• Outlook for Oil Prices and the Industry in Turbulent Times: A Q&A with Philip K. Verleger

    In early March 2020, oil prices collapsed as a result of simultaneous shocks to the supply of and demand for the commodity. Oil markets are no strangers to volatility, but in March 2020 prices for crude and refined products reached historic lows.

    Amid geopolitical tension among OPEC+ members and uncertainty about the impact of the coronavirus pandemic on the broader global economy, the long-term outlook for prices remains unclear to many. In late March 2020, with oil prices of $40 per barrel, one in six oil executives saw insolvency on the horizon for their firms.

    As insolvent firms begin to negotiate restructuring plans with creditors, oil prices – a key input of company valuation – will play an essential role in determining bankruptcy outcomes. To get a sense of where oil prices might be headed, Analysis Group spoke with Dr. Philip K. Verleger, the president and founder of the consulting firm PKVerleger LLC. Among other corporate, academic, and government positions, he has been a BP Senior Fellow on the Council on Foreign Relations, the David Mitchell/Encana Professor of Strategy and International Management at the University of Calgary Haskayne School of Business, and a visiting fellow at the Colorado School of Mines and the Peterson Institute for International Economics.

    We have seen negative prices for some oil products recently. Some commentators argue that this is the result of simple supply and demand, and that the markets are functioning properly. Do you agree with that assessment?

    Philip K. Verleger - Headshot

    Philip K. Verleger: President, PKVerleger LLC

    The price of oil can go negative in a well-functioning market. The combination of the supply boost from the price war and the consumption drop due to the pandemic created what could be the largest inventory increase ever recorded. This manifested in dramatic rises in storage costs and freight rates. If those holding oil discover they cannot sell it and face sky-high storage rates, they might indeed be willing to pay people to take it off their hands – that is, sell it for a negative price.

    However, while oil prices can go negative in a well-functioning market, this does not mean the market was functioning correctly in April when prices did go negative. In this case, investors with no storage capabilities held oil futures contracts dangerously close to expiry. When this happens, the market may not work as it should, and the prices that result can be driven by a few panicked investors desperately trying to unload their contracts.

    Are these troubling developments all due to the coronavirus pandemic, or are other factors, such as the price war between Russia and Saudi Arabia, also at play?

    The pandemic is the dominant driver. The lockdowns implemented across the world caused a huge decline in global demand for fuel, so the price declines are an inevitable result of basic economic principles.

    Usually, economic downturns are regional. When this happens, inventories can, to some extent, be coordinated and shifted to mitigate the worst effects. But such options are not available in a global crisis like the current one.

    The price war certainly did not help, but as the extent of the economic crisis associated with the pandemic comes into fuller focus, it is becoming clear that the oil industry will be devastated.

    Are the effects of this crisis uniform across the oil and gas industry, or are there significant differences in how different segments are being impacted?

    The lockdowns have collapsed jet fuel and gasoline use. The impact on other products like diesel has been much smaller.

    Unfortunately, refiners find it difficult to respond quickly to sharp changes in demand for different products. This sluggishness is leading to a buildup of gasoline and jet fuel inventories that could threaten the oil industry’s logistical system, which sets the stage for rock-bottom gasoline prices and sky-high diesel prices.

    US refinery configurations have historically emphasized gasoline output, so the current price movements could force portions of some refineries to be shut down. These closings are costly and take time to implement. And ramping up later, after demand starts to pick up again, is equally tricky.

    Additionally, the industry has already started to make substantial reductions in oil production to prevent severe bottlenecks in the logistical system as producers confront a scarcity of storage. My analysis suggests that a reduction of over 30% from pre-crisis levels over three to four months may be necessary to maintain supplies at levels that can reasonably be handled by existing infrastructure. Such a decrease would deal a heavy blow to oil producers.

    “The combination of the supply boost from the [oil] price war and the consumption drop due to the pandemic created what could be the largest inventory increase ever recorded.”

    –Philip K. Verleger

    What are the implications for the future of fracking and shale?

    The fracking business model will face severe challenges if current supply and demand conditions continue. Shale crude oils produce high yields of gasoline and jet fuel, which have a limited market at present, and low yields of diesel fuels, whose market is currently expanding. In the mid-to-long term, shale production will probably remain depressed, as high production costs make the industry’s recovery difficult.

    Fracking was and is a great idea. However, investors poured in too much cash too quickly, driving costs to unsustainable levels. As a result, firms in the industry have rarely succeeded in returning cash to their investors. Restructuring the industry to be profitable at lower prices will be difficult, as the prospects for global oil become less certain and oil-exporting countries with better cost structures seek to increase their market share.

    While the pandemic may be the primary driver of the price declines we have been seeing for oil, what did you learn from watching the price war play out between Russia and Saudi Arabia? Why was Russia resistant to cutting production to support prices?

    Russia was well positioned to endure a price war, as it had achieved a low level of domestic spending and relatively little debt. The reporting that came out as events unfolded suggested that Russia was unhappy with US sanctions directed at its Nord Stream 2 pipeline, which supplies Western Europe. Given this slight, its insistence on low prices was at least partially aimed at independent producers in the US. These companies were mostly able to survive the 2016 price slump by heavily using credit extended by financial backers. But with a credit crunch for the fracking industry emerging in 2020 as part of the fallout from the pandemic, that backstop may not be there. As a result, Russia may have acted because it saw an opportunity to harm US producers substantially.

