Cover Story: Crude oil slips from bad to worse

This article first appeared in The Edge Malaysia Weekly, on April 27, 2020 - May 03, 2020.

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LAST Monday was as perplexing as it was historic for those in the oil and gas sector as well as market watchers. To recap, West Texas Intermediate (WTI, one of the three benchmarks for oil pricing) for May delivery on the New York Mercantile Exchange settled at a negative price of -US$37.63 per barrel, ahead of its expiry. This is the first time it has ventured into negative territory. In a nutshell, it means that anyone trying to sell a barrel of oil would have to pay a buyer US$37.63 to take it, which is incomprehensible.

Credit Suisse, in a report, explains, “The negative WTI prices on Tuesday were more of a technical issue, driven by May futures expiry plus lack of storage capacity in the US.

“US Cushing (a refining town in Payne county in the US state of Oklahoma) crude inventories were up 40% in the past three weeks, and at current rates, it will hit a maximum capacity of 77 million barrels by May. Speculators did not want to take physical delivery at settlement with nowhere to store, hence, dumping it at all costs, which resulted in negative prices.”

Some, such as the founder and executive chairman of Continental Resources Inc, Harold Hamm, think there is something sinister at play and are pressing for market regulators to probe the “potential market manipulation” behind the crash.

It is not clear if the views of Hamm, who is a known associate of US president Donald Trump, will have any effect on the perception of the authorities.


Interesting points

On whether this historic fall into negative territory could happen again for WTI, Macquarie says, “Our view is yes and no”.

“The ‘no’ component is that even with full storage, a reoccurrence of a large negative price is unlikely,” the research house states. It adds that in its experience, in the ensuing months after a financial squeeze of any kind, market participants go out of their way to avoid the situation again.

On the other hand, “The ‘yes’ component is that oil storage capacity is still filling and by the end of next month (May), Cushing storage could be full,” Macquarie continues. It adds that if this occurs, it will once again create the ingredients for futures prices that approach zero along with wide contango, where spot prices fall way below futures.

Howie Lee of OCBC Treasury Research, in a report on a reoccurrence, comments, “I will not bet against it. The lack of storage/expensive storage is unlikely to be resolved unless demand improves or the US cuts its output. The timeline for the US reopening its economy remains an enigma, although a conservative bet would be from July onwards.”

JP Morgan, meanwhile, says the negative territory the WTI fell into marks yet another extraordinary chapter in the history of financial markets, and notes that there has never been a negative price for oil in its 150 years of data.

“This is stunning as it basically says that a barrel of oil earlier this week was effectively cheaper than it was in 1870,” it says in a report.

The Organization of the Petroleum Exporting Countries (Opec) in its monthly oil market report released in mid-April — before the WTI slumped into negative territory — says the term structure of all crude benchmarks moved to super contango in March. This was brought about by massive oil demand destruction, significant refinery cuts and rising global oil supply, which created a large surplus in the oil market.

Opec says the market surplus is expected to reach around 15 million barrels per day in 2Q2020, pushing prompt prices to decline much more compared with longer-dated contracts.

Opec, made up of 13 oil-producing nations, including the de facto leader Saudi Arabia, accounts for as much as 45% of global oil production and controls more than 80% of proven reserves. Meanwhile Opec+, formerly the Vienna Group, comprises 23 members. Apart from the Opec members, it includes Russia, Kazakhstan, Mexico, Oman and Malaysia, and accounts for 55% of global production and 90% of proven reserves.

Opec+ reduced oil production from January 2017 to combat a global crude oil glut that knocked prices down from over US$146 per barrel in July 2008 to under $28 in January 2016.

Its management of oil prices ended in March 2020, and earlier this month, the loose alliance outlined a deal to slash production by 9.7 million barrels a day in May and June, or 10% of daily global oil production. From July to December, Opec+ is looking at slashing eight million barrels per day, and for 16 months from January 2021 to April 2022, by six million barrels per day.

This agreement has taken some time to iron out, with the Russians and Saudi Arabians at loggerheads on how much to cut. The US is also set to join Opec+ in cutting oil production.

While the US oil benchmark WTI was in negative territory, Brent Crude, the yardstick outside the US, was seemingly normal, declining by about 5%.

Last Friday, Brent Crude was slightly above US$22, while WTI was at US$17.44.


Opec’s April report

Opec, in its report, says after growing 2.9% in 2019, the global economy is forecast to face a severe recession in 2020, declining by 1.5%, largely brought about by the Covid-19 pandemic.

About 80% of the global economy has been affected, meaning there is very limited economic activity, with recovery only expected in the second half of 3Q2020. By 4Q2020, it is assumed that global activity would be almost normalised.

The report states, “The oil market is currently undergoing a historic shock that is abrupt, extreme and [on a] global scale. The typical seasonal low for refiners, at the end of the first quarter of each year, is being exacerbated by unprecedented destruction in oil demand due to the global spread of Covid-19.”

Opec says oil demand in 2Q2020 has been revised downward by almost 12 million barrels per day year on year, with 60% of the loss coming from transport fuels, primarily gasoline and jet fuel.

