Making Sense of the Energy Market
March 13, 2020
Amid steep equity and credit market volatility, oil fell sharply on Monday, March 9, adding to broad market uncertainty. COVID-19 dampened energy demand and contributed to lower prices before the Monday correction, but making sense of the current energy market requires a look at the dramatic shift in the supply dynamic that happened this past week.
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The proximate cause of the steep fall in global crude oil prices is the relationship between Saudi Arabia and Russia. On Friday, March 5, Russia unexpectedly walked away from a deal with OPEC to cut production and buoy prices amid declining global oil demand. The following day Saudi Arabia responded by undercutting global benchmark pricing in addition to announcing a ramp to maximum production at the beginning of April. The result was the spot price of Brent Crude falling to $34 and spot WTI to $31 on Sunday evening (when Asian Markets opened).
Looking at producers’ differing profitability break-even points provides important context. Russia has stated the national breakeven is about $40 per barrel after accounting for production costs and government budget requirements. In the US, break-even prices vary by geography but are in the mid-$40s on average. (We know that certain US producers are hedged for some time and are somewhat insulated from the price war in the near-term, but for the longer term, we can assume US producers need WTI in the $40s to cover the cost of development and production.) Naturally, global break-evens vary widely, but Saudi Arabia has the lowest cost of production at less than $10 dollars per barrel. Because the Saudi government is reliant on energy revenues, however, the Saudi royal family needs Brent prices near $80 to balance the budget.
However, looking out beyond the next few quarters, a natural corrective function should be at play. First, the backlog of major developments that we had four or five years ago (the last time oil crashed) has diminished significantly. These projects take 5 to 10 years from discovery to production and can’t be turned on and off quickly. Given where prices had been even before the recent drop, there isn’t and hasn’t been much of an appetite to undertake those kinds of investments. Production should be pressured lower over the long term.
Further, shale is a much bigger part of global oil supply than it has been in years past. Production from unconventional wells (i.e., “fracked” wells) declines at a faster rate than conventional wells. For example, an offshore well might decline 5% each year, at a more-or-less linear pace. Shale well production volumes decline on the order of 30%-40% each year. When producers stop drilling new wells, which we see evidence of since Monday, the supply of oil from shale can dry up rapidly.
Taking these factors together and given the sharp production increase from Saudi Arabia and Russia further disincentivizing investment in future production, the corrective mechanism we’ve previously seen in the market could potentially accelerate. Said differently, sharp volatility in one direction is often followed by sharp volatility in the other.
We are not political analysts, but there is no escaping the explicitly political factors driving the energy markets. Russia, Saudi Arabia and certain other OPEC nations can undercut other global producers for a time, but eventually we must ask when budgets get too tight, what kind of borrowing is required (or possible) and what kind of foreign currency reserves are available to cover current expenses. We shouldn’t forget that Saudi Arabia went into last weekend hoping to cut production—this was not their optimal outcome. They know a price war of this magnitude isn’t in their short-run economic interests.
On the demand side, we think travel will eventually recover from currently depressed levels—how much and how quickly is certainly an open question. The drop was abrupt and contingent on the COVID-19 pandemic, not on the factors that normally predict travel demand such as growth of the overall economy or the cost of travel. We think historical analogies to this downturn should be employed carefully given the unusual nature of this situation.
In the meantime, we will be paying close attention the OPEC+ negotiations as they have proven most any outcome is possible.
This material is for informational purposes and is prepared by Diamond Hill Capital Management. The opinions expressed are as of the date of publication and are subject to change. These opinions are not intended to be a forecast of future events, the guarantee of future results or investment advice. Reliance upon this information is in the sole discretion of the reader. Investing involves risk, including the possible loss of principal.