Oil: From Neutral to Positive
Crude oil prices have plummeted by 20% since their January highs, while tensions between the United States and Iran have fuelled the worst fears. ..
The coronavirus epidemic is expected to drive down global demand due to travel limitations and the slowdown in economic activity.
Our belief is that this price weakness should be short-lived. Profitability problems within the shale oil industry and the fiscal position of the OPEC countries are likely to squeeze supply fairly soon.
Quarantine measures, travel restrictions and temporary business closures in China could slash global demand by nearly 400,000 barrels per day (out of a total consumption of nearly 100 million barrels per day).
This may sound insignificant in percentage terms (0.4%) but in a situation of over-supply versus demand, the impact on prices is enormous.
The shale oil industry is price-sensitive
Our analysis is that a price around $50 per barrel for the West Texas Intermediate (WTI) is untenable for the shale oil industry. This industry, still dominated by small, independent producers, was already in difficulty before crude prices started to fall.
Unlike conventional oil fields, the lifespan of shale oil rigs is relatively short, which means that ongoing investments are needed to drill new rigs. These small producers were already struggling to generate regular cashflows and finance themselves.
The number of bankruptcies doubled in 2019 (42 in the US and Canada) and the total amount of US bonds in default exceeded $208 billion. Shareholders are now demanding more dividends and fewer investments.
In the past, every major decline in crude prices led to a decline in the number of rigs in operation, after an adaptation period of 3 to 4 months. The same will be true this time, and overproduction will thus decrease.
OPEC+ plans to cut production further
OPEC and associated countries (OPEC+) decided in early December to increase their production restrictions by an additional 0.5 million barrels per day, and Saudi Arabia reduced its own quota by 0.4 mb/d, bringing total production restrictions to 2.1 mb/d. For the past three years, OPEC+ has generally complied with its commitments, despite doubts about discipline within its organisation.
OPEC+ is currently discussing additional emergency measures to deal with the tumbling prices. This eventuality may curb downside speculation, with OPEC+ behaving like central banks whose rhetoric influences the markets even before any decision is made.
No geopolitical risk premium is abnormal
Geopolitical risks remain in the Middle East. The extremely effective attack on Saudi oil facilities in September 2019 and the intense tensions between the US and Iran at the beginning of January should remind us that the lack of risk premium in crude prices is abnormal. Any single incident could cause crude prices to soar.
The medium-term outlook remains positive
The 2-3 year outlook remains positive due to the lack of investments in conventional oilfields in the years following the fall in prices in 2014. Without any investments, the production of conventional fields decreases by 6-7% per year on average.
The effects of the energy transition should only be felt much later.
Conclusion
We believe that the lower consumption due to the coronavirus health crisis is temporary. Demand has not disappeared, but rather postponed. Brent crude oil prices are expected to rise from ±$55/b currently to $60-70/b within the coming months.
Profitability problems in the shale oil industry and the fiscal position of OPEC+ countries require a higher equilibrium price. It is in the interest of all producers to temporarily reduce their production.
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