We assess how the oil sector is facing up to an unprecedented fall in global demand.
* The impact of the Saudi Arabia-Russia ‘price war’ on the oil sector is insignificant compared to the effect of the pandemic
*The dramatic drop in global oil demand has led to unprecedented global cooperation on production cuts
*The sector still faces huge oversupply issues in the near term
*The pandemic may eventually help speed up the energy transition to greener alternatives
The oil market has for some time obsessed over the Saudi Arabia-Russia ‘price war’, but it is the Covid-19-related collapse in oil demand that is creating an unprecedented challenge for the industry. As we discuss below, the pandemic has the potential to disrupt annual oil demand growth in a way that makes both the fall in demand witnessed during the global financial crisis, and the last period of oversupply between 2015 and 2017, pale by comparison.
As the pandemic has started to affect all areas of the global economy, we have witnessed a dramatic and extraordinary fall in the oil price over the last month. While the price has recovered somewhat on the latest deal struck between the Organization of the Petroleum Exporting Countries (OPEC) and the rest of the world (OPEC+) last Sunday, the global shutdown instigated to counter the effects of the pandemic is already having a huge impact on the sector.
Erasing a Decade of Demand Growth
On April 15, the International Energy Agency (IEA) spoke about the dramatic impact of the pandemic on oil demand this year. The IEA warned: “Even assuming that travel restrictions are eased in the second half of the year, we expect that global oil demand in 2020 will fall by 9.3 million barrels a day versus 2019, erasing almost a decade of growth”.
The IEA estimates that, in the near term, April demand will be 29 million barrels a day (mb/d) lower than a year ago – a level last witnessed in 1995. Given that the prevailing daily demand had been reasonably stable (it grows by an average of 1% a year, and has now reached the 100mb/d mark), the fall is unprecedented for an industry that typically experiences significant volatility over fluctuations of less than 1mb/d. Previously, these much smaller fluctuations have sparked supply or demand crises; today we are witnessing much more significant challenges for both supply and demand simultaneously.
Faced with such dramatic falls in demand, the level of inventory builds will be unprecedented; oil storage facilities could hit their limits within the next two to three months, forcing supply to be curtailed, whether by force (no one willing to buy the crude oil) or through further coordinated efforts to curb production levels.
Concerning the latter, over the last weekend we saw OPEC and OPEC+ groups scramble to host virtual meetings to devise an action plan to rescue oil markets in the face of the Covid-19-related collapse in demand. The scale of last Sunday’s agreement on coordinated production cuts was unprecedented and eye-watering; members of both groups, including Russia, agreed to cut production by a record 9.7 mb/d from May 1 for two months, and thereafter to reduce it to 7.7mb/d until year end. From 2021, the cut will be reduced to 5.8mb/d, but will be held at this level until April 2022. In the near term, even partial compliance at these levels should help stabilize the oil market into the year-end, but it may yet prove insufficient when compared to the scale of the drop in demand. There are concerns that the market’s fixation on a de-escalation of the previous price war between Russia and Saudi Arabia might be blinding it to a potential near-term nightmare of mass over-supply.
How the current oil price recovers, and how oil firms fare, will be dependent upon how long the economic disruption of the pandemic lasts. Without the voluntary cuts agreed over the last week, the market would be left to rationalize supply, and its main mechanism of doing so is price, which could well have forced the barrel price down into the teens or even lower; this agreement should avoid the very worst of it, but April is set to end on a very turbulent note nonetheless. The agreed production cut is unlikely to be deep enough to manage the level of oversupply in the markets, as it only starts from May, and April is already witnessing a huge drop off in demand. We believe it is most likely that crude prices will face downward pressure to force production to be suspended as refineries close operations, given the poor demand fundamentals. However, over the medium to longer term, this should support prices and allow the market to normalize inventories more quickly.
Navigating Back to Normality
What remains unclear is how the world navigates its way back to normality. The level of activity returning even in May remains uncertain, and the outlook is even more opaque when trying to look through the summer and into next year. How the return to economic activity is paced and staggered can have profound impacts on energy demand (which the IEA forecasts to fall by 9mb/d from 2019 levels). The potential for inventories to build and hit ‘tank tops’ creates a longer-term challenge for the sector, when other industries are able to rebound more quickly once lockdown measures are withdrawn. Typically, low prices are the best cure for low prices, but if consumers are prevented from travelling, even domestically, that reliable price elasticity is likely to be more protracted.
Similarly, as we start to look through the crisis, it raises the question over what lasting impact it may have on consumers, and whether it can lead to more permanent changes in consumption and behavioral patterns (less flying, more working from home, etc.). While such changes are unlikely to be so dramatic as to upend our energy use, the disruption does come at a time when policymakers, investors and the general public are becoming more concerned and aware of the unfolding climate-related crisis.
The oil sector was already facing a long-term threat of substitution as the energy transition looms; it is not inconceivable that governments may now look to accelerate investment towards greener energy solutions, and to challenge oil companies to speed up their transition.
Is This the End of the Oil Bull-Cycle?
As society, governments and executives grapple with the challenge of navigating this pandemic, the energy sector remains particularly susceptible to boom and bust cycles. The flipside of all this is the possibility that a collapse in oil prices could catalyze a future supply shortfall which drives prices higher than before the Covid-19 crisis. Some of the production that will be suspended now may never return, while other fields may be damaged in the process. Capital investment may return slower to the sector in the wake of this crisis, especially if further emphasis is placed on energy transition strategies. In this scenario, the industry’s future is full of unknowns, as there is no blueprint for this type of cycle. As long-term investors, we must try to look past this uncertainty to identify future investment opportunities.
Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that strategy holdings and positioning are subject to change without notice.
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