Q1 2020: COVID-19 steepens oil's slippery slope

It has been a rocky few months for the oil industry so far in 2020, with the Saudi Arabia-Russia price war squeezing prices and the restrictions imposed to fight COVID-19 driving down demand to levels not seen before. This seemingly created the perfect storm to push the price of the West Texas Intermediate (WTI), the main benchmark for US oil, to below zero for the first time ever in April. With fleets of aeroplanes grounded, fewer cars on the roads and other forms of transport operating at a significantly reduced capacity, supply is outpacing demand. An expert interviewed by Third Bridge Forum predicted there will be an excess supply of eight million barrels of oil a day in Q2 2020, or three million barrels a day in 2020. 

“Because the demand is dropping so dramatically, rather than considering stockpiling fuel or releasing strategic reserves at this point, what’s happening is that countries’ reserves are actually increasing naturally,” another specialist said. “The issue right now is quite counter-intuitive, what’s actually happening is that the oil storage capacity of a lot of countries is reaching the point where they won’t be able to store oil for much longer.” Indeed some countries, such as Saudi Arabia, are storing oil at sea to the tune of around USD 200,000 a day.

But there are seemingly opportunities to be had from this storage dilemma within the oil markets. As highlighted in another Interview at end-March, a significant macro driver for crude oil storage is when the industry is in contango. While this usually rises in response to an inventory build up, “this time the speculation really drove the dynamic on the contango”, according to the specialist. That would also indicate that this is a temporary phenomenon rather than a permanent paradigm shift, he noted. As the contango is also a big factor behind what people are willing to pay for storage, prices have surged in recent months. An expert in this business said the number of deals his company typically closes has risen from two to six or seven a day — 10 during the busiest peaks. Now, people are trying to find those “nooks and crannies”, he added. 

Interviews also revealed that the oil markets terminal space has been an attractive private equity investment over the last couple of years “because Wall Street really wasn’t rewarding the valuations for the EBITDA that these companies had”. The “secret sauce” is building more tanks in terminals with extra capacity, as they don’t make more money YoY simply by increasing the price of storage. While the price companies can get is cyclical, depending on whether the industry is in a period of contango or backwardation, building more tanks is the ultimate goal. “If you had 10 tanks and you build another tank of the same size, you’ve increased your revenue capacity by 10%,” the expert said. He added: “If I were an investor and looking at these midstream companies whose prices really took a haircut, commiserating with what happened in the energy space, I would look at companies that were more weighted on the terminal side vs the pipeline side.” Companies that have derived their revenue from terminals are “going to be doing actually very well in this environment” — provided that customers can pay the bills.

Countries are generally continuing to import oil despite having less immediate need for it because the commodity is “simply too valuable to just say no”. However, if something cataclysmic happened to the shipping industry, or demand dropped even lower and a contango and backwardation period continues, at that point strategic reserves would need to be released. Indeed, concerns regarding the risks associated with transportation are growing, resulting in more stringent measures when offloading cargo. Interviews point to more rigorous health checks going forward, with Venezuela’s INEA maritime authority having already prohibited crews from disembarking all docked ships. “That’s all in the light of COVID-19, so it’s happening already,” an expert noted. Seaborne transport is “extraordinarily important” to the oil and liquid natural gas supply chain; without an alternative source, such as pipeline capacity, “you’re in a lot of trouble”. 

Like other industries, the maritime industry is reacting to the rapidly evolving challenges of COVID-19 in real time, making the best decisions it can based on information available at the time when looking at contango and backwardation potential. While this will spur the kind of decisive action required in such an emergency, a specialist warned that unexpected measures could be enforced with knock-on effects across the supply chain. For example, Australia’s Maritime Safety Queensland recently blanket-imposed a 14-day quarantine for all ships docking. “I think people will be playing it very, very safe. As for actually barring the cargo, I don’t think we’ve reached that point yet, I really don’t,” he said. “It’s too valuable.”

These are just some examples of how COVID-19 is impacting the oil industry. Given oil has become the world’s most important source of energy, what happens in the oil markets has significant impacts further afield. The pandemic could also set the industry back in its effort to help lay the foundations for a greener and more sustainable world. The IEA estimates that global CAPEX by exploration and production companies will drop by about 32% in 2020, in turn hampering the development of technologies needed for clean energy transitions.¹https://www.iea.org/reports/oil-market-report-april-2020

Ultimately, the outlook for oil markets will depend on how successful efforts are to limit the impact of COVID-19, as well as how these measures and the health crisis affect the economy. Although there should be a “huge recovery in demand when this is all over”, particularly with fiscal and monetary stimulus, the long-term impact on people’s mindsets and behaviour, including how and when they choose to travel, for example, is much less predictable. What happens in China is also significant as the country — which accounted for over 80% of global oil demand growth in 2019²https://www.iea.org/reports/oil-market-report-march-2020 — ramps up again.