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Flash crash in oil is just a foretaste

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Oil trading at minus $40 a barrel may be a one-off, but ultra-cheap oil is not. The industry’s bonds may look attractive at the current inflated yields — but they should tempt only investors who are brave, patient and selective.

February and March gave the world an oil shock of great magnitude. The price of Brent crude more than halved in those two months, bombing from $56 to $26 a barrel.

“Hold my beer,” said April.

The price of West Texas Intermediate crude turned negative for the first time ever on Monday, dipping below minus $40 at one point. That could be dismissed as a peculiar reaction to the May futures contract expiring at a moment of acute stress. But the pain worsened and widened on Tuesday — by the afternoon, Brent had fallen below $20 for the first time.

The price collapse caused by the economic lockdowns imposed to combat the spread of Covid-19 has been made extra-bumpy by the spat between Saudi Arabia and Russia. After Opec and the Russians failed to agree a production cut on March 8, Saudi declared a price war, counter-cyclically increasing production.

But that is really a sideshow. Opec and Russia have made up and agreed on April 9 to the biggest production cut ever — but the worst price falls have come since then.

Staying long

The price crashes have been historic. But many investors still see good reasons to be invested in credits exposed to the oil industry.

First, oil companies may be at least partly hedged and therefore insulated from the immediate pain. For one thing, integrated companies’ downstream businesses often buy oil in the open market. For refiners, cheap oil is a good thing, as petrol prices to consumers usually still build in a profit margin and tend to adjust downward more slowly than the raw material.

Second, they expect the global fall in demand for oil to rebound as countries emerge from lockdown and economic activity resumes. Many hope that this will happen over the summer, pushing demand and oil prices back up, at least some of the way.

Nobody can say what an economic recovery from the pandemic will look like but the biggest optimists are hoping for ‘V’ for victory. As painful as the pandemic is proving, they are convinced the negative effects will not last.

Central bank pumps

It is a tempting theory for oil lovers, not least because, regardless of the growth of green energy sources, it is still the black stuff that makes the world go round. The world cannot do without oil — even if it might need less.

Underpinning oil debt, too, is good old quantitative easing. In Europe, recent bonds from Royal Dutch Shell, Repsol and OMV are all trading above where they were priced only a few weeks ago, despite this week’s first-in-a-lifetime price slump. Much of the thanks are due to the European Central Bank’s bond buying programmes.

But this is wishful thinking.

You ain’t seen nothing yet

However sick people are of them, lockdowns have so far still been quite short. Hopes that they could be relaxed significantly in April have already gone. May is also in doubt, especially in countries like the US and UK where there has been no real progress yet at slowing the rate of infection.

As recent flare-ups in Singapore and northern China show, even in countries that seem to have beaten the disease, it can easily and rapidly spring up again, forcing governments to renew the fight by any means necessary.

Lockdowns, in other words, may be eased a little, but are likely to remain a feature of life until there is a cure or vaccine for Covid-19. The consensus predictions for a vaccine are next year — and that is probably looking on the bright side.

This is the real threat to oil companies — a ‘W’-shaped recovery, or even something that resembles an ‘L’ — with a longer horizontal.

In emerging markets and the developing world, the coronavirus’s effect on the economy is only just beginning, so more demand destruction is likely.

Debts at risk

Oil is not going out of fashion just yet — unfortunately so, for the climate’s sake.

But nearly all oil producers will, even with partial hedging, be burning cash while prices remain so depressed. So will their suppliers and services companies.

Production has to continue but it has to shrink to bring it back into line with, or below, demand, allowing the glut of oil in storage to be used up.

Western companies operate in a free market and governments have historically not intervened directly to raise or lower supply. They may have to start meddling.

If not, the only way for supply to be curtailed will be forcing weaker players to shut down production.

Oil companies will be forced to lay off workers to bring down costs. Estimates vary wildly of how many jobs in the US rely on the oil industry, from 125,000 directly involved in extraction to a potential 2.1m in the whole supply chain or even a total economic effect of 9.8m jobs, according to a PwC estimate for the American Petroleum Institute in 2011.

But lay-offs are unlikely to be enough to save companies heavily burdened with debt. They face an existential crisis, and many may fold before demand returns to normal.

Those that survive may well have had to lean out so much that they are not well positioned to take advantage of the recovery when it comes.

The big oil majors will survive to fight another day — they have to. That means they are unlikely to default on debt. The oil price will find a bottom somehow, though it is a long way off as much more production will have to be closed.

But during that process, even oil majors’ debt metrics will be under severe strain, and spreads are likely to widen, however hard central banks try to support them. Investors may be richly rewarded if they dive in. But only the hardiest — and those very confident they have their clients’ support — should try it.

Oil assets of all kinds are cheap. But as one seasoned investor said this week: “Just because something is cheap, that doesn’t make it a good investment.”

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