This past week, I wrote an article titled "If You Regretted Not Investing More In 2008, Invest In Oil Now". In it, I discussed how with the market at all-time highs, oil companies represented a bargain that couldn't be found elsewhere. Oil markets (NYSEARCA: VDE) had one of the toughest weeks since 2008 last week, dropping almost 10%. Since then, Saudi Arabia, after failing to come to a price deal with OPEC+, has declared a price war.
Saudi Aramco, in the best interest of maintaining its dominant market position, lowered Asia crude oil pricing by ~$4-6 / barrel. North Sea crude, the closest competitive market for Russian Ural crude, got a $10.25 discount to Brent crude. For reference, given current Brent crude prices, that means the price is <$35 / barrel.
COVID-19 is spreading rapidly. China seems to have gotten a handle on the outbreak, however, outside of China, new outbreaks are popping up in Italy (Europe), Iran, and South Korea.
These massive new outbreaks are spreading at lightning speed. Europe, which was previously segregated from the outbreak, is now growing rapidly. France has almost 1000 cases, Germany has around 750, Spain just hit 500. Several weeks ago, the outbreaks in these countries are negligible, now they're massive.
Italy has recently put Lombardy, a region with more than 10 million people, on quarantine. That's ~16% of the country's population, or for reference, more than twice as big of a quarantine as that of China's Hubei province as a % of the population.
At this point, COVID-19 is looking increasingly unstoppable. The U.S. CDC, under the direction of our highest levels of government, refused the WHO test kit and decided to make its own. Experts are now saying that a botched roll out of test kits by the CDC allowed the virus to enter the country during peak flu season and establish itself.
People and markets are now starting to consider COVID-19 unstoppable. An overall 1-3% death rate makes this incredibly concerning. In comparison to a death rate for the common flu estimated at ~0.1%, this is concerning. In a world where COVID-19 becomes as established as the flu, it implies ~600 thousand annual American deaths.
That would nearly equal the number of Americans who die annually from all types of cancer put together. Bright spots exist as Gilead Sciences (NASDAQ: GILD) works on a cure - with the readout from Phase 3 data being shifted from early-April to late-March. The first COVID-19 vaccine is undergoing human trials, with mass production expected in <1 year.
However, the biggest risk from COVID-19 is not only a short-term oil demand decline, with China oil demand dropping by near 20%. Current estimates for worldwide oil demand are a 3.8 million barrel / day YoY decline in consumption. For reference, the previous largest decline was in 1Q 2009, with a 3.6 million barrel / day YoY decline.
It's worth keeping in mind that this decline is solely from a decline in the movement of people due to the virus, we haven't even hit a recession yet. Not great, when some estimates show that more than 50% of the population was still recovering from the 2008 recession in 2018.
OPEC+ Break-even Prices
OPEC+ was supposed to be the organization that handled situations like this. Traditionally, commodities are susceptible to price shocks. Oil, while susceptible to the same price shocks, always had the unique ability to avoid the worst of the worst thanks to OPEC+. With Russia on board, the group controlled more than 40 million barrels / day in production.
Recently, OPEC+ considered a major production cut, of 1.5 million barrels / day on top of its previous production cuts. That'd push total OPEC+ production cuts to near 3 million barrels / day. Russia decided to back out, pushing prices down >10% on March 6. With an all out price war, prices might be down >10% the March 9-14 week.
OPEC production has slowly trended up, that's not surprising, the member countries, like the rest of us, love money. The last price war was in 1997, where turning on the spigots increased production by nearly 3 million barrels / day. The massive resulting decrease in prices pushed them to ~$10 / barrel. Adjusting for inflation, that's ~$16 / barrel.
That's roughly half of where Brent crude prices bottomed out in early-2016. And they barely spent anytime there.
However, OPEC can't handle prices that low forever. While their lifting costs might be low (onshore Middle East breakeven is at $27 / barrel) the budgets require much higher prices. Across the board, countries need much higher prices to breakeven. Even the wealthier countries, like Kuwait, Qatar, and the UAE need prices closer to $70 / barrel.
Russia, with US sanctions, and a massive population, needs every dollar it can get. Saudi Arabia, with its size-able population versus OPEC peers, also needs strong prices.
The result of high oil prices is clear when you look at Saudi Arabia's debt to GDP ratio. Since mid-2014, the company's debt to GDP will shoot up. How long the company will keep up a price war remains to be seen. It depends on budget cuts, however, when you're running a dictatorship, those tend to only work as long as the government handouts continue. Look at Venezuela.
Saudi Arabia's current GDP is $640 billion and the government's current annual government spending is ~$150 billion. Let's say the country turns on the spigots, increasing production from 10 million to 12.5 million barrels / day and pushing Brent crude prices from $60 / barrel to $20 / barrel. Annual oil revenue would decrease from $220 billion to $91 billion.
