Historic oil crash – Implications for risk assets

DBS is forecasting higher oil prices by 4Q should countries manage to re-start their economies successfully post COVID-19 crisis.
Chief Investment Office22 Apr 2020
Photo credit: AFP Photo

What happened?

WTI oil market entered super contango; plunging 306% on storage shortage fears. The West Texas Intermediate (WTI) crude oil price underwent a historical crash on Monday (20 April), plunging 305.97% to close at -USD37.63 (Figure 1). This is the first negative settle ever registered in history. Why did this happen? 

·        The WTI contracts for May are due for expiry and any holder of such contracts is expected to take physical delivery of the oil in Cushing (United States).

·        Given the recent surplus of oil, storage facilities are in low supply. Contract holders are therefore willing to pay someone to take over their long positions in order to avoid taking physical delivery.

Given that the limitation of storage facilities will not be resolved anytime soon, the volatility seen in May’s contract could overspill to June’s (although Figure 2 shows that this is currently not evident). We expect volatility in WTI crude oil prices to persist in the coming weeks until the market reaches an equilibrium through supply cuts.

This will not be the new normal; sharp WTI plunge predominantly a function of idiosyncratic risks. The global lockdowns as a result of the COVID-19 virus has weighed on global oil demand. In fact, with the curtailment of car and air travel, our oil analyst expects energy demand to fall by 3.0 mmbpd (3% y/y) in 2020. This demand weakness, coupled with the Organization of the Petroleum Exporting Countries’+ (OPEC+) supply concerns, has driven oil price lower on a year-to-date (YTD) basis.

However, one should differentiate between “fundamental factors” driving price weakness and the idiosyncratic ones that triggered the WTI plunge on Monday.

Monday’s price action is the result of idiosyncratic risks arising from the lack of storage facilities (as opposed to traditional demand/supply dynamics). Clearly, onshore storage capacity in Cushing is reaching maximum utilisation rate and this, in turn, is contributing to the surge in offshore storage usage (Figure 3).

Oil demand to undergo slow rebound towards year-end; successful restarts of economies a determinant factor. Based on DBS’s house view, we expect oil demand to start rebounding during 4Q20. However, this assumption is partly premised on the successful restarts of economies post-COVID 19 lockdown. Should the viral crisis be effectively contained and there is an absence of second and third waves, a return to normalcy for global economic activities will provide a lift for energy prices.

Figure 1: Notional amounts of Fallen Angels rising to near-term peaks

Source: Moody’s, S&P, Bloomberg, DBS

Figure 2: WTI May vs June Futures contract

Source: Bloomberg

Figure 3: Offshore storage usage has surged

Source: Bloomberg, DBS

What is the impact on Equities?  

Europe integrated oil and gas – an update. The stock prices of Europe integrated oil have come under selling pressure over the past two months in reflection of the weak oil prices owing to unfavourable end demand. While the OPEC+, the US, Canada, and G-20 members have agreed on production cuts, it would only take effect starting 1 May and therefore, the current supply scenario is still based on pre-existing output.

The supply discipline slated for May should alleviate the current imbalances between the supply and demand. Over the past 20 years, EU integrated oil majors have maintained balance sheet discipline without excessively expanding the debt. The ratio between total debt and total assets have been kept within 25% (Figure 4) and should position the fraternity to weather the current erratic industry dynamics. Under the low rate environment, they would have debt room.

Maintain favourable view on Europe integrated oil majors from a dividend perspective. We like the Europe integrated oil majors as their attractive dividend yields fit into the income side of the Barbell Strategy. Evidently, over the years, the absolute dividend per share among the top three EU oil majors has stayed consistent (Figure 5). The capex discipline should further support the dividend ability going forward.

We expect the financial conditions of integrated players to sustain given the diversity of their operations. Typically, upstream exploration and production account for less than 25% of consolidated revenue.

On a YTD basis, EU integrated oil majors have declined 40% on a total return basis, outperforming crude oil price which fell by more than 60% (Figure 6). After the recent round of share price rout, the sector’s price-to-book (P/Book) valuations are now well below the -1s.d. territory (Figure 7), and this limits downside risks to the equity prices.

Figure 4: The EU oil majors are not stretching their balance sheet

Source: Bloomberg, DBS

Figure 5: Stable dividend per share

Source: Bloomberg, DBS

Figure 6: EU integrated oil majors have performed better than crude oil

Source: Bloomberg, DBS

Figure 7: EU energy at compelling valuations

Source: Bloomberg, DBS

What is the impact on Corporate Bonds?  

Sizeable amount of potential “Fallen Angels” in Energy space. At present, there remains nearly USD1t of bonds near the lowest rungs of Investment Grade (IG) ratings on Negative Outlook by Moody’s and S&P, with the Energy sector again featuring prominently with about a quarter of the total size (Figure 8). With crude prices languishing at USD20-30/bbl for an extended period, the sector is still likely to see further strain. For comparative purposes, we also note that the Energy sector continued to see 2-3 quarters of elevated downgrades even after crude prices first established a temporal bottom in early-2015.

Figure 8: c.USD1t of Mid to Low-BBB credits on Negative Outlook by Moody's/S&P

Source: Moody’s, S&P, Bloomberg, DBS

Low crude prices do not affect corporations alone. On the aspect of sovereign ratings, one must not forget the LATAM/EMEA region which sees some of the highest concentrations of mid-sized oil producing nations – countries that are likely to face fiscal strain under the present levels of oil prices, as well as economic uncertainty with the COVID-19 outbreak still relatively unconstrained in the region. Indeed, looking at the list of sovereign ratings actions since March (Table 1), we see that out of a total of 20 instances, EMEA and LATAM as a region register 10 and 9 instances respectively – a good 95% of the total.

Table 1: List of negative sovereign ratings actions since March

Asia Credit: comparatively more insulated from crude price risks. Asian economies continue to rank well against their LATAM and EMEA peers by measures of external and fiscal sustainability. Moreover, many of the upstream oil issuers in Asia are government-linked, and as such, benefit from a sovereign uplift even while overall credit may face deterioration. More importantly, while (a) Asia remains a frontrunner in a viral recovery scenario, and (b) Asia being a net importer of oil as a region, the threat of the two largest risks are comparatively more benign. Therefore, Asia appears structurally better positioned to weather the downturn from a credit perspective.

What is the impact on DBS CIO Barbell Strategy? 

Minimal oil and gas exposure on DBS CIO Barbell Strategy. The DBS CIO Barbell Index has a total 3.3% exposure to the Energy sector, this comprises respective 1.2% exposures to Royal Dutch Shell and BP; and 0.9% indirect sectoral exposure through the bond funds.

EU integrated oil majors fit in the income-generating theme of the Barbell Strategy on a holistic portfolio construction basis.

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