    We have seen Saudi Arabia take a leading role in combating oil price crises recently. How would you characterize their management of these situations?

    In November 2018, amid an oil price decline, Saudi oil minister Khalid al-Falih said his country must do whatever it took to balance the oil market. The current oil minister, Prince Abdulaziz bin Salman, appears to agree. In one extreme example, Saudi Arabia acted quickly to prevent a price increase after the September 2019 attacks on its oil facilities. The damage done there could easily have caused a supply shock. Instead, the Saudis provided liquidity to stop panic and remove risk premia in the market. Today, instead of a supply shock, we see a demand shock of unprecedented magnitude. While the Kingdom is still working hard to keep prices stable, it is having less success this time.

    The price war ended in mid-April with an agreement by OPEC+ to cut production substantially. Some commentators hope this will stabilize the market. Do you agree with them?

    Their take is far too optimistic for several reasons. First, the agreement did not take effect until May, meaning the oversupply at the time of the deal would continue to grow rapidly for a few weeks. Furthermore, the agreed-on output reduction turned out to be insufficient to support prices, given the demand shortfalls likely to result from the global economic slowdown. World consumption in April and May fell by over 15 million barrels per day compared to February, so the agreed-on 10 million barrel per day output cutback for May and June still leaves a significant source of new inventory accumulation and further price suppression. Even under the more positive economic projections with this agreement in place, I do not expect inventories and prices to stabilize until midsummer.

    More worrisome for the industry are the effects of the shunning of global air travel, a move away from globalization, a prolonged recession, and a shift to remote working – in short, structural changes in how the world and national economies function. These could create an exogenous shock that keeps oil demand low for years despite, should it occur, a strong global economic recovery. Global fuel use was around 100 million barrels per day for 2018 and 2019, but may decrease to 90 million barrels per day by 2025.

    The return of prices to around $40 per barrel cannot be interpreted as a return to stability. Consumption of oil has been boosted by the CARES Act in the US and by similar stimulus measures in other countries. The high level of stimulus is temporary, and eventually its support for oil prices will be removed.

    Who won the price war?

    Economists like to say that no one wins a price war. While that can be debated, the US unquestionably lost this one. US producers have higher costs and so could not compete with the low prices that resulted from the war. Saudi Arabia likely did not welcome the price battle. Still, the country managed by using its excess production to tie up shipping and storage capabilities, further squeezing US producers and boosting the enormous pressure on the industry. While the Saudi goal of hampering US competitors is less clear than what we have seen with Russia’s actions to do so, the Kingdom will likely benefit from these developments just the same, especially as the higher prices that may eventually result would help fund its ambitious development program.

    What do you think about the rest of the oil industry’s future? Do you foresee bankruptcy as an issue? What do you think the oil price will be at the end of 2020?

    Although I’m certainly not optimistic about any near-term stability, the current supply and demand situation is temporary. The global economy will revive, along with demand for gasoline and jet fuel. The first-quarter 2020 Dallas Fed Energy Survey of oil executives indicates an average expected price of $40.50 per barrel for West Texas Intermediate by the end of 2020. At $40 per barrel, roughly half of these executives believe their firms will remain solvent for four or more years, while about one in six expect their firms to stay solvent for less than one year.

    I am less optimistic and so expect the WTI price to be around $30 at year-end 2020. At that price, that one-in-six expectation for bankruptcies will almost certainly rise. Since the beginning of March, 15 independent producers with debt of nearly $10 billion have filed for bankruptcy.

    In the face of lower prices, independent producers will need to write down their reserve valuations. This will further threaten the survival of these companies. The reduction in reserve valuations will also limit the ability of surviving companies to raise money.

    Beyond what you have already discussed regarding Saudi Arabia, Russia, and the gloomy outlook for US fracking, how will such a low price play out for multinationals?

    The era of multinational oil firms dominating the energy sector has passed. Multinationals have already been confronting high-cost legacy projects and the related investor shunning. They now need to face the ever-growing interest in renewables. The multinationals are highly efficient at developing large, complicated projects, and so are more likely to succeed in capital-intensive undertakings rather than labor-intensive ones. These include developing carbon capture, offshore wind, or biofuel facilities.

    Unfortunately, such projects require significant capital expenditures, and given the continued decline in oil prices, the chances of multinationals investing in capital-intensive renewable energy projects seem lower than ever. But with concerns about climate change growing so much, multinationals that neglect to participate in the transition to a low-carbon economy may find themselves left behind.

    How do you think global concerns about climate change will impact the oil industry more broadly in years to come?

    Such concerns have already started playing out. Concerns over global warming and the adoption of electric vehicles are two key factors that have led to the oil industry’s rapid fall from its perch at the top of global financial markets.

    Peak-energy apostles did not foresee a revulsion toward hydrocarbons coming. Most people in the world likely want to see measures to replace oil with conservation or renewables accelerated, which would speed the industry’s demise.

    In 1980, the energy sector accounted for 29% of the S&P 500 index. Forty years later, at the end of May 2020, energy accounted for only 2.8% of the index. The oil industry has fallen dramatically as a share of the market, and now the industry faces the prospect of a long-term suppression of demand due to the pandemic and its economic consequences. Diminished growth prospects will limit investment, and lower oil prices will limit internally generated cash. Much higher prices would be required to generate large amounts of cash internally – and much higher prices would only accelerate the move by consumers away from oil.

    The obvious conclusion is that oil faces long-term challenges that may be difficult to overcome. ■