Amid the coronavirus pandemic, global demand for oil has fallen by roughly 30%, according to portfolio manager and energy market specialist David T. Cohen, CFA, of Boston Partners. David joins Portfolio Intelligence host John Bryson to discuss the recent volatility in oil prices, the ins and outs of the oil supply chain, and considerations for investors in energy stocks as the world attempts to move forward with an uncertain economic recovery. This podcast is distributed by John Hancock Investment Management Distributors LLC, member FINRA, SIPC.
John Bryson:
Hello, and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consulting at John Hancock Investment Management.
The goal of this podcast is to help investment professionals deliver better outcomes for their clients and their practice. Topics we'll address include advisor business-building ideas, capital market updates, the latest trends in portfolio construction, and investment insights from veteran portfolio managers from across our global network.
John Bryson:
Today, we have one of those managers we're joined by David Cohen of Boston Partners. David is a portfolio manager of John Hancock Discipline Value Fund, and he also runs large-cap value strategies for Boston Partners, including the Boston Partners, long, short research strategy. He also has experienced as an equity analyst, specializing in energy, engineering and construction, metals and minings, and he has experience running a global energy hedge fund. David, welcome to the show.
David Cohen:
Thanks John, it's great to be here.
John Bryson:
Excellent. So we want to talk about oil. Today is May 6th. And when we look back at 2020, oil's had quite a ride, it started 2020 to around $60 a barrel. It hit a low on April 21st of almost negative $40 per barrel—I think it was negative 37—only to rebound now to the low twenties. So talk to us about what's driving the volatility in oil. How can the price of oil possibly go negative? And is the oil market overall broken?
David Cohen:
Simply put John, it comes down to supply and demand. A lot was made of prices going negative. On the day that that happened, I happened to be watching CNBC and commentators, and the media had said that it was a symptom of the markets being broken, but it actually wasn't. It was simply the consequence of a generational, albeit temporary, dislocation between supply and demand.
To understand it, we kind of have to go back in history on the supply side. If you rewind U.S. supply peaked in the 1970s at just shy of 10 million barrels a day, and had been in decline for the better part of three decades, it troughed at around 5 million barrels a day in 2009.
So that the prevailing view at the time was that U.S. oil supply was in secular decline. It would never rebound. The discovery and development of U.S. Shell completely turned that on its head and drove oil production in the U.S. from 5 million barrels a day up to 13 million barrels a day from 2010 until earlier this year.
All through that period, Saudi Arabia, who is the lowest cost producer in the world, held this production flat. They didn't gain any market share despite being at the low end of the cost curve. So in 2014, U.S. Shell was growing several million barrels a day and threatened to massively oversupply the market. Saudi simply had enough.
In November of 2014, I call it the Thanksgiving Day Massacre for the oil markets, they shot the markets by flooding them with supply. Prior to that, they had been the swing producer to balance the market.
In other words, when supply demand would get loose, they would pull some barrels off the market. When it got tight, they would use their spare capacity to bring it on the market, but they reversed course on that strategy, given the threat to their supply. And they went to a strategy of defending market share. It didn't work. As I already told you, the U.S. continued to grow through the beginning of this year.
And then in 2016, the OPEC-plus accord was formed, Saudi reversed course on its market strategy of defending share and coordinated a cut with Russia. That was in place until early 2020, earlier this year, when Saudi was trying to coordinate a further cut to balance the market in the face of weak global demand.
Russia baulked at the notion and Saudi broke the accord, reversing yet again and increasing production by 2 million barrels a day. Russia ramped in response to that, and then once again, these guys came together in the beginning of April and announced the globally coordinated supply cut.
So on the supply side, it's come down to these competing interests of nation states in the face of growing U.S. Shell production, trying to preserve their own fiscal well-being as well as their own market share in the market.
On the demand side, what we have is a complete and utter collapse in demand. Demand was a little weak in 2019, and then started to weaken further early in 2020 as coronavirus slowed Asia's economy. But once the virus shut down the European and U.S. economies, oil demand fell 30% or around 30 million barrels a day, which was completely unprecedented. And it led to a severely oversupplied market.
John Bryson:
And a big part of that oversupply has led to problems around storage also, right? So that's a problem that we're running into that if we have the oil, supply keeps going, we run out of places to put it, correct?
David Cohen:
That is correct. Storage isn't full, but it's pretty close. At the pace we had been running last week, if we got five more weeks at last week's pace, we'd have completely filled storage, but it's been slowing. And commodity markets, if nothing else, are highly dynamic.
So the move to negative pricing and low-single-digit prices forced producers to shut in a lot of crude; we have 650 million barrels of storage in the U.S. Globally, that's around 4 billion barrels. No one really knows the exact number, but it's estimated to be around 4 billion barrels of global storage. And so, as I said, we were on pace to fill that storage capacity, but once prices went negative and stayed very low, producers started shutting in supply around the world. And so now it looks like we're going to avert filling storage. Although a lot of that depends on the pace of demand recovery over time from the coronavirus.