The virus containment measures mandated and implemented by various governments, which include far-reaching lockdowns, travel restrictions and social distancing, have impacted over 40% of the world’s population. That, in turn, has led to a slowdown in fuel consumption amid product inventory builds, severely damaging the jet fuel market and driving gasoline margins into negative territory.

“The severity of the collapse is likely to result in a sharper contraction in oil demand, particularly during 2Q2020, extending into 3Q2020 and 4Q2020,” Opec say. It sees a contraction of 12 million barrels per day in 2Q2020, six million barrels per day in 3Q2020 and 3.5 million barrels per day in 4Q2020.

World oil demand in 2019 is estimated to have increased by 0.83 million barrels per day year on year to average at 99.67 million barrels per day. Total global oil demand for 2020 is now assumed at 92.82 million barrels per day, with higher consumption expected in 2H2020.

For 2020, world oil demand growth has been revised downwards by 6.9 million barrels per day from earlier estimates — a historic decline (see table).

The Opec Reference Basket value averaged sharply lower in March, falling for the third consecutive month amid deteriorating oil market fundamentals. In March, it dropped by US$21.61, or 38.9%, month on month to US$33.92 per barrel, which is the largest monthly drop since October 2008 and the lowest monthly value since September 2003.

Opec says, “An unprecedented global oil demand shock and a massive sell-off in global oil markets pushed crude oil futures prices to more than 18-year lows in late March, while economic stimulus plans from governments and central banks, as well as some recovery in equity markets, failed to calm investor worries and to limit the oil price decline.”

The decline in global oil demand is expected to continue over 1H2020, while the extent of the demand destruction remains uncertain, particularly in 2Q2020. Projections of the decline by different sources range from eight million barrels to 15 million barrels per day, compared with the same period in 2019.


When will things pick up?

Based on the Opec Secretariat’s estimates, global stimulus measures in the form of fiscal and monetary stimulus, including guarantees, now amount to more than US$15 trillion, or about 17% of global GDP.

In its report, Opec writes that 2020 is forecast to post much lower oil demand, with downside bias, should conditions worsen during the remainder of the year.

However, oil demand is expected to show a rebound in 2021.

What remains unclear is how the sudden surge in teleworking, distance learning and online shopping that came about because of the Covid-19 containment measures will affect oil demand in the future.

To put things into perspective, oil prices cannot really recover until demand normalises. Credit Suisse sees Brent Crude in 2020 averaging at US$35.50 per barrel, with a low of US$23 per barrel in 2Q. In 2021, the research house forecasts Brent Crude at US$45 per barrel, or a gain of about 27%. In 2022, Brent Crude is expected to gain one third, compared with 2021 levels, to US$60.

Public Invest, meanwhile, has oil prices averaging between US$36 and US$39 per barrel in 2020.

Maybank Investment Bank Research writes in a report, “Recovery in demand remains paramount, which could happen from as early as 2H2020. That said, the sector would see a knee-jerk reaction to this unprecedented event.

“This swing in volatility is an opportunity to trade/pick up oversold, fundamentally strong, financially resilient stocks,” says Maybank oil and gas analyst T J Liaw.

Maybank’s key buys are Dialog Group Bhd and Yinson Holdings Bhd.

Hong Leong Investment Bank, meanwhile, is neutral on the oil and gas sector and has “buy” calls on Dialog and MISC Bhd.


The home front

Petroliam Nasional Bhd (Petronas) has not made any significant announcement of its plans since the outbreak of Covid-19.

The national oil company provides more than 15% of the government’s revenue, and may be called on to assist, irrespective of low oil prices. Apart from that, Petronas also helps to sustain local companies in the oil and gas sector by giving out contracts to them.

Malaysia, as part of Opec+, is cutting oil production by 136,000 barrels per day in May and June, but has not revealed the figures for other periods. This is a substantial reduction, seeing as previous cuts were only between 15,000 and 20,000 barrels.

Considering that Petronas’ daily production is about 700,000 barrels per day, the impact remains to be seen. It is cash-rich and has a strong balance sheet. As at end-December last year, it had current assets of RM206.46 billion, of which RM141.62 billion were cash and cash equivalents. It had long-term debt commitments of RM53.42 billion and short-term borrowings of RM15.32 billion. As at end-2019, Petronas had reserves of RM389 billion.

Its annual capex, meanwhile, is pegged at RM45 billion to RM50 billion per annum.

In 2016 and 2017, Petronas paid RM16 billion each year, and in 2018, RM24 billion, to the Malaysian government, its sole shareholder. In 2019, it paid out RM54 billion, including a RM30 billion special dividend. This year thus far, it has said that the dividend payment will be RM24 billion.

Petronas’ ability to pay dividends is linked to its earnings, which in turn hinges on oil prices, which are currently volatile because of the sketchy demand and supply dynamics brought about by the pandemic.

In 2016, when Brent Crude averaged about US$44 a barrel, Petronas registered an after-tax profit of RM23.51 billion from RM204.91 billion in sales. But in 2016, the ringgit averaged 4.15 to the greenback, compared with 4.36 currently.

Last year, with Brent Crude averaging US$64 per barrel, Petronas raked in an after-tax profit of RM40.47 billion on the back of RM240.26 billion in sales.


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