Energy is an expression and a driver of society’s economic health. Prior to COVID-19, the sector was going through massive transformation with the gradual but steady growth of renewables, while also experiencing an intense storm of geopolitical posturing, particularly in oil and gas.

The oil and gas sector permeates much of the investment markets and hence most investment portfolios. It appears through top names in the S&P 500 such as ExxonMobil and Chevron, though the energy sector is just 2.7% of that large-cap U.S. equity index. It also resides in many investor portfolios through credit issues in both investment grade and high yield bond indexes. The cost of oil and gas directly impacts the bottom line of companies across sectors and industries. And of course, the American oil and gas sector directly employs 145,000 individuals and indirectly employs 6.7 million (Source: US Energy and Employment Report).

It has been a challenging time for the energy sector, especially oil and gas, as the confinement measures to control the spread of COVID-19 caused an unprecedented fall in demand for oil. In addition, the Organization of the Petroleum Exporting Countries (OPEC) production talks stalled resulting in increased supply. The reduced demand and increased supply (below) led to a decline in oil prices from $60/barrel at the beginning of 2020 to $12/barrel through April 19, an unprofitable level for many energy producers, including those here in the United States.

The confinement measures instituted by governments globally have caused transportation activity, a large driver of oil demand, to fall dramatically over the last two months. Global airline flights declined by 67.2% from February 21 to March 29 (source: Flighttrader24), while commuter rush-hour is no longer a phenomenon in many large cities. The International Energy Agency (IEA) estimates that global demand for oil in 2020 will drop by 9.3 million barrels per day (mbpd) or about 9% of total yearly demand, even if travel restrictions are lifted in the latter half of the year.

While declining demand has weighed heavily on prices, so, too, has an increased supply from petroleum exporting countries. OPEC+, which in 4Q 2019 produced roughly 45% of the approximately 102 mbpd of global oil supply, initially attempted to negotiate production cuts to meet lower global demand in late March. Disagreement led to an all-out price war in which Russia and Saudi Arabia promised to boost oil production to gain market share by driving out higher-cost producers. On Sunday, April 12, OPEC+ agreed to a 9.7 mbpd production cut (reduced supply) to be implemented beginning in May with support from the G20 and other countries. In addition, the IEA expects a drop in production of roughly 3.5 mbpd from other producers, including the United States and Canada, through market forces.

However, even with the decrease in supply, the demand shock created from the coronavirus pandemic will strain the logistics of the oil industry. April and May could see oil storage facilities nearing capacity, requiring creative thinking around storage and forcing some producers to stop production as pipelines become backed-up, potentially creating a logistics nightmare.

The outlook for near-term oil prices is weak and the near-term price collapse of oil will strain the higher cost producers within the industry—primarily those from the US and Canadian oil shale industry. Some producers likely will not survive.

Implications

Given the uncertainties inherent in the energy sector, Syntrinsic does not think that it makes sense today for most investors to make dedicated energy investments, though almost all investors have meaningful energy exposure through their stock and bond portfolios. That said, as with any distressed sector there can be emerging investment opportunities that arise. The current pressures—combined with the growth in new technologies with both traditional and renewable energy sources—may indeed create compelling investment opportunities ahead. The energy sector generally anticipates and reflects societal changes; we’re eager to monitor and engage in the changes to come.