John Bryson:
Okay. Now you talked about prices and we've talked about the price going negative. How is that possible? Walk us through how that could play out and how it did play out.
David Cohen:
Sure. So effectively it came down to the May contract and May WTI contract. WTI again is West Texas Intermediate. There were players in the market who, to put it bluntly, we're caught long with nowhere to put the crude. So the way crude contracts work is if I'm long the contract and it's approaching settlement, I either have to close that contract out by selling it to someone who can take delivery of those barrels and put them into storage, or I have to take delivery myself and put it into my own storage.
There are many financial players in the market, some of the ETFs, traders, all these different players and with storage capacity running very thin, people didn't have the ability to close out crude contracts as they normally would.
So what happened was, we're approaching expiry and the financial players were looking to close out their contracts. And so they had to go to people who actually ended up having storage, and they were in a power position being the storage holders and effectively what they said was, "Okay, we'll take the crude, but it's going to cost you."
So instead of having to buy that crude at $30, $40 a barrel, they were getting paid upwards of $37 a barrel to take that crude off of the other person's hands. So from a trader or storage holder's perspective, they effectively were getting paid to take crude oil and then could turn around and sell it forward—a year or wherever they wanted to go out of the curve and lock in an arbitrage trade and make $40 to $80 a barrel for each one that they were able to take delivery of.
So effectively, it was just the desperation of speculators or financial players in the market caught long needing to close out contracts that lead to distress selling. And this kind of brief plummeting in the oil price to the point where it went to negative prices.
John Bryson:
Okay. So as you said, supply and demand drives the price of oil, but there's also these technical factors and market participants that at certain periods of time can skew the price. And that's basically what we saw happen.
David Cohen:
That's correct.
John Bryson:
Okay. Now, when we talk about oil companies and gas companies, we often hear about them falling into three types of categories: upstream, midstream, and downstream. Can you talk about those and where that fits in this?
David Cohen:
Yeah, so the upstream players are really producers and Eps, or exploration production companies. These are typically the most levered to oil prices since they sell oil and they're price takers of oil. So they drill wells, they produce the oil out of the ground, and then they sell it into the market. Their cash flows and revenues are directly tied to the price of oil.
Then you have midstream players. So midstream players are pipeline and infrastructure companies. They're less directly tied to the price of oil. There are some price linked contracts, but the vast majority of midstream revenues are fee-based contracts. So it's producers paying them a dollar or two or $3 a barrel to move the crude and a fee to process that crude into its components and then sell it into the market. They typically get paid to move, store, process oil, natural gas, and associated liquids; pretty stable companies, but they benefit from high prices and also struggle with low prices because when prices go low, there's less barrels produced. And so the amount of crude they're moving, storing and processing goes down.
Then you have downstream. Downstream is kind of a blanket term for refiners and chemical companies. These are the most complex businesses to understand. There's a lot of process chemistry involved. Typically, what they want to see is strong demand. Gasoline and diesel are the two main products that refiners sell. Gasoline is consumer driven, tied to obviously driving your car. Diesel is more economic activity driven. Jet fuel was also a component of that. So strong demand and abundant crude is pretty much the best environment for downstream companies. And when prices fall, sometimes they win, but sometimes they fall. So it's really a nuance situation. It really depends on the demand outlook and the overall supply picture.
And then I would throw in a couple other categories to this too besides upstream midstream and downstream. Oil service companies—they're not exactly upstream players, but they benefit the upstream. So if you look at a producer's expenditures, those are oil service revenues. So if an EP is paying a company to help them crack a well, help them fish something out of a hole that they drilled, and that's an oil service company revenues. So they do best when prices are going up and producers are actively drilling wells.
And then finally, you've got the “integrateds” or the majors who span the entire supply chain: They produce, they move, they process, they refine oil. And typically high prices leave more margin across the entire supply chain for them.
John Bryson:
Okay. So it's a really nuanced industry with a lot of competing factors, and while often a decline in oil prices is going to hurt a lot of the companies, there's so many more factors to really think through.
David Cohen:
Yeah, there are, and it's very dependent on what the oversupply looks like. So one thing we haven't talked about is really the difference between types of crude.
Oftentimes people talk about crude oil, but really it doesn't make sense to just talk about crude. You have to specify which crude oil. So if you think about WTI that's West Texas Intermediate, that's produced in the Permian Basin in the United States. It's an inland crude, meaning it's produced not in the ocean; it's produced inland and has to be moved to the coast.
And then you've got something like Brent, which is North Sea crude. Now those two crudes are similar in quality in that they have similar viscosity and sulfur content. So all things equal, they ought to trade at very close to the same price.
