March 11, 2020
Energy Market Turmoil: What's Next?
Energy Market Turmoil: What's Next?
March 11, 2020
March 9 saw the biggest one-day drop in oil prices in 30 years. After what was supposed to be a coordinated supply cut by OPEC+ to balance markets and keep oil prices high (oil prices had been falling due to decreased demand globally due to the coronavirus), Saudi Arabia and Russia instigated an oil price war. Instead of a coordinated cut, Russia refused to cooperate, as they viewed previous OPEC+ cuts as having aided America’s U.S. shale industry. Saudi Arabia reacted by announcing aggressive plans to boost oil output next month to well above current output levels and slashed prices for crude oil sent to Asia, Europe and the U.S., cutting oil prices and enticing refiners to use Saudi crude.
Source: Bloomberg, Cboe Global Markets as of 3/10/2020
What Caused the Collapse in Negotiations and Saudi Arabia’s Aggressive Response?
Analysts suggest that Russia’s refusal to agree to further cuts in oil production stem from its view that the current agreement with OPEC+ was too one-sided against Russia. In the Kremlin’s view, production cuts only furthered the interest of American shale oil producers. Russia is particularly sensitive to helping American interests given they are under renewed pressure from U.S. sanctions.
Saudi Arabia’s reaction appears to be aimed at increasing market share, given its cost advantage over other oil-producing economies, as well as enhancing its credibility as a key enforcer of the cartel.
Where From Here?
Baseline Scenario: Significant Costs on Both Sides
In our baseline scenario, we see a war-of-attrition scenario where Saudi Arabia follows up on its threat to increase production, and Russia sticks to its position. This scenario, if maintained for long enough, would entail a significant economic cost on both sides (as well as for other oil exporting countries).
We think Russia has the upper hand. The country has a much more solid macroeconomic framework than Saudi Arabia: it features a floating exchange rate regime that allows the economy to cushion the impact on growth from negative external shocks. In Saudi Arabia, they use a rigid FX system, where negative external shocks lead to loss of reserves and a much more costly adjustment in economic activity. Furthermore, Russia has a much stronger fiscal situation than Saudi Arabia. Russia ran a budget surplus last year versus a large fiscal deficit in Saudi Arabia, which translates into a much lower fiscal break-even oil (Russia at $40/barrel vs. Saudi Arabia at $84/barrel). In addition, reserve levels in Russia are higher than in Saudi Arabia ($570 billion, comprising of Central Bank Reserves and assets in the National Wellbeing Fund vs about $500 billion in Saudi Arabia). In addition, debt metrics in Russia are slightly better than in Saudi Arabia, both in terms of public debt/GDP and on gross external debt levels). Finally, it is our view that the leadership in Russia appears to be more stable and less prone to impulsive decisions.
Benign Scenario: Posturing Ahead of Negotiations
A more benign interpretation of the recent developments is that the parties are adopting a tougher stance ahead of potential new meetings before the April deadline. However, this is not our baseline as we have not heard of any planned meetings between representatives of Russia and Saudi Arabia, though it is true that the Russian Energy Minister has not ruled out further talks with OPEC nations aimed at stabilizing energy markets. On the Russia side, a strong macroeconomic framework should allow it to resist the pressure from lower oil prices, whereas in the case of Saudi Arabia, the kingdom already demonstrated a determined approach to gain market shares despite the economic pain from lower prices. Admittedly, Saudi Arabia was in a more robust position back then than today, as oil prices were above $100. From a reputational perspective, backtracking on Saudi Arabia’s decision to increase volume would undermine their credibility as the key enforcer of the OPEC cartel.
We believe the key difference between the oil price drop now versus in 2014 and 2015 is that it potentially is a demand (Coronavirus) and supply issue at the same time. If prices remain low, liquidity concerns and bankruptcy risk will rise for oil leveraged Energy & Production (E&P) and Oilfield Services companies. On March 9, higher quality, High Yield E&Ps bonds were down 10-15 points while mid-tier and distressed/lower tier were trading down 20-30 points. IG HY spread moves ranged from 90bps wider for higher quality single A names, to 350bps wider for higher beta credits.
