Oil – Helping to Fuel the Current Bear Market
Cambiar Investment Principal Kate Minyard details the recent disintegration of the oil industry.
Over the last few weeks, I have been on oil-focused calls with companies, regulators, and commodity analysts. Although we are not directly involved, I wanted to share some thoughts on the current situation in the oil markets given the extraordinary shocks to demand and supply in March and April and the role the commodity still plays in the broader economy. With low oil prices making headlines and perhaps serving as tailwinds for cost savings in several industries, it is worth parsing the key issues in the sector and what may unfold in the coming months, especially since we have just ended a quarter that saw us exit all our energy holdings across all strategies.
What started the oil price decline?
A supply shock. On March 6, OPEC and Russia failed to reach an agreement on extending production cuts beyond the end of March. The failure to cooperate to support prices took OPEC members and the market by surprise, with benchmark WTI oil prices falling ~10% that day, from $46/bbl to $41.5/bbl as the market internalized the idea that Russia would likely quit cooperating with production quotas as of April 1. Over the weekend of March 7-8, Saudi Aramco marketed its crude oil at prices $5-8/bbl lower than international prices to refiners all over the world, apparently most aggressively targeting regions where its crude oil competes with Russia’s.
In the following days, major producers (Saudi Arabia, Russia, Iraq, Nigeria, and others) announced they would supply an additional ~3 million barrels of oil per day to the market. Note that global oil demand is about 100 million barrels per day. A 3% move may not seem like much, but severe price swings often occur when oil is over- or under-supplied by only 1-2%.
Why? Is the market that fragile?
In a way, yes. The most straightforward explanation I can offer is that if you have 50 cargoes and 50 buyers, you have a balanced market. If you add another cargo, you have 51 cargoes and 50 buyers. One extra cargo is looking for a home and everything will price off the lowest price the extra cargo is willing to take to find a home.
Why the severe drop in oil prices?
An unprecedented demand shock. It would have been damaging enough to the oil markets to see supply 3% higher than demand. However, in the days following the announcement of incremental Saudi supply and severe price competition, social distancing initiatives/lockdowns began on a much broader basis. Current estimates suggest a global demand contraction of 12-23 million barrels per day for 2Q, although the ultimate impact depends on the shape of any economic reopening. Note that the most severe impact suggests a demand contraction of 29 million barrels per day in April, and therefore the 2Q figure could easily trend lower if what we are observing in April extends into May and June. With jet fuel demand down an estimated 70% and a drop of at least 10 million barrels per day of personal-vehicle transportation fuel globally, refiners have cut runs and will cut more. In the US alone, implied gasoline demand over the last two weeks was 5.8 million barrels per day, down from more than 10.2 million barrels per day in the first two weeks of March. Our data set goes back to 1997 and this is the lowest point on the graph.
During the week of April 6th, U.S. refinery utilization was only 70%, steadily falling from 87% during the third week in March. We have seen levels this low before, but for very brief periods coinciding with hurricane-related shutdowns of Gulf Coast refining capacity in 2005 and 2008. Average U.S. refinery utilization over the last 20 years has been about 90%. As a result of the reduction in refinery utilization, crude oil inventories increased by more than 19 million barrels, following builds of 14-15 million barrels each of the prior two weeks. Trends around lower refined product demand, lower refinery utilization, and a build in crude oil inventories are likely to continue under lockdown-related activity curtailments. And remember this is happening globally. The U.S. just offers higher-frequency data.
Where does all the extra oil go? Can we store it?
