Energy Sector Likely to Remain Under Higher Pressure Following Oil Price Collapse
The world’s second and third largest oil producers, Saudi Arabia and Russia, entered into a price war this past weekend, sending the price of oil crashing as much as 30%.
After working together since 2017 to curtail production and support oil prices, the two nations have reached different views on the best path forward.
Russia believes past production cuts did nothing more than allow higher-cost shale producers to survive and take market share. After all, U.S. oil production continued surging during this period and has now doubled from 6 million barrels per day (bpd) in early 2012 to a record level at 12.2 million bpd in 2019.
Russia will no longer subsidize rival American producers by helping prop up the price of oil. Saudi Arabia refuses to cut its own production if Russia won’t comply with its proposed output curtailments and is therefore effectively joining in on the battle against U.S. shale once more.
The previous effort to disrupt American oil producers in 2014 was abandoned in late 2016 after shale companies proved to be more resilient than Saudi Arabia thought.
The previous effort to disrupt American oil producers in 2014 was abandoned in late 2016 after shale companies proved to be more resilient than Saudi Arabia thought.
However, this development comes at a particularly bad time for the energy sector; global oil demand is expected to decline in 2020 for the first time since 2009 as a result of the spreading coronavirus.
Oil now sits near $35 per barrel, a level that we believe could persist for at least a couple of quarters, if not for more than a year.
For context, the price of oil has not been this low since the worst of the 2014-16 oil crash. Even then, oil averaged $44 per barrel in 2016.
Clearly no one can predict with much consistent success where commodity prices will go in the short term, and even longer-term forecasts are riddled with uncertainty.
However, if we had to speculate, $35 per barrel oil seems unlikely to represent the new long-term normal for several reasons.
First, there’s the issue of limited spare capacity. Russia and the Organization of Petroleum Exporting Countries (OPEC), whose 14 member countries led by Saudi Arabia account for about a third of global oil production, are estimated to have about 2.5 million to 3 million bpd of excess capacity.
For perspective, global oil production hovers around 100 million bpd. Long-term demand is expected to increase oil consumption by about 1 million bpd annually.
The coronavirus’s impact muddies the short-term outlook for oil demand, but continued growth should help chip away at the supply-demand imbalance as other energy producers pull back. Eventually, more U.S. shale output (and its higher marginal cost) could be needed to fill the gap.
The coronavirus’s impact muddies the short-term outlook for oil demand, but continued growth should help chip away at the supply-demand imbalance as other energy producers pull back. Eventually, more U.S. shale output (and its higher marginal cost) could be needed to fill the gap.
It's also worth noting that unlike most oil producers, OPEC has historically maintained about 1.5 million to 2 million bpd of spare capacity to keep its status as a swing supplier and cushion unexpected production disruptions, which happen every year. In other words, maxing out all available production may not be realistic or sustainable.
Besides capacity constraints, Russia and OPEC ultimately need higher prices to balance their budgets; it's in their best interest to eventually work together to stabilize the oil market. Even oil prices near $60 per barrel are too low for most OPEC nations to cover government spending, according to Bloomberg.
But Russia and Saudi Arabia have the financial resources to endure shortfalls for a long period of time. Saudi Arabia has approximately $500 billion in foreign currency reserves, and Russia has stated that its $150 billion sovereign-wealth fund can support low crude prices for a decade.
In other words, investors should brace for a lower-for-longer oil price environment that could persist for several quarters, or perhaps a couple of years. This extreme environment was practically unthinkable before this weekend, and it has potential to cause major challenges for energy producers.
For example, consulting firm WoodMackenzie estimates that every $10 per barrel move in the price of oil impacts the global oil sector's cash flow by $40 billion each quarter.
Pioneer Natural Resources CEO Scott Sheffield believes it's possible that about 50% of the publicly-trade shale exploration-and-production companies will go bankrupt over the next two years.
Smaller, higher-cost producers can't survive if this environment is sustained for long, especially with fewer obvious levers to pull to become more productive compared to 2016. Investors today are also much more reluctant to put money into the energy sector, drying up access to affordable capital.
Until the pricing environment improves, the oil shock has potential to disrupt financially weaker energy producers and put greater pressure on their dividends. Certain banks (energy loans), pipeline companies (less production flowing through; excess capacity; contract defaults), and oilfield services providers (lower capital spending) could face challenges as well.
Given the conservative, long-term view we take when assessing dividend risk, relatively few energy companies (less than 25) had Safe or Very Safe Dividend Safety Scores heading into this development.
Given the greater likelihood of a more extreme lower-for-longer oil price environment, we are proactively reviewing our Dividend Safety Scores in affected areas and will send out notes this week if any score changes are made.
However, we don't expect sweeping changes to be made due to the long-term view our scores took prior to this price shock.
In other words, investors should brace for a lower-for-longer oil price environment that could persist for several quarters, or perhaps a couple of years. This extreme environment was practically unthinkable before this weekend, and it has potential to cause major challenges for energy producers.
For example, consulting firm WoodMackenzie estimates that every $10 per barrel move in the price of oil impacts the global oil sector's cash flow by $40 billion each quarter.
Pioneer Natural Resources CEO Scott Sheffield believes it's possible that about 50% of the publicly-trade shale exploration-and-production companies will go bankrupt over the next two years.
Smaller, higher-cost producers can't survive if this environment is sustained for long, especially with fewer obvious levers to pull to become more productive compared to 2016. Investors today are also much more reluctant to put money into the energy sector, drying up access to affordable capital.
Until the pricing environment improves, the oil shock has potential to disrupt financially weaker energy producers and put greater pressure on their dividends. Certain banks (energy loans), pipeline companies (less production flowing through; excess capacity; contract defaults), and oilfield services providers (lower capital spending) could face challenges as well.
Given the conservative, long-term view we take when assessing dividend risk, relatively few energy companies (less than 25) had Safe or Very Safe Dividend Safety Scores heading into this development.
Given the greater likelihood of a more extreme lower-for-longer oil price environment, we are proactively reviewing our Dividend Safety Scores in affected areas and will send out notes this week if any score changes are made.
However, we don't expect sweeping changes to be made due to the long-term view our scores took prior to this price shock.
