April 23, 2020

Perspectives on Oil and the Recovery

In this commentary, we continue to respond to questions that we have received from clients. We are committed to keeping you informed throughout this crisis, providing our perspective on the key issues as well as insight into the focus areas of our in-house fundamental research.

What does it mean when the price of oil is negative?

Despite dramatic declines in planned capital expenditures, voluntary production cuts by North American producers and a large promised reduction in May OPEC production, the drop in demand caused by travel restrictions has been quicker and deeper than predicted, leading to regional excess supply and not enough storage capacity.

The May WTI futures contract expired on April 21st and obligated any holder to take physical delivery of oil at Cushing Oklahoma during the month of May. Storage at Cushing is almost full and could be completely full by mid-May.  WTI is priced at Cushing and is effectively land-locked, so when storage is full, a holder of a long position in the futures contract essentially has to pay someone to get out of their contract before they are faced with the physical delivery of crude. Hence the price appears to be negative. For most major producers this will have a small impact on their realized pricing.

This is all part of a process to force a dramatic re-balancing in supply and demand regionally and globally in a short period of time. Assuming OPEC+ production cuts are in-line with history there should be moderately higher prices and dramatically lower volatility once there is a clearer path to an economic re-start. “Normalized” oil prices will require full economic (non-recessionary) activity, compliance of OPEC+ producers and rational consolidation among North American producers, with continued restraint on access to capital. Until these things occur, we expect further volatility.

Within most of our strategies, we have already decreased our exposure to the riskier end (non-integrated producers and weaker balance sheets) of the oil industry, reducing our overall weightings in oil and gas. Therefore, the direct impact to our portfolios is not significant.

Some are predicting that the recovery will not start until the third quarter of 2020. What is your view?

While we are predominantly a bottom-up manager, and therefore focus most of our efforts on long-term company fundamentals, there is no doubt that the markets are very concerned with macro developments at this time. The depth and length of the recession will depend on the ability of governments to manage their program of fiscal responses, supported by the central banks, to effectively provide financial aid to individuals and prevent bankruptcies of otherwise sound businesses. Reuters recently polled 50 of the world’s leading economists for their forecasts and while there was certainly divergence in opinions they could effectively be separated into five “camps”:

  • A V-shaped recovery – The best case outcome, where the plunge in GDP is followed by an equally sharp recovery. The Q2 GDP contraction will likely be on a scale not seen for decades. But fiscal and monetary stimulus —over $10 trillion worldwide and counting—could aid an equally swift rebound.
  • A more drawn out U-shaped recovery – In this scenario, recovery will take more than a couple of quarters because economies will experience a faster and deeper contraction than in 2008-09; easing of lockdown measures will be gradual, social distancing will continue and some industries will likely continue to suffer.
  • A ”double dip” or W-shaped recovery – If new coronavirus cases emerge after the initial relaxation of lockdown restrictions, as has been the case in some Asian countries, there will be an initial boost to activity but the effects of unemployment and corporate bankruptcies then start to filter through, resulting in a second hit to growth.
  • Delayed recovery or L-shaped – If growth plunges but does not recover for some time because the infection figures continue to rise and lockdowns are extended into Q3 and Q4 2020. This scenario looks unlikely, given positive trends out of Wuhan.
  • The combination or Swoosh – Implies a sharp downturn, followed by a gradual recovery as lockdowns are eased at a slower rate than they were imposed. It is feasible that consumer spending and travel will be impaired by a “fear factor” and that re-investment will be a slow process.

Given the volatile and far-reaching effects of this pandemic on the global economy, it is impossible to accurately predict what the recovery will look like. We have yet to see the actual numbers for the first quarter’s GDP but equity markets have already shown some signs that the recovery will be V-shaped. Historical record shows a range of one to six quarters, and judging by other countries’ experience with the virus and previous economic shocks due to influenzas, our best estimate at this moment would be at the shorter end of the range, around two quarters. We do not see it as economic capacity having been destroyed, but rather as being sidelined for future use.

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