The oil sector's playbook for periods of weakness is well known. When prices weaken, the industry enters a cycle of divesting or idling higher-cost production, consolidation among players to achieve economies of scale, and slashing payrolls to ride out the storm. Unfortunately, this playbook was written for situations where overproduction is the key issue. Thanks to COVID-19, however, the energy industry as a whole and the oil industry in particular are facing unprecedented demand destruction. Given the widespread changes in oil consumption, it is worth asking whether the oil sector can recover from the pandemic.
- Due to COVID-19, the energy industry as a whole and the oil industry in particular are facing unprecedented demand destruction.
- Oil companies that are hoping to hold on and ride out the pricing dip may not have easy access to capital though traditional credit facilities.
- Producers of marginal barrels may collapse first, leaving the few remaining players and national oil companies to fight over the refining scraps of a once mighty industry.
More Than Just a Rough Market
The oil sector's problem looks like the same old problem on the surface – prices have dipped. West Texas Intermediate (WTI) has been sitting below $50 per barrel for almost all of 2020. Although every source of production is different, sub-$50 prices mean that a lot of marginal production is either coming off line or in danger of losing money. This is one of the reasons the consolidation in Canada's oil sands has been faster than in countries with vast conventional production. Consolidation in Canada will continue, with the most recent merger being a $3.8 billion one between Cenovus Energy Inc. (CVE) and Husky Energy Inc.
Canada's oil sector obviously has a range of production costs, with some companies maintaining profits even when WTI dips to the $30s, with most preferring a price well above $50. The same is true of domestic shale oil production in the United States, with some companies folding operations at the $50 mark and others still comfortably producing into the $30s. For these two production sources in particular, however, the price is just one of the problems.
ESG Financing Having an Impact
Demand is weak, and COVID-19 is playing a definite role in that, but there is the simultaneous issue of environmental, social, and governance (ESG) financing metrics being adopted by institutions and investors. Oil companies have long depended on financing based on their proven reserves to actually help get those reserves under development. As sources of financing are drying up for oil specifically, new production that would otherwise be in development is being shelved. More importantly, companies that are hoping to hold on and ride out the pricing dip may not have easy access to capital though traditional credit facilities. This will mean yet more consolidation among companies at all levels of production – not just the unconventional oil crowd.
A Price Recovery With Bigger Challenges Ahead
Of course, there are some oil producers that are extensions of national governments. While they are insulated from some of the financing issues facing the publicly traded firms, these national oil corporations are seeing less cash flowing from the oil they are putting on the market. OPEC production and non-OPEC production have both dropped by roughly 3 million barrels per day in 2020, taking 6 million barrels off the market. Even with lower demand, the supply cuts will continue as consolidation and idling assets ramps up, eventually putting some upward pressure on prices.
With new financing constricted, it will likely be the national oil corporations that increase production first, and some of these market players will be producing. As has happened in the past, OPEC may find some of its members producing for the sake of having any cash flowing in to deal with COVID-related costs, profit be damned. If this comes to pass, tentative demand recovery would once again be hit by an oversupply of crude.
Is This the End for Oil?
COVID-19 has introduced a lot of uncertainty into macroeconomic projections. A successful vaccine could, in theory, bring oil demand back up to 2019 levels in short order. With many countries in the grip of a second wave, however, this seems to be far from a certainty. Even so, there is still a case for oil production for many years yet. While we are travelling less, we are still shipping large amounts of goods, and right now, there are not many viable long-haul alternatives to burning oil-derived fuel. There is an additional demand cushion in the form of plastics and other downstream petrochemical products that will continue to grow for some time even with some countries aiming to regulate their use.
So this is not the end. It is, however, a sobering preview of what the oil sector may face post-peak oil, with producers of marginal barrels collapsing first and the few remaining players and national oil companies fighting over the refining scraps of a once mighty industry. The timeline for peak oil has been pushed back many times, but meaningful investment in alternatives is growing and the pace of innovation is increasing. This is a real headwind now and could see proven reserves abandoned due to green competition rather than just because of an ESG financing pinch.
The Bottom Line
Overall, COVID-19 has put an exclamation point on what has been a rough decade for oil. The 2014 supply glut dealt the industry a blow that many companies never recovered from. Now COVID-19 has hit the demand side at a time when financing is harder to find than ever. There will likely be a demand recovery due to the cuts to supply, but the question facing investors is just how many good years or decades still lie ahead for the oil industry.