It is important to note that petroleum is unique in that it must be produced into an existing, sophisticated, and purpose-built logistics network. Other commodities, like copper or iron ore, can be mined and then stacked to the side if there is a demand shock. Not so for oil. We can store some of it but only within the existing system. Current estimates of available storage generally suggest around one billion barrels of storage remaining, depending on what you count (do you include pipelines as “storage”, do you include tankers that could be called back into service) and the quality of your data (probably good in the U.S., perhaps murkier for some other regions). Assuming we have one billion barrels of storage available and the market is oversupplied by even 15 million barrels per day, we will fill the storage in fewer than 70 days. However, that assumes no constraints in accessing the storage at a rate of 15 million barrels per day of flow. That is a terribly unrealistic assumption. Storage is designed to take excess, and we have never had 15 million barrels per day of excess oil for an extended period of time. It is the equivalent of trying to divert traffic from the freeway to an offramp. There may be plenty of places for the vehicles to go once they exit, but the offramp capacity is the limiting factor. We are likely to see the logistics network overwhelmed before storage is full. Also note that once petroleum is refined into products such as gasoline and jet fuel, the products must be stored separately. You cannot commingle gasoline and jet fuel.
What happens if the logistics networks is full?
Inland crudes with limited options to access the market are the most disadvantaged, and this comes through in severely depressed prices. While the global reference crude, Brent (delivery point in the North Sea), is trading above $28/bbl, NYMEX crude oil (delivery point in Oklahoma) is now about $18/barrel as is crude oil in the Permian Basin, which had fallen to as low as $11/bbl as of the end of March. Crude oil in the Bakken in North Dakota is around $11/bbl after falling as low as $8/bbl, and Canadian crude has recovered to $11/bbl after falling as low as $4/bbl. (Data as of 4.17.20)
At some point soon, pipeline operators will refuse to take production, which will force some producers to shut in their wells if the cash-negative nature of their production hadn’t already.
Note, also, that individual refineries cannot operate below about 60% capacity before they have to shut in the entire refinery. A large refiner can cut back to 50% utilization across a system, but this will happen by completely shutting down, say, four smaller refineries and keeping three larger ones running at ~85%, as an example. This may result in geographic dislocations in terms of product build, and may pose additional challenges when activity resumes.
What about the production cuts announced by OPEC and its Partners?
The production cuts announced on April 12th amount to just under 10 million barrels per day. This is a start, but is not enough to offset the contraction in demand we are witnessing. Earlier, we discussed how even a 3 million barrel per day oversupply situation was enough to cause prices to plummet. There is a limit to how much some producers will be able to cut, not only from a budgetary standpoint, but also from a practical standpoint. Producing nations that rely on natural gas produced alongside oil for their own internal consumption are unlikely to cut production to the point that they place their internal energy supply at risk. Even with perfect compliance, the supply reduction of 10 million barrels per day is still not enough to overcome a demand contraction of what may well amount to 20 million barrels per day in April alone. However, this will buy some time in terms of how quickly storage fills and may mitigate the overload on the logistics system.
What happens when demand comes back?
On the oil side, shutting in production may damage some reservoirs and they may not return to full capacity. Oil production requires management of a changing pressure situation in a reservoir and a balancing act to maintain a pressure differential that will get the oil to flow over the life of a well. Hypothetically, if we shut in or severely restrict volumes across ~20 million barrels per day of production, we may only be able to bring the wells back at ~80% of what they were previously producing. This would suggest a loss of 4 million barrels per day of production and, ironically, would set up the market for an undersupply situation if we got back to 100 million barrels per day of demand before incremental supply could fill the gap. However, it depends on how soon and how quickly demand comes back.
We believe that medium to long term, well-capitalized producers with strong balance sheets, high-quality crude, and ready access to the global market should fare well on the producer side.
Who wins in all this?
In the short term, we believe the companies that own storage and can charge fees just to hold onto barrels look like the only short-term winners. If end demand returns and we have lots of oil in storage and depressed prices and most crude oil production is still intact, refiners could come out ahead, but portfolio positioning is critical. We believe that medium to long term, well-capitalized producers with strong balance sheets, high-quality crude, and ready access to the global market should fare well on the producer side.
Who seems most disadvantaged?
Oil service providers, undercapitalized producers with stressed balance sheets, producers far from markets, and producers of disadvantaged crudes.
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