Good afternoon, this is David Cohen, portfolio manager at Boston Partners. Oil’s been in the headlines this week with prices turning negative for the first time in history, and we thought we’d share our perspective on it with you.
I happened to be watching CNBC on Monday as prices turned negative and the host was saying that the markets were broken. They’re actually not broken—they’re functioning perfectly. This is a symptom of an unprecedented dislocation between supply and demand. On the supply side, Saudi Arabia and Russia couldn’t come to an agreement and the OPEC+ accord broke. Saudi and Russia ramped production by several million barrels a day in April just as demand was starting to falter due to the virus.
On the demand side, this is truly an unprecedented shock. Supply is down more than 30 million barrels a day. As an energy investor over the past few decades, I’ve seen several sell offs and we’ve never come anywhere close to this in terms of the demand impact. Even in the Great Financial Crisis, demand was only down 2 million barrels a day at one point and was actually positive for the full year. U.S. storage is now full in most regions and as the May WTI contract approached, some players were caught long oil and had nowhere to put it. We don’t know if it was the producers or the financial players like the ETFs (exchange traded funds) that were caught long, but someone was long and had to pay someone with the storage capacity to unload those contracts.
Something to watch is that the USO, the largest U.S. oil ETF, holds 25% of the June contracts and will need to unwind that position. We could see a repeat of what we saw on Monday, as that happens over the next month. For companies, this is a very difficult period to navigate. There are almost no wells in the world that make money with global oil prices below $20 dollars a barrel. Most of the cost curve sits above $40 dollars a barrel. Hedges will help but most companies are at best partially hedged, and only for this year and the next. There’s severe pressure on company cash flows and balance sheets.
Companies continue to cut capex (capital expenditure), dividends, buybacks, G&A (general and administrative) and other operating costs. They’ve even now resorted to shutting of mature producing wells where prices are below cash operating costs. The large banks are now setting up structures to be able to repossess energy fields and operate them. There will be more bankruptcies. The path to normalization is somewhat uncertain, but this is what a bottom looks like.
The beautiful thing about commodity markets is that they’re self-correcting and price is the ultimate signal for that correction to kick in—it just takes time. The producer actions I talked about before, the OPEC cuts coming in, plus an economic thaw and a demand recovery will all help.
When prices fall, producers take all the actions we just discussed. That ultimately leads to lower supply and lower service cost. What’s unique about this is the unprecedented demand shock and nobody knows what the shape of the recovery will look like.
What distinguishes oil from other commodity markets is that oil wells have decline curves. Eventually, demand will come back and inventories will draw and that will lead to rising prices again. This period we’re in with low to negative spot in front of the curve prices will only last as long as the U.S. economy is shut. My best guess is that we have another 4-8 weeks of this, but it is a multiple varied equation with the added complications of the virus. But this is the bottom, we think, and ultimately higher energy prices are likely ahead.
Boston Partners Global Investors, Inc. (“Boston Partners”) is an investment adviser registered with the SEC under the Investment Advisers Act of 1940. Registration does not imply a certain level of skill or training. The views expressed in this commentary reflect those of the author as of the date of this commentary. Any such views are subject to change at any time based on market and other conditions and Boston Partners disclaims any responsibility to update such views. Past performance is not an indication of future results. Discussions of securities, market returns and trends are not intended to be a forecast of future events or returns.
David T. Cohen
Mr. Cohen is a portfolio manager for the Boston Partners Large Cap Value strategy. His experience at the firm included managing a portion of the Boston Partners Long/Short Research strategy focusing on security selection within the energy sector as well as the engineering & construction, and metals & mining industries. Read more