With crude oil futures contracts crashing through the floor into negative territory at the beginning of the week, what opportunities are opening up for institutional investors?
Panic set in on commodity trading floors on Monday because physical storage options for oil were filling up fast, with much less demand for petrol from consumers due to global coronavirus prevention efforts, says Bill Callahan, an investment strategist at Schroders. “The reality is, we’ve never seen demand stop like what we’ve just had. This is uncharted territory for the global economy.”
Adding to the growing list of unprecedented capital markets scenarios in the wake of the coronavirus, the sudden worldwide fall in the demand for petroleum products means some energy companies will survive and some will not, he says.
The major determining factor will be how long oil companies can hold out, says Callahan. Even if the global economy were to switch back on today, there’s still a massive pent up supply of oil that will have to be worked through before prices could return to any degree of normalcy. “Unfortunately, for companies that have lots of debt, time is not on their side, so we will see a huge wave of bankruptcies in the energy field.”
Oil exploration companies have the biggest struggle ahead. Refineries and other entities further down the supply chain will be in a better position when demand for petroleum products picks up again. Energy players with diversified revenue streams will have the best chance of surviving the shock, says Rachel Volynsky, chief investment officer for delegated solutions at Mercer Canada.
“There will be a lot of money made in equities. I think the safest way to play it is through the integrated oil producers. First, they typically have the size and scale and they also have much healthier balance sheets that will allow themselves to survive through this downturn. They will likely have to become leaner. . . . And dividends aren’t safe. There’s obviously no such thing right now as the sacred dividend.”
The energy market is set for a significant period of consolidation since integrated energy companies will be in a good position to take advantage of distressed assets on sale once prices begin to rise again, she adds. “Value managers are probably favourably positioned with their expertise to take advantage of this recovery when it will come.”
Looking geographically, Canada is one equity market heavily tied to the energy sector. But for other economies, the plunge in oil prices will have an inverse effect, says Callahan. “Every coin has two sides. While this certainly hurts the producing countries, it’s a huge help to some of the consuming countries like India and China.”
There’s no telling when markets return to normal, with extremely optimistic guesses putting it at three months, and more realistic estimates putting a recovery six months or even a year from now, says Volynsky. “It’s tough because the industry is pretty much flying blind.”
The market was already oversupplied before the coronavirus shut down much of the global economy, she notes. “So we were already in an oversupplied situation with uncertainty around how much [the Organization of the Petroleum Exporting Countries] can cut. So it wasn’t a very favourable environment for oil to begin with.”
But there isn’t a serious argument to be made that prices will remain depressed at anywhere close to current levels forever, says Volynsky. At current prices, “nobody can produce the amount of oil that is necessary even if we assume the most optimistic transition to a decarbonized world.”
One advantage for institutional investors is the ability to be patient, notes Callahan. “As we see capacity exit the industry in the form of bankruptcy, we will see opportunities on the other side for the players who survive and are able to take market share and actually increase their prices. The wild thing about this cycle is, on the other side, some of these companies will end up being worth more than they were heading into this because their future stream of profits will be higher with all the excess capacity out of the industry.”