That's a $130 billion decline in revenue as oil prices approach breakeven. That's near pure profit. With a GDP of $640 billion and annual government spending of $150 billion, how long can that continue. Russia debt to GDP is at 17.2%, with annual government spending at ~$230 billion. It could handle low oil prices longer than Saudi Arabia, but what's the point?
It's clear that OPEC+ needs higher oil prices to achieve breakeven in government spending.
Oil Market Capital Spending
So what's the goal here? Clearly, Russia is hoping that lower prices are resolved through someone besides Russia cutting production. The question becomes who?
The question becomes, at various crude oil prices, who decides to cut production. The answer is, effectively no-one. As Occidental Petroleum (NYSE: OXY), with its $40 / barrel breakeven price shows, most major producers have adjusted to a world with $50-60 prices / barrel breakeven. Sure, at $20 / barrel, companies will go bankrupt, but so will countries.
However, what will decline is capital spending. That's important because oil feeds naturally experience a steep decline with massive capital spending ($10s of billions). Based on ExxonMobil's forecasts, with no capital investment oil production will decline 40 million barrels / day in the next 10-15 years. The decline is steepest at the start, no investment for 1 year is 4 million barrels.
In 2013, capital spending of mid/large capitalization oil and gas companies was almost $600 billion. In 2016, this dropped to less than $300 billion. At sustained prices of less than $30 / barrel, this could start to approach ~$200 billion. That significant capital is below sustaining, IEA estimates are ~$800 billion annually ($20 trillion until 2040) in annual spending required.
The point to be made is that rapid declines in oil prices won't drop production immediately, but through sustained lower capital spending, it will lead to slow declines in production. Just a few years of this, combined with recovering demand, could balance the oil markets. But would the cost be worth it?
The Result of War
As can be determined above, through a mix of the sustaining price for budgets, along with production from shale, long-term Brent crude prices need to be ~$45-60 / barrel Brent (Occidental Petroleum has a $40 WTI breakeven with 20% of production hedged at +10% above prices). That means the company's breakeven is closer to $50 Brent.
Even major projects, such as ExxonMobil's (NYSE: XOM) Guyana discovery (one of the largest in decades) has a breakeven for Phase 1 at $35 / barrel Brent. Long-term, whether through product cuts or declines in production, I expect oil prices to move toward ~$60 / barrel Brent crude. There was evidence of that after early-2016.
I expect there will eventually be an agreement of a production cut. That, combined with capital spending declines, will allow prices to recover. At $20 / barrel, parties around the world are strongly incentive to allow prices to recover. The question becomes, in a complicated time, how do you play such a period.
There are a number of potential ways to play this environment. I recommend starting out with the Vanguard Energy ETF (NYSEARCA: VDE). The ETF has a near 25% stake in ExxonMobil, and a dividend approaching 5%. With the 10-year treasury dropping below 1%, that spread is >4%, and you're insulated from individual company bankruptcies.
Alternatively, I recommend taking a look at some of the oil majors or MLPs. MLPs have a double-digit dividend, and some, like Wes Midstream (NYSE: WES) have a dividend of more than 20%. AMLP (NYSEARCA: AMLP) has a dividend yield of more than 12%. Even the classic secure midstream companies, like Kinder Morgan (NYSE: KMI), have a dividend >5%.
Investing in companies affected by the broader market sell-down, like Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B), which has the cash pile to take advantage of market turn downs, and ~3% of its value tied in Occidental Petroleum (NYSE: OXY) is also something I'll be doing. Given the high IV of options currently, there's plenty of ways investors can build a portfolio of quality companies at double-digit yields.
For those who want to see our current model portfolio, I recommend signing up for a 2-week free trial of The Energy Forum.
Oil markets had a tough time this past week, and I expect the coming weeks could be even tougher. The joint issues of COVID-19, OPEC+ falling apart, and recessionary fears could be the thing that tips over a market that in 2019 and early-2020 looked like it was starting to stabilize. The last time this happened, in the late-1990s, with an OPEC war among partners, prices dropped to ~$17 / barrel adjusted for inflation.
Despite that, company budgets and planning, along with the spending of the countries in OPEC, shows that long-term, prices ~$60 / barrel Brent are required. That means that either capital budgets will have to decline significantly, decreasing production, or an agreement will have to be reached. Either way, with Saudi Arabia looking at a revenue drop of >20% its GDP, a decision will need to be reached.
Investment opportunities are aplenty. Safe investors can look at something like Berkshire Hathaway. Otherwise, the Vanguard Energy ETF is yielding 5%. Income focused investors can have bargains abound in the MLP sector. Alternatively, one could construct their own portfolio of quality large cap oil companies with the yield of the majors approaching 10%.
Let me know what you think and what you're doing in the comments below.
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