The year 2020 has arguably been the most interesting year for crude oil prices ever. As prices seemed to have finally hit some semblance of normalcy, COVID-19 and the related shutdowns led to tens of millions of barrels a day of demand removed from the markets. However, despite that collapse, there’s a strong thesis for oil prices reaching new highs.
Oil Supply and Demand
Fundamentally the oil markets run off of supply and demand. The mid-2014 collapse started with a few million barrels a day extra. COVID-19 obviously caused a massive collapse in demand.
The above graph highlights oil supply and demand through 2020. Here the effects of COVID were clear as the 2Q 2020 went through with a 15+ million barrel / day stock fill. 1Q 2020 resulted in a 6-7 million barrel / day stock fill with the net stock fill across the two quarters at roughly 2 billion barrels. The brief negative oil prices highlights how massive this stock build was.
However, going into later 2020-2021, this will change dramatically. The company will spend the last 6 months of 2020 with roughly 4.5 million barrels a day as a shortage. That will consume roughly 800 million barrels of the stock build up over the last 6 months, resulting in a net stock build of 1.2 billion barrels in 2020.
Long-term, for reasons we’ll discuss, this shortage will continue.
Oil Capital Spending
As a result of COVID-19, oil capital spending has dropped off of a cliff. That’s expected to result in a long-term drop in supply.
The above chart shows oil and gas capital expenditures by company in 2020 and the budget cut. Across the board, for the vast majority of companies, budgets were cut by 20% – 60%. Not included in this are other giants like ExxonMobil that have also dramatically cut capital spending by >$10 billion annualized. That capital spending isn’t expected to recover instantly.
That’s because, even with the coming quarter expected to have a supply shortage, prices are still $20+ / barrel lower than before COVID-19. That means that capital spending will remain low. In fact, as some of the largest capital spenders take the biggest hits, as investors value cash, we expect it will be many years for capital spending to recover.
One example of the capital spending changes is closely visible through one of the largest U.S. midstream companies, Energy Transfer (NYSE: ET) as investors have questioned the company’s debt for growth strategy, despite the yield on that growth. The company as a result, has listened to the market and decided to chase FCF positivity.
The above plan for Energy Transfer’s growth capital shows what we expect for many companies. The company’s growth capital from 2017 of $5.5 billion slowly drifted to $3.4 billion in 2020E. That was already cut from $4 billion at the start of the year. From there its supposed to drop to $1.3 billion in 2021E and ~$600 million for 2022E and 2023E.
This highlights the long-term capital spending decline despite a recovery from COVID-19.
Crude Oil Storage
It’s also worth noting that all of the remaining storage in oil after 2020, the 1.2 billion barrels leftover above, won’t flow back into the markets instantly. Storing oil costs roughly $0.4 / barrel a month at Cushings, one of the major oil terminals and where WTI pricing is determined. At $5 / barrel, the relative cost on a multi-year price recovery is acceptable for many traders.
As long as traders expect a longer term shortage in supply, they’ll continue to store this oil. However, it’s worth noting that even this storage will still need to be quickly used up. Looking into 2021, OPEC is eager to rebound its production from its previous production cuts. OPEC+ sees demand re-surging to pre-COVID-19 levels in 2021 with non-OPEC supply still 2.5 million barrels / day lower.
It’s also worth noting OPEC+ actually sees demand for its crude at 29.8 million barrels in 2021, higher than 2019. How hard OPEC+ pushes for a price recovery remains to be seen, but if they simply go back to pre-COVID-19 production, after the cut ends in December, the non OPEC+ production will remove 900 million barrels from supply in 2021.
Across the board, the shortages seem to be positioned to continue for the coming years. OPEC+ can obviously chase a larger market share, but pre-COVID-19, they seemed to have expected prices around $60 / barrel as a sweet spot.
Oil Price Potential
The potential for oil prices comes from continued OPEC+ production cuts along with a potential resurgence in demand. Specifically, the factor we recommend paying attention to is the chance for accelerated vaccinations for COVID-19.
Russia has announced that starting in the next month it will begin vaccinating its citizens. Donald Trump, seeking to hide the fact that his U.S. response has lost control of the outbreak versus other countries, has announced a similar timeline. Experts have condemned both countries for skipping the medically necessary trials.
However, realistically, the chance of the vaccinations failing in Phase 3 trials is low. Phase 3 trials are to catch issues like thalidomide’s birth defects, but vaccine technology is fairly well understood. Regardless of the safety of those vaccines, if hundreds of millions start to be vaccinated, it makes little sense to not, at a minimum, reopen the country.
That could lead to a large spike in demand well before the December end of the OPEC+ supply cuts at the lower 7.7 million barrels / day level. In the short-term, a several million barrel per day shortage, could lead to a massive increase in oil price before the end of the year. That could reward shareholders well.
For investors, we recommend taking a look at debt-laden oil companies that have continued to perform well. We have written articles about some of our favorite picks in the sector like ExxonMobil, Occidental Petroleum, and Energy Transfer. Rather than rehashing the same thing, we recommend taking a look at them here.
The risks to this thesis are fairly obvious, COVID-19 can always re-surge causing new shutdowns and associated impacts. That would cause oil companies that we’re a fan of to obviously be impacted, the Vanguard Energy ETF has been devastated this year. Still, we feel that the supply and demand numbers point towards a strong recovery for the company.
Capital spending has fallen off of a cliff. We expect it to remain that way for the next several years. Additionally, a supply shortage is expected to start and stay for at least the next 15 months based on OPEC+ forecasts, potentially larger. This combination of factors will quickly eat up storage that has built up this year.
Additionally, in the short-term a vaccine is looking more and more likely which could cause a spike in demand. That could result, with the continued OPEC+ shutdown, in a rapid spike in oil prices. That would result in significant benefits for major oil companies. We recommend taking a close look at our recommendations.
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Disclosure: I am/we are long ET. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Originally published on Seeking Alpha