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OIL MARKETS: THE GOOD,
THE BAD AND THE UGLY
Member of SPW Investment Team
Apr 28, 2020
Read more below or listen to Christiaan's views here:
Since the start of the year the price of Brent crude oil, the best-known benchmark for the commodity, has fallen from US$65 to below US$20 per barrel. Current oil demand is estimated to be down about 30% since January, at levels of consumption last seen in 1996. At the same time, supply isn’t much lower than it was at the start of 2020 since, unlike a mine or a factory, it’s not so simple to just switch off an oil well once it’s already producing.
In addition, from the beginning of March, the two largest producers in the OPEC+ cartel, Russia and Saudi Arabia, have been involved in a war for market share. Instead of cutting production to support the market, they’ve been applying price cuts and aggressively pushing supply into the market. After a historic meeting between the cartel and other world powers in early April, the two countries did manage to come to a resolution, however, agreeing to cut back on global production by a staggering 10%.
But even this large cut isn’t enough to balance markets in the short term – a key concern being the level of global storage available for the excess oil not being used at the moment. According to some estimates, at current daily excesses, global storage limits will be severely tested within the next few months. Storage availability is of particular concern for the US, where prices for the grade of crude oil called West Texas Intermediate (WTI) tanked to below zero for the first time in history on 20 April.
With its delivery point situated at Cushing, Oklahoma, the price of WTI is the main benchmark for oil sold in the US. In contrast, Brent crude references the price of oil produced in the North Sea near Norway. Unlike Brent crude, WTI is landlocked and most of its consumption is from within the US. When there’s this much excess oil, storage can become a problem, causing prices to fall to very low levels.
There’s also another, more technical explanation for why prices plunged the way they did. On 21 April, the WTI futures contract for May 2020 expired. A futures contract is traditionally used by buyers and sellers who want to lock in a price for a certain commodity at a specific point in the future. However, it has also become the means through which traders can make money from oil prices going up or down. So when the contract expires, a trader who doesn’t want to take physical delivery of the oil will simply sell the May contract and buy a June contract without too much stress.
But in these highly abnormal times, no one wants to buy the May contract from the trader and take physical delivery of the oil, since they’d need to store the oil somewhere. This caused the futures price to temporarily fall to as low as -US$40 per barrel on 20 April, which means the seller actually paid the buyer US$40 per barrel to take the oil! (It might have been a better solution to pour the oil down the drain.)
Over the short term, the market outlook for oil is likely to remain very depressed, with much uncertainty about when demand will return to more normal levels. With lockdowns set to be eased across major economies in the coming months, demand should improve from very low current levels. However, since world travel and remote working policies are unlikely to return to pre-crisis levels soon, and with high levels of inventory that need to be reversed, oil demand may remain weak for some time still.
In a few years’ time, however, we believe the events unfolding today may well turn out to be positive for oil markets, mainly because current low oil prices will force high-cost producers out of the market and result in development projects being cancelled or delayed. For oil producers who can survive the current downturn in prices, there might yet be light at the end of the tunnel.
A lower oil price is generally positive for South African companies, pushing down the cost of transport for producers (lower cost of production) and consumers (freeing up more money that can be used elsewhere in the economy to buy goods and services). At Sanlam Private Wealth we do, however, hold two stocks in our clients’ portfolios that are negatively exposed to a declining oil price: Sasol and BHP.
On 25 March, we wrote about Sasol, setting out the implications of the oil price decline for the company. Since then, Sasol has hedged most of its oil exposure for the second quarter of this year at US$32 per barrel, which does provide some near-term protection to lower prices. In addition, the company said it was progressing well on cost savings targets of around US$2 billion per annum and had received significant buyer interest for the sale of a part of its chemical plant in Lake Charles. This should help ease the pressure on the balance sheet somewhat.
The company maintains that a rights issue of up to US$2 billion remains the last resort – it will try to avoid this by prioritising larger asset sales. However, as things stand it still seems likely that some form of rights issue will be required in August, which means the share price should remain depressed for as long as this possibility exists.
BHP drills oil and gas mainly off the coast of Western Australia and in the Gulf of Mexico. In 2019, oil contributed around 20% to BHP’s earnings – this figure will be lower in 2020 as a result of the oil price collapse. Unlike Sasol, BHP has a very strong balance sheet and good commodity diversification to help it manage the downturn in prices. In addition, many of the company’s mining operations use trucks running on diesel, so it will now be able to save some costs, providing a natural hedge to lower oil prices.
BHP is currently investing heavily in deep-sea oil production facilities in the Gulf of Mexico, which will see a large increase in production from 2024 onwards. If our medium-term positive view on oil does play out, this might turn out to work nicely for the company.
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