WHAT HAPPENS NEXT IN THE OIL MARKET?

It’s very strange times for the oil market and there could be further trouble ahead. Unless demand picks up dramatically in the coming weeks then mid to late May could see a repeat of the recent scenario where people had to pay others to take oil off their hands.

In this article we will explain what is going on with oil, what it reveals about the economy and what it means for wider markets. We also look at how oil companies can and will respond and potential ways of playing an eventual rebound in the commodity.

SUB-ZERO OIL

A confluence of factors led to the extraordinary situation of 20 April where the price of West Texas Intermediate (WTI) oil for delivery in the month of May fell as low as minus $40.32 a barrel, becoming negative for the first time in history.

Some of them were technical and linked to the futures market but at its root the weakness in the oil market is a question of demand, supply and storage capacity.

The level of demand destruction in the oil market is greater than has been seen in living memory. Within a matter of weeks people have stopped flying, they aren’t driving nearly as much and many businesses have been closed down as countries take measures to contain the coronavirus outbreak.

If oil is the ‘engine’ of the world economy, then, in effect, it is not needed as the world economy is off the road.

On the supply side the situation wasn’t helped by the seemingly kamikaze decision by Saudi Arabia to launch a price war with Russia after a 4 March meeting of oil producers’ cartel OPEC+ (the plus effectively being Russia) failed to agree on production cuts.

The cuts eventually agreed at a meeting of the organisation in early April probably didn’t go far enough to rectify the situation.

What is contango and backwardation?

Contango refers to the market condition whereby the price of a futures contract in a commodity is trading above the spot price (which is the current market price).

The resulting futures ‘curve’ would be upward-sloping with prices for dates further in the future trading at ever higher levels.

Backwardation describes the reverse – where futures are trading below the spot price – often because of short-term tightness in the underlying market. Arguably contango is a more natural state as it reflects costs of ownership such as storage and insurance.

FUTURES SHOCK

Like the majority of commodities, oil is traded in futures contracts. The purchase or sale of a barrel of oil is agreed at a fixed price for delivery on a specified date.

WTI was already trading in a state of ‘super-contango’ (see box-out for an explanation of contango and backwardation) but then the situation became truly remarkable.

With the May futures contract for WTI expiring on 21 April, no takers for physical delivery, a growing supply glut putting pressure on key infrastructure, most notably the delivery hub in Cushing, Oklahoma which is heading for capacity, and traders looking to sell or roll over contracts to the next month, there was a perfect storm which drove the extreme market action which saw sub-zero prices for the first time.

There are reasons why this won’t happen with Brent which is the main pricing benchmark outside the US. Brent futures contracts are settled in cash rather than with physical delivery of a barrel of oil so a fall into negative pricing is not on the cards.

There is also more waterborne storage and not the same pressure point on a single infrastructure hub as there is with WTI. However, at the time of writing Brent was still close to historic lows itself at just over $19 per barrel.

The wildcard with the oil market is geopolitical risk and traders were served notice of this fact with oil prices bouncing back a bit on sabre rattling from the Trump administration against Iran on 22 April.

There is certainly a chance of a more meaningful recovery in oil prices when demand returns.

There are two points to consider. First, demand destruction won’t be repaired overnight as the coronavirus crisis is likely to have a lasting impact on global growth and there will be lots of oil in storage to absorb.

Equally, OPEC and its affiliates are cutting output, while drilling will stop and production is likely to be reduced or stopped by independent operators as it becomes uneconomic to continue pumping oil out of the ground. Bringing this production back on stream is not as simple as turning on a tap.

Looking further out, the cancellation and deferment of projects which would otherwise have been greenlit will further affect the supply/demand balance in future years.

Although the world is attempting to move away from oil, that change will happen somewhat in slow motion.

Ron Lansdell, the chief operating officer of UK small cap oil explorer Jersey Oil & Gas (JOG:AIM), says: ‘Oil is forecast by most reliable commentators to play a large part in the energy mix for the next 25 to 30 years. That’s true in developed economies but particularly true for developing nations.’

