Exhausted Energy

Ok, I admit it. For a moment I was kind of hoping the local gas station would give me some cash if I stopped by with our SUV and took some fuel off their hands. Unfortunately, my truck doesn’t run on crude oil where the price recently dipped below zero dollars per barrel. But how can this be? Have we lost our collective way? If oil is going to trade at a negative price what are the future implications for the global economy and Canada as a major oil producer?

Why Oil Prices Went Negative

Firstly, you probably shouldn’t read too much into the negative price as it was more of a technicality than anything. Oil trades on both the spot (immediate delivery) and futures (future delivery) markets. The futures curve is generally upward sloping reflecting the cost of “carry”, with the carry being primarily storage costs for future delivery. Most futures traders do not want to take physical delivery, so they sell off their shortest contracts at the end of the month and “roll” them forward, usually for hedging purposes. In the last part of April, month end selling put downward pressure on already low prices. In addition, and due to very light COVID-19 oil consumption, global storage capacity has filled up fast which increases the cost of storage. The rising cost of storage is essentially what pushed prices below zero. Unlike other commodities, you cannot just plow oil back into the fields, pour it down the drain, or burn it off. It must be stored before it gets refined and ultimately consumed.

One big reason crude became “worthless” is that transportation consumes 60% of the world’s crude oil. With airplanes parked, cruise ships docked, and highways empty as employees work from home it’s easy to see how our energy demand has dried up faster than a puddle in the Arizona heat. One third of oil consumption had evaporated in just one month. To make matters worse, the spat between Saudi Arabia and Russia ramped up production to an already over supplied market. Prices? Down they went. Despite recent OPEC+ agreements to cut production, the market remains oversupplied, mostly due to virus-impacted demand destruction. We do expect oil demand will eventually return, but not back to levels seen a few months ago, at least not for some time. Why? Some find work from home arrangements to be more, not less productive without the commute. Also, we are not convinced people are ready to squish back into airplanes for long-haul flights or book cruises any time soon. Check out the collective market forecast of where WTI prices are expected to go over the next few years. It may be some time before we see prices back to pre-virus levels.

The Impact on Producers

As with most price moves, there are both winners and losers. Big producer nations like Saudi Arabia, Russia, and Canada are pinched the most by falling prices. Economies in Europe, China, Japan, and the United States benefit as big consumers when prices fall. Perhaps the silver lining for producers is that the cure for low prices is in fact low prices. We have already seen oil rig counts begin to decline and the OPEC+ producers have just started but appear to be honoring their agreement.

Actively Managing Portfolios

So, if low energy prices are in fact with us for some time how should our portfolios be positioned? It’s hard to imagine that just 10 short years ago Exxon was the largest company (by market cap) in the S&P 500 Index. Today, the value of all the energy companies in that index combined is worth less than that of Google-parent Alphabet (source: S&P Dow Jones Indices). In Canada, Energy remains our largest economic export and is the third largest sector on the S&P/TSX. Clearly, still very important to us`. The entire energy sector has seen downward pressure on share prices suggesting all companies are being penalized. Logic would suggest high quality, well-financed energy companies are better positioned to endure this downturn than those with less operational and financial flexibility. In fact, shrewd operators have used past price dislocations as a catalyst for merger and acquisition opportunities.

According to our colleagues at Franklin Bissett, Suncor is one of the most integrated energy companies in Canada. Most of their crude oil production is upgraded and refined in their own facilities are ultimately sold through its own retail fuel stations. This level of integration has historically provided significant insulation against commodity price shocks. Franklin Bissett has also suggested oil servicing and medium sized exploration & production companies are likely to struggle most in an extended low-price environment. Their preferred angle is to look to energy infrastructure businesses (pipelines, midstream processors) which are much less exposed to the price of crude oil or natural gas. We don’t know how long the period of subdued energy demand lasts, but we are convinced of one thing. Active management will remain a critical component to successfully managing exposure to this volatile and important sector.

Active management at the asset allocation level of is also important. The pressures facing the Energy sector, and knock-on effects to other sectors such as transportation and even the banks, are one reason we prefer to remain underweight Canada versus other regions. As better transparency surrounding a global economic recovery improves, we will revisit this positioning.

David Andrews’ comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.