Market Newsletter – March 2020March 01, 2020
Fear can be a truly debilitating force – while it is an intelligent and natural part of the human response to present and impending dangers, it can also cripple rational processes and hijack the most evolved parts of our brain, societal structures, and economies. In the midst of a pandemic, fear itself can develop a similarly contagious effect to the underlying causes. One of the most powerful responses to fear that we can employ is to be mindful of its arrival, investigate and understand the dynamics of its impacts, and assess those dynamics through a strategic lens that provides clarity amid chaos. Especially true in today’s energy market, chaos (a fundamental force of nature) presents new opportunities that, in time, will result in a new equilibrium.
Before COVID-19 became the dominating global news headline, there was a story developing that is the biggest development in the oil industry since the Gulf War in 1991 and will have rippling effects throughout the energy industry. The failure of OPEC countries and Russia to agree on further production cuts in Vienna earlier this month triggered what has now become a price war between Saudi Arabia and Russia, targeting the U.S. shale industry in a dash for market capture. OPEC and Russia are now flooding an historically oversupplied market with ~12mm bbl/day. Coupled with the demand destruction wrought by the coronavirus, that drove U.S. oil prices below $20 per barrel on Friday, down over 50% and far below the price American shale producers need for newly drilled wells to generate cash. It will take time for this market to recover as the excess supply gets mopped up, and U.S. production is going to be cut as result. The unknowns that follow then, are the questions of when the cuts will happen, by how much, and when will demand begin to rebalance the market. What we do know, is that this has several distinct consequences in the short-term.
Firstly, we will have cheap energy (oil, natural gas, power, gasoline) available to bolster the economy when it is ready. Secondly, chronically low crude oil prices will be bullish for natural gas prices, because lower U.S. oil production means lower associated natural gas output. Additionally, now more than ever, natural gas producers are going to need more revenue, not less, for the commodity in order to service massive levels of debt and to preserve cash. Companies will go out of business in the coming weeks and months in oil/gas and that will also cause production to fall. In short, natural gas prices at these levels are likely to be short-lived and are not sustainable. Demand levels are steadily decreasing in part due to seasonal reductions (shoulder period) but also because of COVID-19 demand destruction. For now, low natural gas prices are expected to remain in the short-term as both production and demand are in declining lockstep, but there is another wrinkle to consider that could lead to a steady reversal in the charts. While capex cuts will take a few months to manifest in the supply part of the equation, it’s important to keep in mind that markets are in the business of anticipating. EIA natural gas projections were already showing declines in overall production in 2020, and when combined with the oil price-war impacts to natural gas production and COVID-19 economic impacts, that scenario is likely to be even more drastic than what was initially thought. Furthermore, production will likely fall off sharply around the same time that demand is expected to increase following COVID-19, meaning we could see a quick lift in natural gas prices as soon as this summer. Whether the economy and commercial activity bounce back (it is a when, not an if) in a V-shape or a U-shape will largely determine the angle of ascent for natural gas and wholesale power prices.
There is certainly an abundance of factors at play, but for the end-user, the opportunity is clear. The economic recovery will begin in a low-price environment. There are opportunities that exist now that did not exist in the beginning of the year, and likely won’t be around at the end of the summer. If you are a on a fixed agreement, consider adding years to your position. If you’re on a hybrid product, consider additional layers/hedges. The future value of these commodity contracts to end-users’ bottom line is something to seriously consider.
We’re no longer in a rational environment, fear and cash are in control. This is a once-in-a-generation opportunity to buy energy when it is cheap. The back-end of the curve is already on the rise, and if chaos is a ladder, why not grab a rung or two and climb ahead of it?