Skip to main content

Why Oil Prices Are Stuck in the Mud — ICYMI

Publish date:
Video Duration:

Investors are looking ahead towards the eventual end of the coronavirus and a return to economic growth. And OPEC has cut oil production. But oil prices have given back their recent gains. 

One might think that, as the S&P 500 had fallen 34% from its all-time high and then rebounded 30% from its 2020 low, oil might follow the same path. Crude oil, down about 66% year-to-date, hit a 2020 low of $20 per barrel in late March, as the coronavirus decimated oil demand and OPEC struggled to come to terms on an agreement to limit production because Saudi Arabia and Russia refused to end their competitive price war.

When news broke that OPEC was meeting and progressing towards a production cut agreement, crude oil rose 40% to $28.34 from its 2020 low. It has completely given up that gain, driven by an 8% down day Thursday. 

OPEC agreed to cut oil production by 9.7 million barrels a day in May. The production cuts will fall to a 7.7 million barrel per day cut through the end of 2020 and 5.8 million through April 2022. 

Three main drivers are at play, one of which is long-term. The market had already priced in an agreement between OPEC members, which is why the day the agreement became official -- Monday -- oil only rose less than 2%. 

"Oil prices and equities priced in the OPEC+ deal last week, which explains Monday’s underwhelming market response,” wrote UBS’ Chief Investment Officer of Global Wealth Management, Mark Haefele in a note. 

Secondly, the supply glut is daunting and current production cuts may be insufficient to lift price very much. "With demand likely down 20mbpd (20% year-over-year) this quarter on the back of COVID-19-related disruptions, the agreed cuts, which only become effective on 1 May, won't be enough to prevent oil inventories from rising sharply over the coming weeks,” Haefele said. Of course, holding demand expectations constant and then removing some supply, price should be supported, which Haefele recognizes. 

Thirdly, clean energy is a long-term headwind to oil, but the market hasn’t yet returned to focusing on that factor. 

As the economy rebounds, whether that’s more gradual or sharper, UBS sees oil reaching a price of $43 per barrel, representing more than 100% upside. But "it is too early to become outright bullish on the oil and gas sector given the many uncertainties around the supply and demand factors,” Haefele said. 

That could make oil stocks a good buy. 

The larger ones have been less volatile, as they’re less indebted relative to their earnings streams. Chevron, BP oil and Exxon Mobil are down 28%, 35% and 39%, respectively. 

But smaller companies, with heavy debt burdens, could see huge upside, as they’ve experienced huge downside year-to-date. Occidental, Apache and Halliburton are down 64%, 69% and 66% for 2020. 

Some have expressed mild concern over potential bankruptcy for small and indebted oil companies, as they see revenue estimates plummet to scary levels. Occidental and other small players have cut capital expenditures to shore up free cash flow and they’ve cut their dividends to conserve cash and stay as liquid as possible. 

Investors are now looking for a return to economic activity as lockdowns globally begin to ease. Plus, central bank and fiscal stimulus is aiding consumers and companies through the recession. Most recently, the Federal Reserve has begun buying high-yield corporate bonds to keep the price up and cost of borrowing down. High yield bonds have sold off in 2020, which was another threat to oil companies. Many point out energy’s outsized weighting in the corporate hill yield bond market, so the Fed’s purchase of high-yield bonds is a welcomed sight for investors. 

As for the broader economy and financial market in the near-term, low oil prices are a minor tailwind, among other positive and negative factors, for consumers. They’ll pay less at the pump. That may support consumer spending somewhat, which is certain to plummet in the near-term. 

The main point: oil-exposed investments now offer a better risk-reward scenario than earlier in 2020.

Catch up on the Latest Videos on TheStreet!

Related Videos