When the oil price fell down a well

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‘Unprecedented’ is the go-to word to describe a world knocked sideways by Covid-19. For Laura Sheehan, analyst with Newton Investment Management, it’s an apt one when reviewing developments in the energy sector in 2020.

On 21 April 2020, for the first time in history, the price of US oil went negative. Thanks in part to a Covid-19-related economic collapse but also to a spat between key oil producers Russia and Saudi Arabia, demand for ‘black gold’ plummeted almost overnight.

Never before had oil producers had to pay people to take the commodity off their hands – and yet that’s exactly what happened in the second quarter of 2020 as the bizarre set of supply/demand dynamics unfurled: At one point, the price of West Texas Intermediate¹, plunged as low as -US$37.63 a barrel. Inexorably, as onshore storage facilities filled up, the world’s estuaries and offshore mooring points became the staging ground for thousands of tankers holding millions of gallons of oil nobody wanted.

Yet, for all its shock value, for Newton energy analyst Laura Sheehan, the collapse in the oil price was just one chapter in a litany of unusual events in 2020.

It’s been a difficult time,” she says. “When the Covid-19 crisis started in January, the energy sector felt the impact almost immediately. The ‘solution’ to the spread of the disease around the world was to restrict activity – and since oil and gas are the energy fuelling much of that activity, the sector was hit early and hit hard. At the same time, the lockdowns affected everyone personally, so it was an unusual period where work and personal life converged.

For an analyst, whose role is to understand the fundamentals of valuation and investability, global lockdowns and the uncertainty over how long they would last made the job doubly difficult.

You have to remember,” says Sheehan, “at the start of the year we were dealing with a price hike over Iranian US tensions and threats of military action. To go from that to a complete collapse in the blink of an eye was challenging. Even in the darkest days of the financial crisis, oil demand only fell by a few percent. Never has the industry had to deal with such a collapse, even as OPEC were actually increasing production.

Now, six months on from the oil price nadir, Sheehan says she is surprised by the pace of the general market recovery – “I think it’s as much to do with liquidity and central bank activity than, say, pure fundamentals”. With prices closer to US$40 a barrel she says, this is “far less scary than US$30/b and below.”

Nevertheless, Sheehan also believes the crisis has created an enduring legacy. For one thing, people have learned to work from home, which should lead to less commuting. Supply chains, too, are shortening, partly due to perceived political risk but also because of an increased awareness of how vulnerable just-in-time or cheapest-cost networks are. Finally, the crisis has encouraged the adoption of ‘green’ fiscal stimulus from governments the world over. Taken together, says Sheehan, these developments will hasten the speed of structural change away from hydrocarbons towards a more sustainable energy framework.

I don’t think the way one looks at the energy space has changed fundamentally, but expectations on peak demand have come forward, and companies can no longer pretend it’s a non-issue in this decade,” she explains. “We’ve seen a wave of European companies promote greater green strategies, discussing the prospect of fading their oil production sooner and investing to become broader energy companies. Relative to how things were pre-Covid, investors now require a higher rate of return to warrant investing in energy, even as the size of these companies in benchmarks has shrunk.

Against this background, companies in the energy sector with solid ESG credentials have performed well, partly because of a limited supply of ‘quality’ names in the space. But, according to Sheehan, this new emphasis on ‘greener’ energy could also be brewing its own structural problems.

Valuation metrics have already begun to compress, she notes, as an influx of ESG money chases the same limited number of opportunities. This in turn heightens the risk of companies destroying value, a bubble forming or distress in the sector further down the line.

I do wonder if the green energy excitement has blinded the market from some challenging realities and the influx of ESG money does make it harder to uncover value,” she concludes, “but this is where deeper knowledge of company strategies and their product suite really aid the analysis. We’re moving towards a more complicated energy system and within that complication comes opportunity as well. There won’t be one silver bullet to solve the climate crisis: we need all solutions and we need them now.

¹WTI: A proxy for the global oil price

GE116678 EXP 5 JAN 2021

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