INSIGHT: Oil bulls sidelined as coronavirus/price war dual threat continues

LONDON (ICIS)–Oil markets are in turmoil as the coronavirus pandemic rips through Europe and the US.The demand destruction has already been vast, and the worst is yet to come.

The OPEC+ safety net is a distant memory, with the major exporters now bent on grabbing market share, further crushing oil prices. The outlook for April remains bearish. However, with the price crash exacerbated on the near-curve, the steepest M1-M12 contango for a decade is presenting some opportunities for traders in the physical market.

DUAL THREAT
The decision by Saudi Arabia and Russia to increase output from 1 April has come at an unprecedented time for oil markets, pumping more crude into an already saturated market.

Saudi Arabia has pledged to increase output to a record 12.3m bbl/day from April, offering this cut-price oil to major buyers of Russian oil.

Russia has promised more modest increases in output, limited by the complex nature of its oil reserves.

Despite Saudi Arabia’s oil being some of the cheapest to extract from the ground ($2 – $10/bbl), the price required to balance the country’s books is over $80/bbl, according to the IMF. This dwarfs the ~$50/bbl that Russia requires, a similar level to that of US producers.

State-owned oil companies have the added cushion of large cash reserves and easy access to additional capital. However, for US shale producers are already swamped with debt, low oil prices could see bankruptcies rise and production fall in the longer-term.

THREE-WAY COLLAR
Almost half of shale producer output for 2020 has been hedged. Many companies opted for a strategy involving complex financial contracts called three-way collars, as they are relatively cheap way to hedge against price fluctuations. However, this leaves producers exposed if the price falls too much, as we see today.

The graph below shows the three way collar strategy of Noble Energy, one of the largest US shale companies. The red line indicates the hedge realisation (the actual selling price per barrel), whilst the blue dotted line shows the price of oil.

Noble Energy, like many shale producers, is now exposed to losses, with oil prices well into the graphs red zone.

The three-way collar has insulated Noble Energy from some downside, adding around $10/bbl to the price of sold oil. However, with the oil price now touching $20/bbl they find themselves deep in the red zone, well below the average shale breakeven.

One-third of hedged output uses three way collars. In the current climate, a loss of ~$20/bbl.

Noble Energy has been increasing its use of three-way collars since the oil price crash of 2014. With around one-third of its hedged output using this strategy.

This strategy is commonplace amongst US shale producers, leaving them heavily exposed to the low oil price environment we now find ourselves in. The situation is likely to worsen in 2021, where less than 5% of output in the sector has been hedged.

INDIA LOCKDOWN
India, one of the engines of global oil demand growth, has announced a countrywide lockdown for much of April to battle the coronavirus outbreak. The country’s crude oil imports total well over 4m bbl/day, with the low oil prices potentially presenting an opportunity to fill commercial storage and strategic reserves. However, domestic demand is set to take a hit.

“The lockdown in India is another blow to the oil market; with people instructed to stay indoors, the annual demand of 90 million tonnes of gasoline and diesel will be impacted.

Gasoline demand will be particularly affected as it accounts for over two-thirds of the passenger vehicle fuel mix.

As with the lockdowns in other regions across the world, this will represent an unrecoverable loss of demand, leaving refining margins lower. Major refiners such as IOC have already announced run cuts of up to 30%, with many others likely to also cut throughput over the coming weeks,” said ICIS Senior Analyst Ajay Parmar.

CONTANGO CONUNDRUM
The front-end demand demolition coupled with pledges to increase production have triggered the steepest contango since 2009. This has allowed market players to push crude into storage to sell for a profit at a later date. However, with consumption languishing, on land storage sites are beginning to fill up.

This has incentivised market players into enter long-term VLCC (very large crude carrier) charter agreements for floating storage.

This fresh dirty charter demand has pushed rates upwards, as the tug of war between contango and freight continued. The deeper the contango in April, the more upward mobility freight rates will have available.

Insight by Richard Price

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