When and how the Oil and Gas market will be in equilibrium once again is yet uncertain, but there is no reason to doubt the industry´s resilience

COVID-19 impact in the global economy may not be as severe as anticipated. When the COVID-19 pandemic is controlled and we reach “COVID ground zero” for the economic turnaround that will be needed, it is not yet clear all that will have to be done.  However, there are clear signals from the market that probably the “COVID ground zero” is more likely to be a 2-3 years recession rather than a global economic meltdown.  Second quarter YoY GDP numbers have been very poor, especially in Europe.  The hit on tourism and the more stringent social isolation measures adopted in Europe are among the main reason behind these numbers, which means that the recovery might not take very long.  One should not be surprised if by 4Q 2020 positive YoY GDP numbers start to appear – we are already seeing it happening in the Far East (China, South Korea).

The biggest threat to economic recovery is the massive public debt that countries had to “accept” to fight COVID-19.  There is more than one answer on how to fix that, but like the 1980s, if the “world’s” liquidity is drained by developed countries, very volatile foreign exchange rates, inflation and increasing trade wars can be expected, alongside financial salvage for some important countries in the global economy landscape.

And finally, in the last month, some analyses are pointing to a potential bubble in the capital markets that might not take long to burst.  S&P, DJI, and NASDAQ are all at their 5-yr high, and even Warren Buffet has mentioned that the market is likely to be overvalued.  There are two or three possible interpretations of the facts, but the markets may actually be right, well priced, and there should be no reason for panic when one thinks about economic recovery.

Oil and Gas markets resilience should never be doubted.  There have been countless political and economic crises in the last 50 years, and the industry has always found a way to move forward.

After the unprecedent event of negative oil prices in April 2020, the crude oil price curve has been ascending.  Volatility is still very high, and it will continue for some time.  Interestingly, fear of a second wave of COVID-19 and news about COVID-19 vaccines seem to be the variables that are currently mostly affecting oil prices and its volatility.  But the recovery of demand in some countries like China and Brazil, an “acceptable” level of bankruptcies in USD outstanding debt terms, M&A transactions like the recent acquisition of Noble by Chevron, and the fact that exploratory efforts (e.g East Mediterranean, with major success for natural gas) and project sanctions (more than 1 MM bpd of FPSOs processing capacity were sanctioned in Brazil and Guyana alone) have continued.  It all leads us to believe that the “COVID ground zero” for the Oil and gas market recovery will also not be as bad as once expected.

Recently Goldman Sachs has stated that there is a good possibility that crude prices reach USD 65 / bbl in 2H next year, against their former projection of USD 60 / bbl.  But even it is not market consensus: a USD 60 / bbl is enough for the industry to regain traction both by unlocking value from their projects (NPV) and by generating enough free cash flow to keep sanctioning new projects.  No blue sky scenario should be expected, but those tornados we feared 3 months ago seem to have vanished.

There are two ways to look at the behavior of two of the main indexes in US equities market:  either the market believes that economy will quickly resume to “business as usual.” – or a bubble is coming given the excess liquidity in the US economy and the negative yields in more conservative investments, let alone the risk aversion to investing in real assets.

5-year S&P 500

(Credit: Yahoo Finance)

5-year DJI

(Credit: Yahoo Finance)

When it was clear that COVID-19 could really hurt the economy, both S&P and DJI melted down and capital markets lost 30% of its value very quickly.  The rebound of these indexes came either because equities have become very cheap according to each companies’ fundamentals, or the expectations about COVID-19’s potential damage changed… or both.

Legendary investor Warren Buffet always mentions that his favorite market ratio for evidence that the market is overvalued is the S&P 500 to GDP ratio.  The chart below brings us back to the same picture of before – the market seems to be overvalued.

S&P 500 vs US GDP

(Credit: LinkedIn)

How monetary policies will play out, and their effect on interest rates and real returns, is a key question to how much liquidity is required to support the global economic turnaround.  The US Government has issued more currency in the last months than in several decades.  Major bonds markets today are yielding negative returns.  Relative prices of currencies will also be a very relevant economic indicator to follow, especially because prices can be very volatile depending on demand recovery and trade movements. The risk of “trade wars” as a result of lack of coordination for a smoother global economic turnaround should not be neglected.

The economic activity especially in 2Q 2020 was quite hurt given all the measures that were taken to try to minimize the effects of the COVID-19 on public health.  The scenario is still uncertain, but like in any other crisis, defending the purchasing power of the population is the main lever for economic turnaround.  Actions are being taken by many countries to minimize economic damage.  Expansive monetary policies are being adopted to defend purchasing power and supply capacity of goods and services, with policies that go from direct income transfer to families, to governments increasing credit mainly from state banks for companies to sustain their activities and to avoid bankruptcies and huge unemployment.

GDP growth YoY 2H 2020

(Credit: LinkedIn)

It is a point of concern that as of now the fiscal deficits are already very significant on a global perspective, above 100% of global GDP.  Monetary expansion has already started, and there are uncertainties about (lack of) liquidity to finance public debt given capital markets risk aversion, potential inflationary pressures, unemployment, and future tax increases.  A certain imbalance among developed countries and other countries is to be expected – there will be no “one size fits all” solution, and the “economic pain” will be heterogeneous among regions.

