ClearBridge Investments, a Legg Mason affiliate
By Dimitry Dayen, CFA, Senior Analyst Energy & Jeffrey Schulze, CFA, Investment Strategist
Key Takeaways
- The outbreak of an oil price war between Saudi Arabia and Russia has caused crude oil prices to plunge at a time when the coronavirus has severely curtailed global demand, causing a worldwide supply glut.
- In a worst-case scenario, OPEC and Libyan production increases and demand takes time to recover, inventories hit recent highs and lead to sharp production cuts by U.S. shale producers. Best case has the coronavirus impacts fading, causing global demand to recover in the second half of the year.
- The latest oil shock has sparked further selloffs in equities and, combined with virus-induced headwinds to consumer and business confidence, has raised the likelihood of a recession.
Production Likely to Increase as Global Demand Weakens
In a flashback to the 2014 Thanksgiving massacre, the OPEC+ deal to further cut crude oil production was blocked last week by Russia, which refused to cut its own production significantly under an ultimatum from Saudi Arabia. Saudi Aramco initiated a price war by pushing through price cuts on its own oil exports and crude oil plunged following the news. Global equities opened the week sharply lower as a result.
The OPEC+ price war is one of the three worst possible shocks for markets engulfed by the COVID-19 crisis. The other two would be a hypothetical lockdown of parts of the U.S. economy and a second wave of infections in China. This regime change has accelerated the convergence of central bank rate expectations and brought long-end bond yields toward zero. We believe the March Fed meeting will bring an additional 50 basis point cut as the economic situation continues to deteriorate.
The Saudi proposal was for an OPEC cut of 1 million barrels per day (BPD) and OPEC+ (mainly Russia) to cut 500,000 BPD. Our understanding from the site of the OPEC+ meeting in Vienna is that Russia wants U.S. exploration & production (E&P) companies to feel the pain rather than be protected by OPEC+ and is hoping that OPEC will shoulder more of the cut by itself (as has been the case the last four years). Saudi Arabia has now signaled its intention to sharply ramp up production starting in April in order to battle Russia for market share. The OPEC+ alliance is on hiatus for the time being.
With demand down drastically, OPEC+ unwilling to support the market, and the fate of Libya’s production uncertain, inventories could build to 2016 highs or higher. Recall that crude oil dropped into the low $30s back then and has fallen to similar levels in futures trading since the meeting. The market will have to balance through a short cycle reduction in production, specifically from U.S. E&P companies reducing drilling and hopefully through demand coming back eventually as the coronavirus fades. In 2014–2016, it took roughly six quarters for the market to bottom through a combination of U.S. supply declines and OPEC stepping back in. The market got to $30 per barrel (bbl) much faster this time, which calls for a quicker rebalancing. We model potential outcomes and impact on inventories below.
Coming into the year, Chinese demand growth was expected to represent up to 60% of global demand growth. First-quarter Chinese demand is now expected to be down significantly, sending overall global demand down 2.4 million BPD year-over-year — the first time demand has fallen since 2009. The International Energy Agency (IEA) has lowered its base case global demand forecast to a 0.1 million BPD decline. However, the forecast assumes an improvement in demand starting in the second quarter. While new cases of the coronavirus are slowing down in China, life on the mainland (transportation, electricity demand) is not getting back to normal. In addition, the global spread of the virus could further impact demand in regions such as Europe.
Exhibit 1: Global Crude Oil Demand Growth
As of March 9, 2020. Source: ClearBridge Investments and IEA.
There are no winners in the Russia/Saudi fight. Given how fragile crude fundamentals have suddenly become (and could still worsen) and high levels of uncertainty due to the trifecta of tough to forecast factors (coronavirus, Libya, OPEC+), we are maintaining a higher quality, more defensive posture in our energy exposure. With U.S. production growth potentially coming to an end, relative preferences are skewed to E&P stocks with strong balance sheets and free cash flow generation. Crude is well below marginal cost, which is typically the time to buy. However, it can stay there much longer than we anticipate and cause a bleed in the stocks as highly levered credits get in trouble. On the other hand, we can have the coronavirus fade and demand snap back harder than imagined because of elasticity just as Russia/Saudi cut out the fighting.
Bigger picture, this latest punch to the global economy has caused the odds of a U.S. recession to rise materially as it adds to the following headwinds:
- A drop in shale production. In 2016, the rig count troughed 50% below current levels suggesting a pronounced decline in activity. While energy accounts for just 3% of the S&P 500 Index, it generates 8% of revenue.
- The Boeing shutdown.
- Payback for pulling forward demand from a warmer winter.
- A coronavirus-induced drop in consumer and business confidence resulting in lower spending.
- Corporate profit margins already under pressure due to the tight labor market and tariff-related issues.
- The ClearBridge Recession Risk Dashboard remains firmly in “yellow” territory and we believe the bias for equity markets will be lower until the virus’s path and the efficacy of the U.S. reaction are determined.
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
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