WHAT DOES THE OIL PRICE SLUMP SAY ABOUT THE ECONOMY AND MEAN FOR MARKETS?

The extreme price action in the oil market is sounding a clear alarm bell on the global economy. Oil is central to areas like transportation, power generation and plastics production, to name but three of its end uses. As such its fortunes are closely tied to movements in GDP.

It was notable how oil seemed to factor in a coronavirus-inspired deterioration before stocks did earlier in 2020.

So is the renewed weakness in crude a new warning signal that equity investors are too complacent about the impact of the outbreak and the measures taken to contain it?

The fact that the economy is in a period of stasis is not new news. Spot oil prices (covering immediate delivery of crude) and those for futures contracts which are close to expiry have to factor in the supply and demand picture as it is today.

Stock markets act as a discounting mechanism which reflect a perception of the future ahead of time. Shares will be valued and priced according to this perception until reality – in the form of a trading update, set of results, macro-economic development or some other piece of news – intervenes to change the market’s view.

There is no reason for investors to get too concerned about backward-looking economic data which is inevitably going to be horrible at present, the focus is on how and how quickly economic activity can recover. That explains the attention given to the number of infections and deaths from the outbreak and progress towards vaccines and treatments which can fight it.

If we look at contracts for oil covering delivery around the end of the year they are still at very depressed levels. As a very crude comparison the December 2020 contract for WTI is trading at
half its level at the start of 2020 while the MSCI World stock market index is down by around 16% year-to-date.

This suggests it would be naïve to expect smooth sailing for equities from here on out. Assuming you have a long-term investment horizon then the best thing to do is to stay invested, rather than trying to time the market, and to do what you can to prepare for further volatility.

Another factor to consider is the risk of contagion as bad debts in the oil and gas sector affect the banks. This may be a particular issue in the US, where institutions have lent heavily to the domestic shale producers.

Many of these could go out of business if oil prices remain depressed, though US president Donald Trump may come to the rescue with his promise of financial aid to the industry.

WHAT DOES THE PRICE CRASH MEAN FOR THE OIL INDUSTRY?

Already under pressure thanks to the so-called energy transition as the world looks to wean itself off fossil fuels and move towards renewables and other alternatives, the oil industry faces a huge challenge in the near term as it contends with the collapse in oil prices.

The chart shows UBS’s estimates on a price threshold for cash neutrality at the big global major oil companies. This is the price at which they would have the same amount of money coming in as is going out the door. The average is $53 per barrel – a long way north of the current level.

In previous oil price crashes, which didn’t see this level of demand destruction, the integrated oil firms had something in their locker which they don’t this time.

As well as developing and producing reserves of oil and gas, integrated firms also have big refining and marketing arms. These parts of the business acted as a natural hedge against falling prices as cheaper crude boosted refining margins. Today there is very little demand for refined products.

We are beginning to get an indication of how this is impacting the big oil firms. Italian outfit ENI reported a 94% drop in profit for the first quarter – and that’s despite the fact the full impact of coronavirus wasn’t really felt until March.

WHAT WILL HAPPEN TO DIVIDENDS?

Norway’s Equinor became the first oil major to cut its dividend where its proposed quarterly payout was slashed by 67% quarter-on-quarter. BP (BP.) said on 28 April that it would keep paying dividends. Royal Dutch Shell (RDSB) was scheduled to report on the day this article was published (30 April), including news on its dividend intentions. 

Morgan Stanley believes oil sector dividend cuts between 30% and 50% are necessary to keep gearing levels at around 30%. UBS thinks there is a chance firms will hold off for now.

Previewing the current first quarter results season for oil companies, it commented: ‘An area of keen interest will be dividends and how strongly companies defend their payout. There are pros and cons but we see limited benefit in immediate capitulation and longer term value in defending the commitment even if policy is revisited at a later, calmer, date.’

If the heavyweights of the oil sector are wrestling with the pressures of the current situation then this is nothing compared with the challenge facing some of their smaller counterparts – particularly those with substantial debts.

