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Oil Hits Troubled Waters

The oil markets have made headlines as one of the industries most affected by the Covid-19 pandemic, but the industry was already under pressure, says Chris Smith of CMC Markets.

7 October 2021

Winter 2020

The 2020 oil crisis will be remembered for many years as a major result of the Covid-19 global slowdown and the economic freezing of economies.

It’s likely to cause more long-term damage than the effects of the Asian oil demand crisis of 1988-89. The oil business may never be the same again, Shell chief executive Ben van Beurden told Bloomberg. “There will be changes, and therefore we have to be ready for that.”

The Covid-19 nightmare

With a constant steam of data and oil industry dynamics being released, it’s easy for an investor or trader to overcomplicate their thinking about the oil markets.

But, at the core of the problem, price movements come down to basic supply and demand, and the outlook for both.

Before Covid-19, the world consumed 98 million barrels per day (MBPD) of oil. That supply was met by over 50 countries, from both Organisation of Petroleum Exporting Countries (OPEC) and non-OPEC nations.

Goldman Sachs oil industry reports show the global demand impact of the pandemic is an estimated loss of 21 MBPD, or over 20 per cent daily.

Covid-19 shutting down almost entire economies is a nightmare many industry executives would have never imagined.

Past crisis events such as 9/11 and the 2008 Global Financial Crisis led to substantial declines in travel, but not to the extent we’ve seen.

There’s been a complete shutdown of consumer air travel, the cruise line industry is on ice and most individuals are barely driving, because working from home is the norm.

This crisis hit the oil industry when producers were pumping record volumes to meet demand, and the world was seeing strong growth among world economies.

The outlook is bleak. The International Energy Association says oil demand could drop by 9 per cent, or 9 MBPD on average across the year, returning oil consumption to 2012 levels.

Coal demand could also decline by 8 per cent, in large part due to electricity demand expected to drop nearly 5 per cent over the course of the year.

Oil price falls into negative territory

Within 20 minutes of trading on 21 April 2020, the oil market did something it had never done before. Prices for the West Texas Oil futures contract for May dropped to negative US$40 a barrel (more than 310 per cent down from the day before).

Why did this happen?

The US energy department suggested it was a perfect storm of factors, including unprecedented dislocation in oil markets, forced liquidations, margin calls by large holders of oil futures, limited storage options and a lack of traders wanting to take the delivery on the expiring May futures contract.

This created a scenario where some participants in the oil market who would usually close their futures position via cash settlement (as most do to avoid the physical delivery of oil) were stuck and forced to sell contracts at negative pricing – effectively, paying someone to take the oil off their hands.

Global supply battle

The United States has become a real problem for OPEC nations in recent years. It went from being a net importer to a net exporter of oil – producing less than 9 MBPD back in 2016, to almost 13 MBPD in 2020. Before Covid-19, debt was cheap, and capital was abundant for the shale oil industry.

There was new major exploration under way, and other big producers in Saudi Arabia and Russia were ramping up production to help supply the economic boom in China.

With its sudden hit, Covid-19 created a nightmare, sending oil prices below break-even levels for most of the US industry, as well as many other global producers.

And we’re only just beginning to see the flow-on effects.

Countries’ ad budgets are forecast based on oil prices usually over US$50, there have been cuts to capital expenditure and dividends are slashed.

Also, banks are not only trying to protect their own loan book to the energy industry, but they’re also raising bonds for these firms to ensure their survival. Where can you invest?

  • Leading oil firms – look at firms that have the strongest balance sheet and track record of surviving large drawdowns in profit and oil price declines.
  • Futures and ETFs – look at futures and exchange-traded fund (ETF) products, and ensure you understand the underlying product and its structure.
  • Oil storage companies – look at firms benefiting from this supply and demand issue by providing storage facilities for the excess oil.
  • Oil service firms – look at firms that provide the expertise to drill and refine oil and gas.

Outlook

Firms such as Goldman Sachs have noted that oil fundamentals are finally showing signs of improvement. Supplies are starting to decline from panic levels, and production halts and household lockdowns are beginning to lift in countries.

Demand is starting to emerge again.

But the oil recovery will require patience and time because airlines and the travel industry will be the last to bounce back.

With a vast amount of oil still in storage, daily supply will be above demand for a long time.

Getting life back to more normality and manufacturing back in full swing is the only good solution to improving the oil markets.

Cutting supply increases the cost for the driver at the pump and brings in far less revenue for both countries and listed oil firms.

Informed Investor's content comes from sources that Informed Investor magazine considers accurate, but we do not guarantee its accuracy. Charts in Informed Investor are visually indicative, not exact. The content of Informed Investor is intended as general information only, and you use it at your own risk.

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