Oil suffers its coronavirus moment
The Covid-19 outbreak is having large repercussions around the globe, with quarantine and containment measures affecting the economy both on the supply and demand side. We continue to think that the economic damage could be sharp but short, pending adequate fiscal and monetary measures being implemented to support businesses and consumers.
But one piece of collateral damage from the virus outbreak which could have a long-lasting impact is the oil market, after the oil price fell by more than 20% on 9 March.
The implosion of OPEC+
The OPEC+ group, comprising the members of the Organisation of the Petroleum Exporting Countries (OPEC) and allied producers, most importantly Russia, had restricted its output in the past couple of years to balance supply with demand. Collectively the group had reduced its output by 4.4m barrels per day (mbpd) since late 2016. This led to a stable oil price but resulted in OPEC+ losing market share. In fact, over the same period, the rest of the world increased output by 5.7mbpd, with US shale oil contributing the lion’s share of that increase.
In light of Covid-19’s economic impact, it was expected that OPEC+ would cut production by a further 1.5mbpd to match the fall in demand. But Russia decided against such a strategy to focus on taking market share from US shale producers, for which the marginal cost of production is higher than that for Russia or Saudi Arabia.
In reaction to Russia’s decision to not cut production further, Saudia Arabia announced that production would be lifted to more than 12mbpd from 9.7mbpd and that it would focus on gaining market share.
Period of oversupply
The above surge in production at a time of depressed demand will likely lead to the oil market being oversupplied for the next few quarters. The rebalancing process, which should lead to a loss of market share from the US oil shale industry, is likely to take longer than the transitory impact that Covid-19 is set to have on demand.
For this reason, the oil market is unlikely to rebound as quickly as other financial markets once the uncertainty stemming from the virus outbreak starts to recede.
US shale oil companies most vulnerable
With the price of Brent crude below $40 per barrel, the outlook for most oil majors is rapidly deteriorating. The sector’s attractive dividends are the main reason why many investors own oil stocks. So we would expect management teams to fiercely defend shareholder returns to support the share price.
At current oil prices, most companies will probably have to rely on disposals in order to generate sufficient cash to cover their capex requirement, dividend outflow and, in some cases, share buyback programmes. As such, we would not be surprised to see spending cuts, which would likely hurt future growth prospects, combined with a suspension of buybacks and, potentially, the reintroduction of scrip (ie payments in kind) dividends as was the case in 2016.
In the US, many shale oil and gas exploration companies also appear vulnerable. While some bellwether names may be able to use this period of stress to consolidate the industry, smaller indebted exploration companies may be forced into administration. At this stage, refiners appear best positioned as their profitability will likely be boosted from lower input costs. However, in the short term, a further slowdown in economic activity would not leave them totally immune either.
Bonus for consumers
Away from oil companies, the drop in the oil price should be a slight positive for the US consumer. While fuel represents less than 3% of personal consumption in America, oil is a key input cost in many industries including transportation and chemicals. As such, once the Covid-19 induced slowdown has passed, the deflationary impact of a significant drop in the oil price could help support a rebound in consumption.
Shock waves for credit
Yield spread premiums in the investment grade and high yield markets have widened significantly on the back of the deteriorating outlook for the global economy due to the potential impact of Covid-19. The supply risk in oil has sent additional shock waves into the credit market with energy issuers being the most affected. Within the last month, investment grade issuer spreads widened by almost 200 basis points (bps) to 350bps while spreads of the high yield counterparts widened by approximately 750bps to almost 1,500bps, the highest levels seen since the energy crisis in 2016.
A lower oil price will result in more downgrade or default risk overall. Should the price not recover quickly, then highly leveraged exploration & production (E&P) companies may run out of time to avoid a rating downgrade, or even a default for some lower rated high yield issuers. The first response is probably being felt by oil service industries, as E&P issuers will likely cut capex investments. At the same time, we believe that oil integrated issuers and refiners should be better placed to withstand a lower oil price.
While wider spreads in the high yield market have led to selective investment opportunities, increased default risk could occur in the energy sector. Meanwhile, a large part of the Baa3-rated issuers in investment grade will likely see downgrades given that asset sales in order to defend the rating may be difficult in the current environment.
Emerging market issuers
Most of the emerging market (EM) sovereign issuers are commodity exporters. As such, the spread widening towards the highs of 2016 should not come as a surprise.
Some EM countries have increased their oil reserves and have stable fiscal and trade balances, like Russia. Others, like Colombia, Argentina or some African exporters, though had seen a significant deterioration of their credit profile compared to 10 years ago even before the oil price decline.
While most of the Gulf states may rely on a relatively low break-even level, the fiscal situation is highly leveraged to the oil price and would be hit should oil price levels stay depressed. In the current volatile environment, credits like Indonesia, Brazil and Russia are likely to be more resilient.
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