand for fuel does not provide a traditional stimulus.
Sovereign balance sheet damage
The dramatic drop in prices with no consumer offset is causing severe balance sheet damage for multiple countries, with far-reaching consequences. Given that oil is such an important driver of trade flows, losses in crude will reach beyond the direct energy sector. This includes direct impacts on FX rates, which then have knock-on effects on trade balances, inflation, and GDP. These impacts can also be traced to the remittances that immigrant workers of oil-producing countries make back to their families. This is a significant flow of capital for consumers in other emerging markets that will not be replaced as we have seen in prior events. With all impact indirectly linked to energy, the oil price shock is expected to result in long-term headwinds to manufacturing, as shown in the chart below.
Source: SSGA Macro Policy; Macrobond
Oil companies slashing their capital expenditures is creating a ripple effect that is triggered to other sectors and a lag in US manufacturing. The US will likely have a weaker recovery than will its global counterparts, and we see the best evidence for a V-shaped recovery in Germany, parts of continental Europe, and East Asia.
Given the rise in defaults, banks and financiers of the energy industry are also impacted. In particular, lenders to US shale companies will struggle to offset the losses on the loans to that industry. This drop in risk appetite means a likely pullback in lending to non-oil markets across their loan books. Without lenders to jump in to make up the shortfall in financing, a credit squeeze will result and will limit the potential impact of other monetary stimulus.
Potential changes to the energy sector
Oil price volatility will continue over the next several months and cause structural changes to supply and demand. The chart below shows the production of US shale. Production was already at a reduced pace going into the year, and lower demand has caused it to fall further, resulting in a structural change to supply.
Once shale production shuts down, it becomes difficult to restart production. Not because the physical pumping of the wells is a challenge, but rather, because these producers will face significant spending to restart the wells. This will make it likely to have less output than before the pandemic. Shale requires higher oil prices to support production, and this will be limited due to shrinking cash flows. This substantial decline in shale production will be hard to reverse and will cause a significant change in the US oil profile for the next two to three years.
Impact on equities
For oil prices to return to $45/bbl, there will need to be a balance that includes the normalization of surplus inventories and a stabilization of OPEC production. Even with the projected May cuts by OPEC producers, we will enter the summer with significant inventory overhang. As economic activities return starting midyear, we could start to see a balance in supply and demand and possibly see $35/bbl by year-end.
First-quarter results from refiners and integrated producers are showing a drop in gas demand by nearly 50% since mid-March. Diesel demand was initially flat but is now down 20-30%. The most significant decline is in jet fuel, which fell by 80%. With April likely the worst month, gas demand is starting to show signs of improvement but will start the traditionally demand-heavy summer months with a need to work through built-up inventory.
Given the severity of the crisis, there are very few winners in the energy sector. The only positive is the possibility that US natural gas prices could improve, given that lower oil production could lead to a tighter market for the commodity.
The relative losers are the companies with high levels of debt and high production costs and without the flexibility to significantly reduce capex this year. Energy Equipment & Services stocks are facing the toughest challenge, as they were already suffering from overcapacity and the resulting lower prices and margins. Companies are also challenged, in that much of any excesses were cut in 2016 with the last oil shock, and they have been running more efficiently since then. But that means that there is little room to maneuver today.
In this environment, when analyzing energy companies, we are looking for valuations that compare favorably with intrinsic value. We are taking into account not only the current crisis, but also the long-term secular decline of oil demand and the impact of supply and OPEC’s reaction to a secular decline. As we assess companies, we are looking at their enterprise value over the barrel of oil reserves compared with the long-term profitability of those reserves. We are also looking at their balance sheet strength, production costs, ability to reduce further, ability to acquire more assets, and how well positioned they are for the longer-term energy transition.
The pandemic has the possibility to be the catalyst for broader consolidation. In April, French oil company Total acquired the Ugandan oil assets of British firm Tullow. We could see further activity toward the end of 2020 and into 2021, particularly among second- and third-tier firms in the US that are at risk, given the balance sheet demands.
We are also seeing energy companies cutting dividends. The sector typically pays healthy dividends, especially in the integrated space. During the last crisis, integrated companies cut dividends by 22%.Today, we are looking at dividend cuts of approximately 23% as companies free up cash. For example, Royal Dutch Shell, which has paid a growing cash dividend since World War II, cut its dividend by 67%, stating concerns about cash flows.
Ripple effects to bond markets
There has been a severe impact on funding capacity in the sector, with fewer available options. During the last cycle, capital markets were very accommodative to the exploration and production companies, providing about $30 billion of equity raises ─ mainly to lower-rated companies ─ and this is unlikely to happen again. The high-yield companies have limited access to debt markets this time, and with borrowing capacity limited, we expect market access to be challenged, except for the strongest companies.
If future prices don’t improve, rating agencies will revisit companies in the sector, and numerous downgrades are possible. This crisis is exposing those firms with weak balance sheets and inadequate assets. Looking ahead, we’re sticking with companies with strong balance sheets, strong liquidity and high-quality assets to pick up the pieces. Another challenge will be the impact of this oil price drop on the lenders themselves. Bank loans are typically collateralized by the reserves themselves. Those reserves are now worth much less, impacting both the banks’ ability to lend, as well as the companies’ ability to borrow.
From a sector rotation perspective, we have been and continue to be cautious on the energy sector, and carry it as our largest underweight. From a valuation perspective, it looks reasonably attractive by some measures. But it is cheap for a reason. Price momentum and earnings expectations have been very weak relative to other sectors, and there is very little in the near term that will be a catalyst relative to other opportunities within equities.
The energy market will continue to be a key area for investors to watch, as it has implications – positive and negative – for trade, FX and macroeconomics, and it impacts multiple segments of the equity and bond markets around the world. And while the current uncertainty has created risks and challenges, it also creates the potential for opportunities that must be monitored carefully.
1 Bloomberg Finance L.P., as of 04/28/2020
The views expressed in this material are the views of Daniel Farley through the period ended May 15, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal. Past performance is no guarantee of future results.
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