Trying times ahead for energy sector, but renewables could gain from oil’s problems. 

Although oil has had nine major downturns in the past 35 years, the latest has been nothing short of spectacular. COVID-19 and the ensuing lockdown measures have destroyed the demand for oil, so prices needed to adjust dramatically. 

Chart 1: West Texas Intermediate (WTI) Oil Price (per barrel)
 

Source: Macrotrends.net. WTI Crude Oil Price – 10 year daily chart. Prices shown are in US dollars. As at May 31, 2020.

Compounding this situation has been the untimely failure of OPEC+ (see glossary, at end of story) to maintain production discipline, with supply ramping up in March while demand fell.

Broadly, the impact on the oil price has been a drop of half to two-thirds, from $60 per barrel to $20 to $30.

The shale oil revolution has seen the re-emergence of the United States as a major oil producer and helped lead to the oversupply that has broken the market balancing function of OPEC+.

US producers, having borrowed heavily in recent years were reluctant to cut production and even hit record output of 13 million barrels a day at the end of February, leading to April’s historic negative WTI oil price (-$39) due to a shortage of storage facilities.

Advocates of the “peak oil” theory (a hypothetical point where global crude oil production hits its peak), so vocal in recent years, were resoundingly silenced as the market was awash with oil, seemingly with no one to use it and nowhere to store it.

Who are the losers?

The collapse in the oil price had a significant impact on the whole supply chain, from producers and suppliers to integrated majors and refiners.

The largest sector hit has been oil services, which provide all the specialist drilling, fracking and other field activities. Some exploration and production shale producers will not be drilling or fracking in the second quarter of 2020 in response to the price collapse.

The normally more stable and less volatile midstream and infrastructure sector that provides oil gathering/transportation services has also been impacted by lower volumes, reducing their revenues.

More broadly in the energy sector, the global liquefied natural gas (LNG) market has seen a material price decline, with recent spot sales below cost. Many normally reliable customers have been looking to cancel delivery due to low end-market demand. The much-touted next wave of proposed LNG projects may need to be delayed.

We are now seeing the self-correcting nature of a commodity market at work, with exceptionally low prices rapidly driving cuts to production and growth activities.

Having only recently restructured their businesses to cope with the fall in prices from $100 to $50 to $60 a barrel, oil producers are now scrambling to adjust again. The first transition was long and painful as denial and inertia slowed the rate of restructuring required to achieve costs around $40 a barrel.

This cycle, with oil at $20 a barrel so quickly, has seen a rapid response from the industry. Cutbacks to production will help balance the market as the demand recovers after COVID-19 lockdowns are eased and it is reasonable to expect oil to approach $40 in the medium term.

This prospect will provide a path to survival for companies that were not too highly exposed to debt and high-cost production methods.

The collapse is so severe that some companies have already announced their third capital and operating costs reduction plans in just one quarter.

Following OPEC+’s announced cuts of about 10 million barrels of oil equivalent, so far non-OPEC+ oil producers have cut their capital budgets 30 to 40 per cent, with production declines of 10 to 20 per cent to follow.

Who are the winners?

Although lower fuel prices would normally cut costs for households and fuel-burning industries like aviation, in this instance lockdown restrictions have so far meant limited benefits to consumers and businesses.

This will naturally unwind as the COVID-19 pandemic is brought under control, but demand for oil could be lower in the longer term, given the severe impact to economies, businesses and individuals.

Near-term beneficiaries have been North American pure gas producers that have seen NYMEX gas prices rise on the back of lower by-product gas production due to lower shale basin activity.

Other winners have been companies that provide storage capacity to deal with near-term excess oil that cannot be sold. Oil shipping companies that provide crude or refinery product tanker capacity for offshore storage have been in strong demand.

Will the environment be another winner?

The sustainable energy transition required to meet net zero emissions by 2050 could see a rapid boost as the super majors (see glossary, below) scramble to find solid energy investments with long life and less cyclical exposure to the oil price.

Previously, renewable generation assets earning 7 to 10 per cent were seen as sub-standard against hoped for 15 per cent and more returns from oil and gas. Capital previously planned for short-cycle oil shale projects could see investment flows rapidly switch to longer-duration stable renewable utility investment.

Governments, directly or indirectly, influence more than 70 per cent of global energy investments and investing in decarbonisation arguably achieves two objectives: stimulating job creation and addressing climate change.

The fall in fossil fuel prices also gives policymakers the chance to reduce and reallocate fossil fuel subsidies towards competitive renewables.

Beneficiaries of this megatrend include renewable energy developers and producers, wind turbine manufacturers, battery companies and renewable diesel producers.

The effects of this will also be felt in several metals markets. Huge amounts of copper will be needed for electric vehicles and electricity networks. Battery raw materials such as nickel, cobalt and lithium stand to benefit in the transition from internal combustion engines to electric vehicles.

Janus Henderson’s approach and outlook

Lower commodity prices for producers means cheaper input costs. Looking specifically at the agriculture sector, lower gas prices are positive for fertiliser producers, for example, and lower fuel costs benefit companies involved in the transportation of agricultural output.

In mining, lower oil prices lead to better economics for bulk mining of iron ore, copper and gold. With China’s economy restarting, demand for resources will start to build once again, although with the evolving dispute between Australia and China our ability to invest outside of Australian companies means we can limit our exposure to this thematic, while still benefiting from exposure to the sector.

A possible permanent reset in demand post-COVID-19 and acceleration in renewable energy sources will make it a trying time for all but the best of the energy sector. While lower oil prices reduce input costs, like economic stimulus it will benefit uniformly rather than provide any one company with a competitive advantage.

Our aim is to invest in companies we have identified as having a natural resources advantage that can benefit from investment through being able to fund innovation within the company and expand their productive operations.

We actively invest in companies within the mining, energy and agriculture sectors throughout their various commodity cycles and with diversification into the many sub-industries that comprise them.

We also invest across the entire supply chain, including upstream (producer), midstream (transport/processing) and downstream (manufacturing, sales), meaning we can invest where we see opportunities emerging.

Glossary:

• OPEC+: The coalition of the 14 OPEC member nations and 10 other oil-producing nations.
• Super majors: BP, Chevron, ExxonMobil, Royal Dutch Shell, Total.
• Note: All prices are in US dollars unless stated otherwise.