Where to from Here? Putting the Oil Shock in Context

Oil prices plunged the most since the Gulf War during the first weekend in March after coronavirus fears dampened the demand outlook and forced a standoff between Russia and Saudi Arabia on production cuts, worsening the supply picture. At the time of writing, both Brent crude and West Texas Intermediate (the global and US benchmarks for oil prices) were trading in the mid-US$30 per barrel range, near the lowest levels in six years.1 We believe these low price levels are unsustainable long-term and that this will likely prove to be a good long-term buying opportunity for those with the ability to ride out near-term volatility.

There are several reasons that we view current oil price levels as unsustainable:

• Production is unprofitable. Spot oil prices are nearing estimated marginal cash costs of production (i.e., the average operating costs of the marginal producer), a situation that over the past three decades has always signified a bottoming process. Simply put, producers that cannot cover cash costs are losing money by operating. Higher cost producers will have to cease pumping to stop the bleeding, which will curtail supply and help re-establish equilibrium, though this process can take time.
• Capital expenditures (capex) are being cut. Oil companies are actively cutting growth capex to protect dividends and balance sheets in the current environment, which will also limit supply growth. US shale oil production has high decline rates, increasing the speed at which capex cuts impact supply.
• Credit markets are closing. US shale is currently the industry’s swing producer, and supply in the American oil patch is managed by market forces, not fiat (like OPEC [Organization of the Petroleum Exporting Countries]). Many US exploration and production companies are leveraged and will lose access to cheap capital at these prices, further curtailing supply.
• Saudi Arabia and Russia need higher oil prices. In our analysis, Saudi needs oil to be ~US$80 per barrel to manage its budget, while Russia needs ~US$50 per barrel. Russia currently seems to have the upper hand, not just on Saudi, but also on the US shale industry, which cannot sustain low prices for long. Saudi Arabia and OPEC aren’t sitting idly by; they’ve responded by opening the taps in an apparent effort to exert maximum pressure on oil prices and force Russia to capitulate. Both Saudi and Russia can hold out for a while but will struggle longer-term if prices stay low. The farther and faster that prices fall, the sooner Russia and Saudi may be forced back to the negotiating table.

For long-term investors, the best time to buy or own energy stocks historically has been when the price of oil is trading below cash costs, as it is today. It is also one of the most emotionally difficult times to own energy stocks because low oil prices reflect pervasive fear and a bleak consensus outlook. Yet, to quote Sir John Templeton: “People always ask me where the outlook is best, but that’s the wrong question. The right question is: Where is the outlook most miserable?” Adding to the negative perception in energy are structural concerns about demand that extend well beyond the coronavirus and into the realm of demand replacement by alternative fuel sources. On this point, we do model in demand destruction over time as a result of shifting to alternative energy sources. However, we also believe people generally underestimate the world’s reliance on hydrocarbons to sustain global commerce and drive economic development. Furthermore, even in a structurally declining demand environment (not our base case assumption), cash-generative energy stocks could still be attractive investments, as evidenced by tobacco stocks over the past two decades.

At Templeton, we manage our energy holdings by attempting to buy and sell counter-cyclically. In years past, we have increased exposure to the sector during periods like today when oil has traded down near cash costs, and we have decreased exposure or rotated into more defensive holdings when oil has traded further up the cost curve. Over the past couple of years, this has meant rotating out of price-sensitive oil service industry stocks when oil rallied and into more defensive integrated producers with solid balance sheets and dividends. While the integrated oil firms have held up better than the service stocks amid the current oil price shock, the integrated industry was hit hard nonetheless. In our view, these stocks have declined somewhat indiscriminately, with some of the industry’s best firms now offering dividend yields on the order of ~10%. These are companies with strong balance sheets and numerous levers to pull while waiting for the market to rebalance (e.g., stopping share buybacks, flexing capex, reducing operating costs, cutting dividends or changing payouts to scrip, and so on). As this adjustment continues to play out, we are comfortable with our bias toward the more defensive integrated names while also actively seeking opportunities among higher-beta E&P (exploration and production) and oil services stocks that may become excessively discounted.

Supply and demand in oil markets are notoriously messy, and the combination of virus-led demand destruction and lack of political coordination on the supply side could weigh on oil prices and energy stocks in the near term. The main uncertainty remains how long it will take for oil markets to rebalance in the wake of this price decline. The credit environment in the US oil patch and political calculus among OPEC+ members2 will be key variables in determining the length and severity of the drawdown. While these periods are never pleasant, they usually represent favorable entry points for long-term investors, and we expect that current oil market turmoil should create attractive opportunities for those prepared in advance.