Canaccord Genuity analyst Charlie Sharp believes a trio of firms in this positon – Premier Oil (PMO), EnQuest (ENQ) and Tullow Oil (TLW) – enjoy little if any equity value at an oil price below $45 per barrel.

Tullow managed to improve its situation with the $575m cash sale of its Ugandan assets (23 Apr) but Sharp still estimates the company will be weighed down by a $2.15bn net debt position by the end
of 2020.

Asia Pacific-focused Jadestone Energy (JADE:AIM) is in a much stronger shape with net cash of $72.1m as at 31 March. The company has hedged 50% of its oil from its flagship Montara field in Australia at a floor price of $68.45 per barrel through to September and capital expenditure has been cut by 80%.

Tight control of operating costs mean that for the remainder of the year it expects to be breakeven on a free cash flow basis at an oil price of $27 per barrel.

Chief executive Paul Blakeley tells Shares the company hopes to take a further $3 to $4 per barrel off that number by driving down operating costs. Notably Jadestone still plans to pay its first dividend later in 2020 at a targeted range of $7.5m to $12.5m.

Blakeley says: ‘We’re assuming, to be prudent, this is going to go beyond this year and into next. We’re going to do the right thing for the business and are managing our programme accordingly.

‘I don’t think we’ll be on complete lockdown but it will take global industrial recovery at least that amount of time and more to get back to normal. Whatever normal is.’

If Jadestone’s strong financial position and low operating costs shield it somewhat from oil price volatility, SDX Energy (SDX:AIM) benefits from having significant gas production on long-term sales agreements.

In Egypt this output goes straight to the state energy firm, where sales have continued as normal. However, in Morocco customers are in lockdown and aren’t taking the company’s gas.

SDX does also have some oil production and CEO Mark Reid says: ‘We’ve budgeted at $30 per barrel for 2020 and $35 for 2021. It could bounce down below that or bounce slightly above that, but we’re not going to be at $60 next year.’

From an operational point of view Shares’ conversations with oil companies suggest they are better placed than some to contend with the coronavirus. Teams are often highly dispersed and used to working from remote locations so social distancing is less of a challenge than it is in other industries.

HOW TO PLAY THE OIL MARKET

While oil could experience further weakness in the short-term there is reason to believe the commodity will trade at a higher level than it does today when the world emerges from lockdown.

We must stress that the commodities market is very high-risk, volatile and trying to time the rebound in the oil price is not something most investors should consider.

However, if you understand the risks involved and have money you can afford to lose then there are various ways to get exposure to the oil market.

We suggest you only consider the shares of financially-strong oil producers and diversified investment funds.

At 42p, half its level at the start of 2020, we think Jadestone Energy looks well positioned and its strong balance sheet means it could take advantage of opportunities that arise from the current dislocation in the market.

We recently added Royal Dutch Shell to our Great Ideas list on the basis of its double-digit dividend yield and an exceptional track record of not cutting the dividend since the Second World War. We will find out today (30 Apr) if this record is being maintained.

As we write the shares are up modestly since we said to buy and we still think there is further recovery potential, particularly if Shell continues to be a good source of income in a dividend-starved world. If the dividend is cut then we will reassess our view on the stock.

WHAT ABOUT ETFS?

It is worth noting that several exchange-traded funds offering exposure to oil have been affected by the recent extreme volatility in this market.

A large US product – United States Oil ETF – actually contributed to oil’s recent journey into negative territory as it was one of the largest holders of the WTI May 2020 contract. It couldn’t take delivery of the crude these futures implied so dumped them in the open market.

It has subsequently had to adapt the way the product is structured using separate derivative vehicles which mean its ability to track the oil price effectively could be further constrained.

In a sign of the stress on oil-related ETFs, several leveraged products (offering two or three times the movement in underlying oil prices) have recently delisted from the stock market.

There are also technical reasons why oil-related ETFs don’t always track the underlying price over a long period. For example, WisdomTree WTI Crude Oil (CRUD), rose 79% from the bottom of the previous oil crash in January 2016 through to a high point in 2018. However, WTI itself was up more than 150% over the same period.

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