One black swan is unfortunate, two may be careless.

Summary: “Unprecedented” supply increase in the face of demand destruction. Fueling the fire.

About the publisher: Richard Norris is a leading business developer and advisor to energy investors, developers, bankers and the public sector.

As the world is coming to terms with the “known unknown” of Covid-19 and the potential for short, medium or even long-term demand destruction… so the OPEC+ coalition collapses. “Unprecedented” is over-used, but I can’t think of a case where over-supply has been deliberately actioned at the same time as a significant demand-destruction event occurs.

The questions now are how can the market re-balance, and if yes, how quickly. Production will not fall precipitously – conventional oil with sunk costs will continue to produce at operating break-evens well below Brent. The role of US Shale as the “swing producer” will be very much in focus. It is worth remembering that US Shale has supplied oil to some 70% of the demand increase in the last seven years (noting that OPEC voluntary and involuntary reductions have allowed some of this to happen). And is expected to continue to do so (at least, “was” expected to do so before this weekend!)

No one will shut in wells voluntarily – unless operating break-even is greater than WTI on a per-barrel basis: cash-flow is king. For those with negative CF on an operating basis, they will shut in if the negative costs continue for more than a short period (not just shale wells but thousands of conventional stripper wells)

However, all companies will have to look at CAPEX and the immediate pain will be in the OFS sector. As I write this I checked… you think oil is bad. Exxon is down 7%, but Schlumberger is down 32% today.

A second variable will be hedged volumes going into this crash. The back end of the curve is down, but not crashing yet. So depending on who has hedged and how much, production may be more robust than one might think.

Thirdly, the US shale producers face a “wall of debt” – most of it coming due in 2H 2020 and through 2021 and 2022. Imagine that as hedges roll off. There will be blood, but not just in the oil patch, this will reverberate into the banking sector. But again, even in cases of multiple bankruptcies, production will be slow to slow – Chapter 11 keeps the wells flowing to protect creditors. Consolidation may follow if there are any buyers.

Curtailment of Capex happened in 2014-15 and saw a moderate impact on production levels. The extent of this correction was limited by two factors.

  1. The industry reacted and cut-costs and improved productivity through technology and focus on high-quality areas.
  2. New money was available via equity and particularly debt issuances (hence the raft of debt coming due in previous image) – which spurred further drilling

I can’t see either of these being repeated in any material way in 2020.

In addition, the sheer size of the production means that even the same percentage drop will be much more significant in re-balancing the global glut.

Good news ! – Collapsing oil prices.

On the other hand, collapsing oil prices are not necessarily bad. Sure its going to be awful in the industry, but for the wider global economy lower oil prices equates to cheaper everything. So today’s conflation of collapsing equity markets with collapsing oil prices sort-of defies logic (although I am yet to hear any media pundits pointing this out).

Of course, markets are not logical but sentiment driven, so the potential for widespread disruption due to Covid-19 already creating fear combined with uncertainty around the primary energy source is naturally going to feed a “risk-off” strategy. Which is odd, as just last week the US Fed slashed interest rates by 50 bps to “stimulate” the economy and equities rose in consequence (although subsequently declined as more fear crept in… “why the big cut, what do they know”?). A 50% decline in the oil price over a couple of weeks should be a much bigger stimulus (and indeed much more wide-spread) than a cut in base rates. So longer-term, one would expect the lower energy costs to filter through and actually help the economy and equities.

In fact, taking a wild swing for the fences, unless Covid-19 turns out to be a major and long-lived pandemic, a period of low energy costs should prolong the current recession-dodging economy once this wobble is over.

As is oft quoted, “the equity markets have predicted 8 out of the last 2 recessions”. Maybe we should make that 9.

Bad News ! – collapsing oil prices

The bad news is of course that collapsing oil prices will further reduce CAPEX globally. This might be exactly what anti-fossil-fuel activists want, but will continue a long period of under-investment. Unless there is a fundamental change in the world economy due to Covid-19, which so far seems unlikely, then when demand picks up again the industry – currently in serious over-supply will transition (possibly rapidly) to under-supply – will be hard pressed to react fast.

Prince Abdulaziz left his counterparts with a grave warning: Trust me, he told them, according to a person in the room. This will be a regrettable day for us all.