Oil Price In Free Fall: A Disrupting Factor In A Troubled World Economy
It has lost two thirds of its value since the beginning of the year, not only due to the slowdown of the global economy in the context of the coronavirus (COVID-19)
A significant imbalance
In the midst of dislocated financial markets, oil stands out as one of the most hit commodities. It has lost two thirds of its value since the beginning of the year, not only due to the slowdown of the global economy in the context of the coronavirus (COVID-19) but also to a new war on market shares, opened by the decision of the OPEC countries not to lengthen the agreement on production cuts. The coronavirus had already hit hard the world’s main consumer of oil, China. The country, which was also showing the fastest growth of marginal demand, nearly halted its imports at some point. This effect on demand is now propagating throughout the rest of the world. The unexpected disruption came from the supply side with the disagreement in late February between Russia and Saudi Arabia on cuts of production that were necessary to compensate for the slowdown of demand, in the context of increased US shale production. In face of a slowing demand, the rise of production implied by the end of the OPEC’s quotas is estimated to be as much as four million barrels per day, on a global consumption of around one hundred millions barrels per day. Even though Russia’s fiscal balance implies an oil price at around USD 45, our experts anticipate that Russia will be able to withstand this shock and we should not bet too much on a renewed deal on supply cuts.
Implication for US shale players
The consequences are significant for the entire sector from oil majors to shale oil producers. The general context
is nevertheless very different from the 2014-2016 situation, where shale oil was on a strong rising trend with huge gains of productivity and large financial resources. The sector is rationalising, debt levels are in some cases unsustainable, and investors are no longer ready to back companies that keep on promising profitability without delivering. On top of that, the hedging policy of shale producers only guarantee about 40% of their production at an average level of USD 50/barrel until the end of the year. As those players represent a significant share of the US high yield market, the risk of default is rising significantly and could lead not necessarily to a supply adjustment but to restructurings, consolidation and capital expenditure cuts affecting the entire chain. This partly explains the spread widening of US high yield segment this year that was also seen in 2014-2016. Lastly, past correlations suggest that a lower oil price is generally associated with an earnings recession, as it happened in the US in the middle of this past decade-long bull market.
Impact on oil majors
Indeed, the impact on oil companies is massive. Over the last few years, majors have been able to lower their breakeven, increase their profitability by rationalising their investment (relying for example on shared projects with guaranteed profitability such as liquefied natural gas (LNG), and lower their debt ratio to between 20 and 30%. A USD 50/barrel oil price offers most of them 15% Internal Rate Return (IRR) and allow them to cover capital expenditure and cash dividends. None of them can sustain a price under USD 30/barrel in the long term at this point. Our internal analysts highlight that generally oil integrated majors do not hedge oil price as they generally offset the negative impact of lower price on their upstream business with higher refinery margins. Up to now, none has announced the intention to lower the dividend or to go to a scrip one, but with yields over 10% the market is discounting such an action on a short term. Services are even worse-off, as majors are already considering adjusting their capex for the coming months.
Macro-economic implications
From a macro-economic standpoint, a lower oil price should in the end have a positive impact on consumption in developed markets, even though it lowers inflation and therefore makes inflation targeting more complex for policy makers. This positive effect is generally witnessed the following year. On a shorter-term view, the negative impact on PMIs and on fiscal balances of oil producing countries may also overcome the positive impact on available income. This is reflected in the significant drop of currencies of oil producing countries such as Russia with the ruble losing 25% of its value YTD whilst sovereign spreads have widened significantly. Oil prices movements are redistributing the cards among emerging markets, mostly in favour of Asian importers. In the past, a lower oil price was often synonymous with a higher US dollar. This topic was notably one area of research of Paul Krugman 40 years ago, at the time when the United States were oil importers, and this relationship transited through oil inflation impact on the current deficit and subsequent inflation pressure on the currency. However, this inverted relationship has been troubled by a growing production in the US and growing demand from Asia, now meaning that a severe drop of oil price generally reflects slower global growth, implies industrial slowdown and results in more accommodative monetary policy. One could argue that in the past few days, this correlation has became true again; but we think that USD relative strength mostly reflects weaker currencies of oil producing countries, and rising sovereign risk affecting the euro these days.
Impact on our 2020 scenario
The oil market collapsed trading from 65 in early January to approximately USD 20-25/barrel (WTI) today with implied volatility trading at unseeing levels. Our scenario for the rest of the year has been revised with an oil price (WTI) that should stay below USD 35/barrel in the coming months, and potentially some recuperation towards USD 45 only if the Chinese demand increases again in the second half, but this is increasingly unlikely given that demand from mature economies is weaker as well. We do not expect Russia and Saudi Arabia to end this dispute any time soon, and we expect that confinement measures related to the COVID-19 virus will continue to weigh on demand which contracts for the first time since the 2008 financial crisis. We should not conclude this article without a word on renewables. The need to decarbonise our energy production is still there, even if economics may for some time not be favourable to green capital expenditure with a lower price of fossil fuels. Better access to capital and a lower cost of capital associated with renewable projects should nevertheless allow them to gain their fair market share in the global offer of energy.
