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On 20 April, the WTI oil futures price fell below zero for the first time in history – in other words, traders were prepared to pay buyers to take oil off their hands!
A negative oil futures price is primarily due to the mechanics of the oil futures market, and the fact that May oil futures contracts were due to expire the following day. However, the fact remains that the price of oil has suffered a massive fall due to the impact of COVID-19 on global demand and the ensuing price war between OPEC+’s key players.
The sell-off we are currently experiencing is unique in that it has featured both a major supply shock (with the Saudis and Russians not agreeing to significant production cuts, and turning to flood the market), and a significant demand-led impact as countries all over the world engage in COVID-19-induced lockdowns.
Some investors may be viewing current levels as an attractive entry point. However, these circumstances are creating extreme conditions in oil futures markets, the common means of getting exposure to changes in commodity prices, where the futures curve is now very steep at the front end (i.e. contracts expiring soon trading at significantly lower prices than contracts expiring in later months) making holding these positions expensive for investors.
For investors in oil futures-based products such as the BetaShares Crude Oil Index ETF – Currency Hedged (synthetic) (ASX: OOO), it is essential to understand the concept of futures contango (or backwardation) and how this affects your returns over time. Those unfamiliar with this concept can read this Insights piece on how an exposure to oil futures differs from an exposure to the spot price of physical oil.
For investors looking to play a longer-term view on oil and the cyclical recovery, an alternative may be via the BetaShares Global Energy Companies ETF – Currency Hedged (ASX: FUEL). We believe a number of structural tailwinds could emerge for the major component companies of the index FUEL aims to track, noting the index has historically had a relatively high correlation to the price of oil, with an ~84% correlation of monthly returns with the Brent Crude Oil USD/bbl since the end of 2018.
Source: Bloomberg. Past performance is not indicative of future performance.
Question marks over the sustainability of U.S. shale
The current oil crisis has created a number of major problems for marginal producers in the U.S. shale patch, who have effectively capped the price of oil in recent years:
- The high-yield market has been the traditional driver of shale activity – and those smaller high-cost producers that have become uneconomic at these prices are now being shut off from capital.
- U.S. shale, in particular, requires continued investment to maintain production levels. Where conventional oil wells typically produce over 15 to 30 years, production from shale wells peaks within a few months of beginning and is estimated to decrease by ~75% after only one year. Meaning that in order to keep producing, shale producers need to constantly finance and drill new wells.
- With shale producers already losing money at these prices and unlikely to be able to fund themselves for much longer, there is potential for widespread bankruptcies in the shale industry.
The positives for Big Oil
The emergence of U.S. shale over the past decade has seen the energy sector suffer excessive fragmentation, and severely damaged the profitability of the oil majors – as new entrants both cut into their market share and began to put a ceiling on the oil price.
However, successful cost-cutting and a renewed focus on improving the economics of conventional deep water projects in recent years has left the energy majors with both strong balance sheets and the ability to operate at a lower oil price – with forecasts that they could withstand two years of oil prices <$40/bbl before going to the top of their historical gearing range1.
The stronger and more resilient ‘Big Oil’ companies therefore appear better-equipped to survive and thrive, with the ability to consolidate the best assets in the industry and shed the worst assets. This potentially could leave the likes of BP, Exxon Mobil and Chevron (three companies which together account for around a quarter of FUEL’s portfolio) with greater market share and with higher quality assets when we eventually emerge from this downturn.
While last week’s OPEC+ cuts may have been insufficient to offset the current glut in oil caused by the demand impact of the COVID-19 pandemic, Energy remains a sector that is critically important to any eventual recovery in global growth.
In a world where the risk of a return to the levels of production from U.S. shale producers of recent years appears to be mitigated by limited access to capital and the potential for widespread bankruptcies, global energy markets could once again be the domain of energy’s ‘supermajors’.
- FUEL provides exposure to around 50 of the largest energy companies globally ex-Australia
- The ‘supermajors’ currently account for 46% of FUEL’s portfolio, including, as at 20 April 2020:
- Chevron (9.4% weighting)
- Exxon Mobil (8.0%)
- Total (7.1%)
- BP (6.7%)
- Individual security weights are capped to 8% at each quarterly re-balance
- The fund is currency hedged – minimising the effect of currency fluctuations on portfolio performance
1. Source: Goldman Sachs.