Oil: The Other Crisis Impacting Markets
Author: Kevin McCreadie
April 22, 2020
The COVID-19 pandemic has wreaked havoc on markets, but plummeting oil prices have resulted in their own set of problems for investors. Kevin McCreadie, AGF’s CEO and Chief Investment Officer, explains in his latest Q&A.
Oil has been routed over the past two months. Is the pandemic solely to blame?
Oil has been incredibly volatile. In March, West Texas Intermediate (WTI) prices fell about 60% to just under US$20 a barrel only to bounce back 50% from that low to around US$30 a barrel earlier this month. Now, in just a few short days, prices have cratered once again and are plumbing their lowest levels since 1999 after oil futures went negative for the first time in history earlier this week. Obviously, the pandemic—and economic shutdown that has resulted from it—is largely to blame. Current estimates show that oil demand has dropped by about 30 million barrels per day, or about 30% of the total global oil market in the past two months. But this goes beyond the demand destruction being caused by the significant drop in people driving their cars or travelling by plane. Exacerbating the situation early on was the dispute between Russia and Saudi Arabia stemming from the former’s refusal to cut supply in early March, which led the latter to lower their official selling price and ramp up their production. So, not only was there an unprecedented drop in demand, supply continued to pump higher, resulting in a lack of storage capacity that may ultimately force producers to cut back production. And then, at the same time, there are financial instruments and hedges tied to the oil markets that have only heightened the distress.
More recently, the Organization of Petroleum Exporters and its allies (OPEC+) have agreed to cut production by nearly 10 million barrels a day. Does this provide some relief to oil prices?
It does and the anticipation that a deal would get done is mostly what drove oil prices off the bottom in the first place. But cutting production by 10 million barrels only partially accounts for the demand being destroyed and unless OPEC+ agrees to cut supply even further I don’t see how oil prices rebound much more from here until the pandemic is over and people start returning to work and living their lives normally again. Even then, I’m not sure everyone is going to be jumping on a plane right away or taking up their daily commute in the same way they did. This experience is likely to affect our behavior profoundly as work from home and the ability to telecommute results in significant changes to our travel habits. And it may be months or years before we truly know what that means for oil, but also the global economy and markets more broadly.
What impact would a longer-than-anticipated economic shutdown have on global producers?
It could have a disastrous impact on some companies if the result is oil prices that remain too low for them to break even and make a profit. Furthermore, some might argue that this type of scenario could eventually lead to the production cuts needed to offset the fall in oil demand. In fact, the price war between Russia and Saudi Arabia was seen by many as an attempt to keep prices low in order to push U.S. shale companies towards the brink. People thought that might happen when oil prices crashed back in 2015, but it didn’t in large part because the U.S. shale industry was able to raise record levels of equity and debt. This time around, capital markets are largely closed to these companies because of their reputation for destroying value and destroying capital. But it’s also possible that the U.S. government steps in and bails them out, which could lead to an even greater surplus of oil when the pandemic runs its course and demand starts to rebound.
How has the oil rout impacted markets more broadly?
It’s had a profound effect on both equity and fixed income markets. Spreads on high-yield credit issued by the energy sector blew out significantly in the early stages of the current crisis in large part because of the drop in oil prices and the related fear that issuing companies would begin to default in greater numbers. Those spreads have come in a little bit of late, but not as much as the rest of the high-yield market, which has rallied significantly over the past couple of weeks. Emerging markets have also been impacted, especially oil exporters like Russia and Brazil, and then there are countries in developed markets such as Canada, whose economy is heavily geared towards the energy sector. If anything, the S&P/TSX Composite Index, Canada’s main equity benchmark, has been one of the most volatile global indices in recent weeks if not longer.
Why is that?
Remember, before the slump in oil prices or pandemic hit, Canada had been dealing with other economic headwinds, including the renegotiation of its trade agreement with the U.S. and Mexico. And then at the beginning of this year, the country was beset by pipeline protests that resulted in railway blockades and a disruption in the flow of many goods and services for several weeks. So, while much of the world has had a double whammy of COVID-19 and plummeting oil prices, Canada’s had at least a triple whammy to deal with because of the way that the year started.
What are governments doing to alleviate some of the damage done to economies like Canada’s that have a large stake in how oil prices perform?
Beyond the OPEC+ agreement and the collective decision to reduce supply, there are a few other ways that governments are trying to provide support. For example, the Texas Railroad Commission, which regulates the natural gas and energy industry in Texas, held a meeting earlier this month about the possibility of pulling in production. Meanwhile, Alberta’s provincial government recently announced a surprise $1.1-billion investment to help build the Keystone XL pipeline and said it will back a $4.2-billion loan to get the controversial project completed. As for the country’s federal government, it has yet to do something specific for the energy sector despite growing pressure for some type of package that could include interest-free loans for oil companies to weather the storm. In this case, one of the issues facing the Prime Minister is his government’s commitment to meeting future carbon emission targets. That makes bailing out the oil companies a political hotbed that needs to be weighed against the oilsands’ impact to the country’s economic growth. Still, we expect the Canadian government—and most other global governments for that matter—will continue to support as many facets of the economy, including the energy sector, as needed and provide any additional stimulus that may be required to keep individuals and small businesses afloat in these trying times.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives.
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