But what we've seen over the last few years is that spreads between those types of crudes get very wide at times. And the reason is that it comes down to logistics, i.e., the ability to move that crude to a place where it needs to either be consumed or shipped to somewhere where it's going to be refined or stored.
And so for inland crudes, typically there's more complex logistics surrounding that they may be very low cost to produce, but given a lack of pipeline capacity to move it to the coast or not enough storage capacity, they can be heavily discounted to kind of the global benchmark. Brent is typically more of a global benchmark crude that trade is representative of a global price.
John Bryson:
Okay. Wow. It's fascinating. Let's take the conversation from the price of oil and talk about specifically its impact on oil companies regardless of where they are in the chain. So what do we consider a break-even price for oil for an oil company to make money, be profitable?
David Cohen:
Well, as a rough estimate, marginal cost is around $50 a barrel. But really that varies depending on the basin, depending on where you are in a given date in oil producing basin. No one makes money at $20 a barrel or below, not even Saudi Arabia. Most companies need at least $40 a barrel. And then there are some fields, some basins that break even at $60, $80 a barrel.
And then to further complicate it, you have nation states within OPEC who are less dependent on the price at which their national oil companies make money, but the price at which their fiscal budgets break even, and that can be anywhere from $80 a barrel up to over a $100 a barrel for countries like Venezuela. So the complexity of the oil market is not just one of supply and demand, technology, geology. It's also has to do with global geopolitics as we see repeatedly in the last several years.
John Bryson:
Got it. All right. So we've hit this point now where we've bounced, we think, off the bottom and we're settling in around high teens, low twenties. Is this what a bottom looks like? What are your thoughts going forward? What will it take to get oil back up to a place where most of the companies are profitable and successful?
David Cohen:
In a word, yes. This is a bottoming process, but what's unknown is what the recovery looks like, what the path looks like. Remember, this is a healthcare crisis that's going on with COVID-19. So as we talk, the economy is likely going to be starting up again over the next month to two months in the United States in most states.
But what we don't know is how consumers are going to behave. Does consumer behavior change? Do they drive less? Is there a pent-up demand? Do they drive more? Do they consume more? It's difficult to project that, but I think a most sensible projection is that demand recovers, but that it doesn't recover to where it was previously. Consumers have taken a hit on their incomes, on their balance sheets. There's still concern over gathering and large groups of people.
So a lot of the activities that we used to do, we're probably not going to be doing right away to the same degree that we were. So, I would say that we've probably gone through the worst in the crude markets over the last month or two, but we're not completely out of the woods again. This could be a very long recovery period if demand recovers but is weak for a while, or if we get a recurrence of this virus in either in the fall or as we open up.
So I think those things bear watching, but over time there's been a lot of carnage done. There's a lot of oil being shut in; producers were shutting wells in as prices went negative, obviously. There's a huge amount of supply shut in around the world right now. And so, I think that all goes to help balance out the market over time. But really with 30% of demand down, that's going to be the biggest variable to balancing the market over time. And eventually though, prices always head back to marginal cost or above, and that's typically what happens. So over time, if you look at the curve, you can see it there, there's a recovery back toward $45, $50 a barrel. And that's what I would expect over the next couple of years, potentially sooner.
John Bryson:
Okay. And with that in mind, as a value investor, looking for opportunities, what segments of the oil and gas market do you say do well coming out of this environment, even if it's longer than people hope it is?
David Cohen:
Well, effectively what you're trying to do is find companies or stocks that are discounting lower prices than what your estimate of what long-term cost of supply is. So if you think oil is going to be $50 a barrel, and you have an upstream producer that's discounting 40, and you think over time that they're going to be able to survive because of their balance sheet strength, and the quality of their assets, then you could take a position in an upstream producer on a recovery scenario.
So the potential range of outcomes is very wide. And you're seeing things in this market that we haven't seen in almost a century. Shell just cut its dividend for the first time since World War II. And so the carnage that's happened in this space is really leading to some difficult projections for stocks. Balance sheets are being destroyed; we're seeing bankruptcies all over the place. So as investors, we're putting a premium on balance sheet strength. We always want to be at the low end of the cost curve, and we have this discipline of trying to buy stocks where we think there's real value. And that means to U.S. stocks discounting less than what we think the marginal cost of supply is.
John Bryson:
Well, I tell you fascinating times. I could talk about this for hours, but I want to thank you for sharing the insights that you did share. It was very informative.
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Disclosure:
This podcast is being brought to you by John Hancock Investment Management Distributors, LLC member FINRA SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and other conditions warrant, and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment strategy discussed will be successful or achieve any particular level of results. Any economic or market performance information is historical and is not indicative of future results. And no forecasts are guaranteed. Investing involves risks, including the potential loss of principle.