STA Weekly Report – Do Oil Markets Offer Opportunity?
Written by Luke Patterson | Friday, April 24th, 2020
INSIDE THIS EDITION: Do Oil Markets Offer Opportunity? Weekly Global Asset Class Performance Coronavirus / COVID-19 Resource Center
There are currently an equal number of arguments for why an investor might be bullish as there are to be bearish in today’s market. This signals the need to take a balanced view, and not allow one or two days of negative or positive market performance cause knee-jerk reactions to de-risk or re-risk portfolios.
The truth is that the current environment remains extremely uncertain and knee-jerk reactions can take investors away from their discipline. Instead, it is far more productive to have a plan for increasing and/or decreasing exposure and then adhering to that plan. However, we must also acknowledge that economic data and markets are changing rapidly. For that reasons, we also believe that having an ability to be tactical is of increasing importance. That means having levers we can pull to position portfolios to take advantage of opportunities as they present themselves.
Along these lines, we are beginning to see investors ask whether oil markets at the current juncture present an opportunity. Frankly, we think investors that are asking this question are thinking about markets the right way – using volatility in the near term to capture opportunity in the long term in beaten down sectors. That said, we caution investors who think about opportunity in beaten-down sectors to beware trying to catch a falling knife. After all, price and value are two different things — just because a stock has dropped in price does not mean that it is cheap. It could merely mean that something has changed and made the value of that stock decline considerably. With that said, we can now explore what we are seeing in oil markets.
On the back of COVID-19, we have seen a breathtaking hit to demand. This is not surprising considering that many parts of the world have gone into lockdown as governments and health officials attempt to squash the spread of the virus. At the same time, we have seen many parts of the world increase production, virtually flooding the market with oil, which has caused an increasingly serious oversupply scenario. In fact, by some estimates, oversupply of oil may average 14 million barrels a day this year. Unsurprisingly, this imbalance has shocked oil markets and caused a ripple effect throughout the industry.
The effects have ranged from a collapse in oil prices, to a widening of contango in oil futures contracts, and a looming shortage of crude oil storage. By some estimates, US storage capacity may be 95% full by next month. In fact, it is the combination of reduced storage capacity and dramatic oversupply that we believe led the May contract of WTI to trade negative earlier this week. While it has not occurred yet, we do believe that there is a high likelihood that Brent Crude Oil contracts will be similarly affected as floating storage fills up. Unfortunately, we don’t know when the storage crunch will end as markets currently have little visibility into when oil demand will come back and begin working off the excess.
However, we do believe that the current oversupply and skyrocketing storage costs due to waning capacity are likely to keep oil markets under pressure for some time, barring something extraordinary. Exploration & Production companies are certainly feeling the pressure. Lower crude prices are poised to hurt profitability and reduce cash flows which will shrink energy sector budgets. Additionally, we would not be surprised to see dividend cuts and layoffs as companies do all they can to survive the current environment.
This is especially true for shale oil. The biggest issue is that breakeven prices are much higher than where oil trades today. As the chart below shows, shale oil breakeven prices are well above where crude is trading today and spells forced shut downs to production and potential distress in the shale patch. The Presidential administration sees the situation and has begun weighing whether to provide a lending facility for oil companies struggling in the current environment.
We don’t know that bailouts are the best antidote in this situation. As painful as it could be perhaps a hard reset might be healthier in the long term. However, we do know that with all the moving parts involved, it may be much too early to start looking for opportunities amid the distress within energy. However, we do believe the time to do so will come. In the meantime, we think investors are best served having discipline, tactical flexibility, and access to cash that can be used to invest opportunistically.
Weekly Global Asset Class Performance
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