Global fiscal deficit as % of GDP

(Credit: LinkedIn)

In general, commodities have been through challenging times in the last 10 years, yields have been quite low, and we can say that it seems the cycle now is at its bottom – for how long, it’s unclear.  Analyzing the O&G sector, over the last five years prices have been in the USD 55-60/bbl range, mostly given the creation of OPEC+, and the general state of global economic growth.  And since the end of 2019, geopolitical events (USA vs Iran, Saudi Arabia vs Russia) and the actual effects of COVID-19 pandemic have been putting a lot of pressure on the O&G market, especially through lower prices and higher volatility.

Brent price trajectory Dec-19 – Aug19

(Credit: Rystad Energy)

It is very clear that in the early stages of the COVID-19 pandemic, Brent price melted down.  But after the episode of negative prices of WTI in April 2020, oil prices, even with high volatility, have been increasing to the level of USD 40-45 / bbl.  Primarily, two drivers are causing volatility for recent oil prices: concerns of a second COVID-19 wave, and information about development of potential vaccines to finally control the epidemic.  The market understands that these two variables are the most important in terms of expectations for demand recovery, so one can say that oil prices tend to go up and have smaller volatility as good news related to these two variables are available.

Most market agents are forecasting a new equilibrium price of USD 55-60 / bbl, probably in 2022.  But Goldman Sachs for example has just raised their expectation for Brent price in 2H 2021 to USD 65 / bbl from USD 60 / bbl.  Indeed, there are signs of demand recovery in the Far East, and some other countries.  But one thing is certain: the idea that market will recovery only in 2025 has no echo today.

One thing about the O&G industry is that it cannot be taken for granted:  it is one of the most resilient industries in the world.

In the last 50 years, crude oil consumption only dropped 9 times YoY, 5 of them on the 1st half of the 1980s right after the 2^nd price shock in 1979/80.  At that time, after the countershock, it took 3 years for demand to exceed 1979 levels.  And since then, only in 2008/09 with the subprime crisis, did demand decrease by 1 MM bpd (-1.3% YoY)

This resilience can also be perceived from the crude oil price side.

Crude oil real 2019 prices since 1965

(Data Source: BP Statistical Bulletin 2020)

We consider the price range of USD 50-80 / bbl as the “comfort zone” for the industry.  Even though real 2019 prices have stayed between 50 and 80 in 30% of the years over the last 50 years, and one can say that prices have been below USD 50 / bbl for almost 20 years, the chart below shows that even in this low price environment, oil production has grown very strongly at an average rate of 4.3% p.y in the period.

Crude Oil Production

(Data Source: BP Statistical Bulletin 2020)

It is interesting to mention that OPEC production has grown 5.7% p.y. in this period, and the non-OPEC production has grown 3.7% p.y.,.

The fundamentals of the oil industry are based mainly in two things: (i) lack of arbitrage opportunities in the crude oil market (ii) oil products crack spreads close to historical level and (iii) how the margins are “divided” between operators and the supply chain.

The first two points above define the equilibrium of the supply and demand:  every time relative prices are in line, and there are no “external forces” like huge productions cuts or increases by OPEC, there is no price arbitrage.  Margins tend to revert to historical levels, and the market can be considered in equilibrium.

Especially in the upstream segment, if prices escalate then operators try to increase production as fast as they can to capture this price movement, which is likely to cause very fast cost inflation in the supply chain side, meaning that a larger portion of the higher margins stay within the supply chain.  When it becomes indifferent for operators to increase production because of the “margin split” production starts to fall.  The more rigid the supply chain cost are, the longer it will take to reach equilibrium again..

For the two reasons above, one should not believe in long-duration price rallies unless external issues, e.g. geopolitical events remove a big portion of the production volume from the market.

In the end, the level of prices is mostly important for companies that need to generate high free cash flow to balance its financial situation or to have funds to sanction new projects.  One additional reason why it makes sense to believe in a comfort zone for oil prices between USD 50-80 / bbl is the fact that the marginal production growth will come from production frontiers like Brazilian pre salt where Capex for new projects are much higher than 15 years ago, even though returns on capital are also very “interesting” at this price range.

The COVID-19 pandemic is a humanitarian tragedy never to be forgotten – almost 1MM lives have been lost in less than 1 year.

In March / April 2020, there was a situation of panic in the world with expectations that the pandemic effects over the global economy would be catastrophic, leading the world to a great depression.  Today, there are signs from both the financial and the real side of the economy that this expectation will not materialize.  A second wave of COVID-19 could create a much worse economic outlook, but there is no reason to believe that the world will face a recession that will last for a long time.  There shall be difficulties in recovering the general level of consumption given short term inevitable unemployment and lack of capacity from governments to increase public debt to come up with policies based on public investment.  But the “COVID-19 economic crisis” cannot be compared to the 1980s crises (crude oil price shocks) and 2008/09 (subprime crisis).

The past shows us that the oil and gas industry is very resilient.  Even though it´s still unclear how long it will take for demand to recover, and what will be the price of the new market equilibrium, it makes sense to believe that equilibrium should not take more than 2 years to resume, and that a USD 50-80 / bbl crude price is a comfortable zone for the oil and gas industry, a price range than can contain the natural volatility of supply-demand dynamics, and to a certain extent, also contain price movements related to geopolitical events and OPEC+ movements.

In times of crises, companies have to focus mainly on 3 things:

• defend its liquidity by protecting free cash flow generation and even finding other ways (e.g. long term low cost debt) to do it
• look for opportunities to benefit from market fragility and strengthen its asset base (e.g acquisition of companies under financial distress where there is business fit)
• build readiness to “hit the ground running” when “COVID ground zero” moment for business recovery arrives, so the company is ready to take a leadership position among its competitors.