For Institutional Investors in the US

Navigating Uncertainty in the Energy Sector

Oil prices suffered one of their biggest single-day declines in decades. Research Analyst Noah Barrett explains the reasons for the price collapse and what investors should consider next.

Key Takeaways

  • Oil prices cratered on worries over a demand shock due to COVID-19 and a supply shock as Russia and Saudi Arabia started an oil price war. In turn, energy stocks suffered steep losses.
  • For as long as uncertainty about the duration of the COVID-19 outbreak and global oil supply remains, the sector is likely to underperform.
  • Valuations for energy stocks look more attractive, in our view, but are contingent on a rationalization of crude production and improvement in the demand outlook for 2020.

A perfect storm erupted in the energy sector this week when Saudi Arabia and Russia effectively entered into an oil price war, even as the growing COVID-19 coronavirus outbreak continued to weigh on demand for crude. The news sent Brent oil, a benchmark of global crude prices, down 24% in one day, the worst single-day sell-off in decades. Energy stocks followed suit, with the S&P 500 energy sector dropping 20%.1

Storm Clouds Build

Unfortunately, we don’t believe investors should expect a quick rebound. Oil markets face an unusual scenario, threatened both by a demand shock due to COVID-19 and supply shock from the expected dissolution of coordinated production cuts by the Organization of the Petroleum Exporting Countries (OPEC) and Russia starting in April. Speaking to the demand shock, the International Energy Agency lowered its 2020 forecast for global oil demand by 1.1 million barrels per day (mb/d) and expects that for the first time since 2009, year-over-year demand will decline, by 90,000 barrels per day. Indeed, we believe that the risk is to the downside for 2020 global demand, even on recently lowered expectations.

As demand falls, global inventories are likely to build quickly: Among the 36 countries that make up the Organisation for Economic Co-operation and Development, crude inventories could rise to roughly 3,170 mb/d by the end of July based on current supply/demand estimates, close to peaks in 2016 and well above the five-year average of 2,700 mb/d that OPEC had been targeting for a “normal” market. In such a scenario, production would need to be shut in to help balance the market.

Caution Warranted

All of which makes the price war between Saudi Arabia and Russia an unwelcome development. If demand continues to deteriorate or takes a big leg downward – say, because air travel is forcibly ceased – crude prices could slip to production cash costs, which for higher cost barrels, such as Canadian oil sands, is a little more than $20 per barrel. In that scenario, we think investors should prepare to see a jump in bankruptcies in the energy sector, as well as dividend cuts, production cuts and fewer share repurchases. Even at current prices – Brent settled at more than $34 per barrel on March 9 and West Texas Intermediate, a benchmark for U.S. oil, closed at just over $31 – many companies will be forced to make significant cost cuts or file for bankruptcy protection should prices remain at these levels for a prolonged period of time.

With that in mind, we believe energy firms with strong balance sheets and that have exhibited capital discipline in recent years should outperform on a relative basis to the sector – but will not escape the sector’s overall malaise (as we’ve seen already). Some multiples now look inexpensive, but in our view, these valuations are contingent on the rationalization of oil supply and an improvement in the demand outlook for 2020. What’s more, while it would be great to see undisciplined producers finally exit the market, they are collectively a small percentage of the broad crude supply; the lost supply won’t be enough to balance the market on its own. For now, we think caution should be investors’ compass in the energy sector, at least until the storm eases.

1Bloomberg, as of 3/9/20