Aside from its immediate, stunning impact on the financial markets, the recent 25% drop in crude oil prices may have longer-term implications.
Following not only OPEC+’s failure to cut production at the OPEC meeting last week, but rather an apparent increase of production from key suppliers, we expect crude oil to remain under $40 per barrel (bbl) for some time, with risks to fall materially lower should the production increases endure for multiple quarters. This will have repercussions for many industries, notably U.S. shale oil, and for consumers around the world.
What is happening?
In a unique confluence, oil markets have just been hit with both a supply surge and a demand shock.
The spread of COVID-19, which is disrupting and putting at risk human lives in many nations, is expected to slow global growth and thus demand for oil – our forecast currently calls for a near-term drop of about 2 million bbl per day for the first half of 2020. Faced with this looming decline, Saudi Arabia reduced its official selling prices for April by $6-$8 per bbl, its largest known one-month cut, essentially signaling the beginning of a market share acquisition effort with other producers. The move was seen as a reaction to Russia’s decision a few days earlier to not cut oil production in line with OPEC and its non-OPEC partners – despite consensus among the other members.
Oil prices plunged more than 30% initially on news of the Saudi price cut. Brent fell to under $34 per bbl and U.S. crude oil to less than $28 – their lowest levels since 2016. The fall in oil prices, in turn, was a big factor in the global equity sell-off on 9 March. With investors already on edge due to the spread of the coronavirus, the S&P 500 plummeted more than 7% while bond yields set new record lows.
The oil market’s reaction was dramatic but not unwarranted, in our view. Saudi Arabia has never before intentionally increased output into a negative demand shock. As the oil surplus builds, we expect U.S. crude oil to linger at $30-$40 per bbl for the next several months. Even a decision to reverse the current production plan is unlikely to lead prices back to previous levels due to spreading demand degradation, and the inventories will provide a buffer that will need to be whittled away.
Investment implications: far-reaching
Lower oil prices can be expected to have far-reaching effects.
- U.S. domestic supply is expected to contract, with shale activity severely curtailed in late 2020 and 2021. While the U.S. is unlikely to be first to shut current producing wells, the imminent decline in capex by U.S. producers will eventually lead to a decline in U.S. oil production for the first time in four years. Unlike 2016, however, capital is not eagerly waiting on the sidelines today. Lower production would clearly hit regions in the U.S. that are highly dependent on energy investment and jobs, and we expect more energy-related defaults and bankruptcies this year among weak high yield exploration and production, midstream, and oil services companies – possibly more than in late 2015 and 2016, given the lack of financing options and the large volume of debt maturing in the next few years.
- Oil producing countries are likely to turn inward, drawing on sovereign wealth funds to sustain spending where possible. For investors, it will become key to differentiate between countries that have the political capacity to adjust to lower oil revenues and those that may not. Commodity importers stand to benefit, though the extent is dependent on the pace of global economic recovery.
- The transition away from oil to alternative energy sources could become more prolonged. On a high level, cheaper hydrocarbons reduce incentives to switch energy sources. Electric vehicles become relatively more expensive when oil prices drop. Outside of policy mandates, the decline in energy prices should give more room for policymakers to pursue a carbon tax. However, political will has generally been lacking for this idea despite some pockets of progress. Bottom line: Lower oil prices create a challenge for those concerned about climate change.
- There are winners beyond consumers. Clearly, consumers stand to benefit most from lower oil prices, a timely reprieve as economies slow due to the impact of the coronavirus. Other likely winners from lower oil prices: refiners who will at least not face prospects for tightening crude oil inputs, trade houses and oil storage facilities that benefit from price discounts, petroleum freight companies that enjoy the benefits of higher Middle Eastern shipments and need for floating storage, and eventually U.S. natural gas prices, as supply drops alongside oil production.
What to watch from here?
The most important thing to watch will be how long the supply surge lasts. There will be an oil market monitoring committee in a few weeks that may facilitate dialogue. In addition, Russian Energy Minister Alexander Novak will be meeting with Russian oil companies later this week regarding investment and production plans. With few winners in this price collapse, maybe a change in plans can be negotiated, although we put this as a low probability event.
Outside of these geopolitical actors, the market will be closely monitoring further developments in COVID-19’s impact on demand as well as the upcoming inventory builds, which should be steep. While this outlook is challenging for those long energy beta, it was only five months ago that the market was worried about running out of spare capacity following the attacks on Saudi Arabia. Over the next few years, OPEC production increases will offset declines in U.S. production, and spare capacity remaining to address imbalances will be greatly depleted.
For more on PIMCO’s outlook for markets and how investors can prepare for volatility, please see our “Investing in Uncertain Markets” page.
Greg Sharenow is a portfolio manager focusing on commodities and real assets and is a regular contributor to the PIMCO Blog.