Crude oil crossroads
Bottom Line After a stunning 70% collapse in crude oil prices (West Texas Intermediate, or WTI) during a brutal coronavirus-impaired first quarter (down from $65 per barrel on Jan. 8 to $19 on March 30), bold action is necessary by OPEC and others to reverse a massive supply/demand imbalance.
Covid-19 has clearly destabilized global energy markets, as the virtual shutdown of the global economy has gutted demand for crude oil. More than 40 states have closed and nonessential businesses, and about 20% of the world’s population is now sheltering in place. While that social distancing has helped to flatten the trajectory of confirmed coronavirus cases over the past two months, it’s also flat-lined demand for crude oil. Some 90% of global airline capacity is offline, and occasional trips to the grocery and drug stores haven’t made a dent in gasoline stockpiles.
Recognizing these trends, Saudi Arabia called an emergency OPEC+ meeting in Vienna in early March to propose an estimated 1.5 million barrels per day (BPD) production cut to help balance reduced demand, but Russia refused to participate. So in an effort to encourage its compliance, Saudi Arabia reversed course and significantly increase production by 2.6 million BPD and also offer 30% discounts to Russia’s oil customers after April 1, when their then-current agreements expired. Consequently, oil prices plunged the most in nearly two decades, almost touching their 2001 low of approximately $17 per barrel. If these support levels fail to hold, oil prices could continue their free fall to about $10 per barrel, the level seen in 1986 and 1999.
Over this same period of time, lagging gas prices fell 27%, from $2.60 per gallon to $1.90. While the decline in energy prices is certainly good news for U.S. businesses and consumers, we believe the damage from sharply reduced oilfield corporate spending and manufacturing will more than outstrip that gain. For example, breakeven production in the U.S. averages about $50 per barrel. So many illiquid and highly leveraged energy companies are closing up shop and filing for bankruptcy, exacerbating the dreadful employment situation in which we currently find ourselves, with nearly 17 million initial unemployment claims filed over just the past three weeks. Even venerable, well-capitalized Exxon announced this week it was reducing its exploration and production budget by 30% this year.
Reflecting this carnage, our research friends at Empirical Research report that energy stocks haven’t been this cheap in more than 90 years, with dividend yields at their fattest.
This week, President Trump attempted to broker a reduced-production deal between Russia and Saudi Arabia, suggesting that a shared-sacrifice cut of perhaps 10-15 million BPD across OPEC+ was in the offing. With a wave of bankruptcies among smaller, less-efficient and highly indebted energy companies, the U.S. might contribute 2-3 million BPD through attrition.
The U.S., which is currently the largest energy producer in the world at about 13 million BPD, has a bullseye on its back. Russia and Saudi Arabia are thought to be willing to suffer some near-term pain to force a reduction in some marginal U.S. production.
Earlier today, Saudi Arabia and Russia hosted an emergency virtual OPEC+ meeting, in which they discussed shared production cuts of around 20 million BPD to stabilize the market. The Saudis would slash 4 million BPD and the Russians 2 million, but details of the cuts by the rest of the OPEC+ countries were not revealed.
Global oil storage has become a growing problem, as storage tanks throughout the world are nearly full due to sharply reduced demand. Tanker ships are leaving port filled with oil, but with nowhere to go. In fact, as part of the Phase Two fiscal policy legislation signed into law March 13, Trump announced he would purchase cheap U.S. crude oil to top off the Strategic Petroleum Reserve (SPR) in Texas and Louisiana.
If the trajectory of confirmed coronavirus illnesses and mortalities, which seemingly has peaked and begun to plateau recently, continues that decline, we may see an eventual resumption of economic activity both here and abroad in the second half of 2020. If OPEC+ can find some oil-production discipline now to remove excess crude, the combination of stronger global demand and reduced supply could allow the market to clear and have WTI prices lift back into the $45-$55 range over course of the next year.