Government response to the coronavirus was to shut down economies, causing a massive decline in energy use – not just for oil, but all forms of energy. Estimates are for a decline of 25-35 million barrels a day in April, or a quarter to a third of global oil consumption. Without an immediate stop to global oil output, inventories will explode. But not only did producers not stop producing, Russia and Saudi Arabia engaged in a battle for who could boost oil output the most. In a world with supply already exceeding demand due to rising shale oil output from America, oil prices have been crushed.
After weeks of demand destruction, falling oil prices and mounting political pressure, OPEC plus Russia finally agreed to cut output starting May 1st. Their decision assumes other oil producers outside of the OPEC+ group, particularly the U.S., Canada, Norway and Brazil, would also chip in with output cuts. Until demand picks up, the crude oil supply tsunami will overwhelm the market.
The excursion of oil futures into negative pricing territory was partly a technical issue. Many recent futures contract buyers failed to understand that if you still held the contract at expiration, you had accept having the oil delivered. People unprepared to own barrels of oil panicked and willingly paid buyers to bail them out.
What does all this chaos mean for future oil prices? As demand rebuilds as the world’s economy reopens, oil prices will rise. How quickly? How high? The futures price curve suggests oil will be in the upper $20s a barrel by year-end, but it is not until the end of 2023 that prices reach $40. Even at that level, many oil projects will be unprofitable. Long-term price projections reflect buyers’ views that oil demand will grow slower than historically, and the substantial supply overhang of lower-cost oil will weigh on prices.
Under this scenario, renewable energy will benefit. Technological improvements will boost its competitive position against fossil fuels. More importantly, renewables offer stable pricing, enabling people to better budget their energy expenditures. The oil price trajectory will be determined by the pace of the economic recovery and OPEC+ producers’ willingness to add to supply. Nothing is clear right now.
NATURAL GAS:
Universally, among all the fossil fuels, natural gas is projected the winner of the economic shut-down. Natural gas prices have been struggling in recent months as the surge of shale oil brought forth a tsunami of associated natural gas. So much gas was produced in the Permian Basin that what couldn’t be taken away and had to be burned to not restrict oil well output. The associated gas tsunami pushed prices well below $2 per thousand cubic feet, a longstanding floor price.
Natural gas futures prices bottomed at $1.55/Mcf in early April, coinciding with growing fear for the future of the oil market in light of the coronavirus. The inverse relationship of oil and gas prices was not a surprise, as roughly 75 percent of gas withdrawals come from shale wells. With crashing oil prices, drilling for new oil wells ceased, and with oil prices falling below breakeven levels, companies were even shutting in producing wells, cutting associated gas output.
The natural gas industry’s greatest challenge is falling electricity demand given the economic shut-down. Not only is use lower, but its daily pattern has shifted due to the shelter-in-home orders. As one utility executive described it, today’s pattern is similar to what is experienced on a snowy day in New England: demand begins rising later in the morning with a daily peak never reaching traditional levels. The usage shift mirrors closely the production pattern of renewable energy, helping to further erode natural gas-generated electricity.
LNG is the other natural gas wildcard. So far, about 20 cargoes from Gulf Coast terminals have been cancelled by buyers, but under the “take or pay” terms of contracts, some of these cargoes will still be shipped, with them then looking for alternative buyers. As long as LNG volumes remain around nine billion cubic feet per day, there will be support for gas prices.
The impact of the prospective loss of meaningful volumes of associated natural gas production is sending signals to producers that they may need to begin drilling for conventional dry gas supply. That is why natural gas futures prices are now in the $3-$3.50/Mcf range for this winter, about $1.25/Mcf above the current price. Another signal for improved health of the natural gas market is prices averaging 30-cents/Mcf higher for next summer than for this summer. That premium may widen as gas production falls and demand remains seasonally stable. The greatest risk for gas prices is they rise to levels that makes American LNG uneconomic in the key Asian gas market. Keep an eye on the natural gas star within the energy complex for signals about the health of the U.S. economy, as well as that of the rest of the world.
This story was originally featured in ON&T Magazine’s May 2020 issue. Click here to read more.