In our view, while HY E&P will likely see significant defaults in the coming months and recoveries will be low, there will be survivors in HY Energy. Many of the higher quality Permian players have the financial means to ride out this downturn. We would also not be surprised to see “shotgun marriages” hit the tape over the coming days and weeks. This could cause some relief, especially if larger investment grade (IG) companies are the dance partner of a high yield (HY) company.
IG independent oil producers are in a much better shape than the last downturn, in terms of having lower leverage, limited near-term maturities and much more capital disciplined management teams. The negative angle to the situation now versus past cycles (e.g., 2015/2016) is that equity valuations are very weak in the sector overall and there is limited support from equity investors, providing less of a cushion. Fallen angel risk is something to carefully consider in this environment, as it is possible several large IG energy names could see their ratings downgraded.
Given rating agencies rate energy companies based off of price assumptions or “price decks,” all of their previous assumptions will have to be revisited and potentially rerun using lower price assumptions. Importantly, S&P is taking a conservative approach, and has revised their 2020 oil price deck down to $35/bbl from $55/bbl WTI. As a result, a few downgrades should be expected to HY but will not be broad based. On the flip side, Moody’s is being more tolerant (very dissimilar to their approach in 2015/2016) and currently have no plans to change their current price band of $50-70/bbl WTI. Instead, they are giving a three to six month window of these current low prices, before reassessing.
Given the historic moves in oil, we are closely monitoring the energy positioning in our portfolios and are evaluating these companies’ ability to operate for an extended period of time in a low oil price environment.
Lower oil prices will affect emerging market (EM) economies in a dissimilar fashion, depending on their status of oil-exporter or importer. The obvious winners are the importing countries of Turkey and Central and Eastern Europe, as well as selected countries in Asia (China, India, Philippines, Thailand, Pakistan, and Sri Lanka). We believe these economies should see relief both on inflation (mainly in Turkey and CEE economies, where inflation is running above Central Bank targets) as well as external accounts (via lower oil import bills). In the losing end, oil-exporting nations will clearly suffer, though we think that some differentiation, even within this more homogenous category, should be made. In particular, countries featuring stronger fiscal and external balances (as evidenced by lower fiscal breakeven prices, per IMF) should fare better than those facing tighter fiscal space:
|Display 2: Breakeven Oil Prices|
|(U.S. dollars per barrel)|
|Fiscal Breakeven Oil Price2|
|MENAP oil exporters|
|Iran, I.R. of||55.9||58.4||64.8||82||155.6||194.6|
|United Arab Emirates||47.6||51.1||59.8||66.7||70.2||70|
|CCA oil and gas exporters|
|External Breakeven Oil Price3|
|MENAP oil exporters|
|Iran, I.R. of||41.5||28.3||33.5||38.2||78.3||87.7|
|United Arab Emirates||55.2||31.5||28.7||30.4||28.7||32.4|
|CCA oil and gas exporters|
|Sources: National authorities; and IMF staff estimates and projections.|
|1Yemen is a net oil importer in 2015 and 2016.|
|2The oil price at which the fiscal balance is zero.|
|3The oil price at which the current account balance is zero.|
The IMF table does not report breakeven oil prices for oil exporters in SSA but sell-side analysts estimate Angola’s fiscal breakeven price at $60/barrel, whereas Nigeria’s budgeted oil price in 2020, at $57/barrel, is substantially above current market prices.
Another source of differentiation is the FX regimes in place in exporting countries. With the exception of Russia and, to a lesser extent, Kazakhstan, which feature more flexible FX arrangements, oil-exporting countries tend to have hard pegs to the U.S. dollar, which limit countries’ ability to cushion the growth impact from negative terms of trade shock, and making them more vulnerable to balance of payment crisis as they have to accommodate those shocks via reserve depletion. Therefore, countries with lower stocks of reserves and rigid FX regimes are more vulnerable in a scenario of low oil prices for a prolonged period of time.
Finally, this analysis does not consider the impact of stimulus (both monetary, and potentially fiscal) that could be unleashed soon to counter the negative effect of coronavirus on global economic growth, which could potentially cap the downside on oil prices if no agreement on restricting output is achieved by April.
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