Could We Get An Oil-Driven Stagflation Shock?

Over the past week we have witnessed an unprecedented collapse in the benchmark US WTI oil future price to outright negative levels. This was due to the Covid-19-related collapse in demand and the inability of many producers to ‘shut-in’ production quickly enough to avoid reaching the effective storage capacity limit. As a result, producers were potentially willing to pay storage facilities to take the oil off their hands and so there was no positive bid left for the front WTI contract. It is now known that at least one large oil ETF, USO, waited until the last minute to roll a large long position and was consequently caught up in the collapse, implying its investors have been wiped out.

Global oil prices have also headed sharply lower, with the tanker fleets increasingly full, but sitting idle, waiting for demand to recover. Given the Covid-19 lockdowns, however, it is unclear how long this situation will persist. In the US, it is estimated that the capacity limit will be reached as soon as in May, so unless demand recovers before then, US and probably global oil prices will remain on the floor or, in the case of WTI, possibly go outright negative again.

While the technical issues within the oil market will certainly be resolved over time, investors need to consider the broader macroeconomic implications of these developments. Oil is the world’s most widely traded commodity; it is an input into essentially all forms of economic activity in one way or another, so it is difficult to imagine that any major macro variable, stock or bond market will remain unaffected. While at first glance a collapse in global energy prices would seem deflationary, the opposite might eventually be true. Indeed, a case can be made that the present supply dislocations in the oil market, combined with the ongoing Covid-19 demand shock, could lead to a ‘stagflationary’ outcome negative for growth yet implying higher oil prices in the future.

 

The High Costs of Shut-Ins

From the perspective of an oil producer, shutting in production is about the worst thing that can happen. Not only does it normally only occur when prices are well below where the producer would make a profit, but there are fixed costs associated with taking a field offline. Most oil fields are set up to produce at a mostly regular pace, with an optimised schedule for well-by-well maintenance. As such, not only do production revenues fall to zero, there is a one-off charge which can be substantial. Moreover, some fields are more expensive to shut-in than others, depending on grade of oil, type of well, and several other factors.

There are also legal considerations in that many fields have multiple smaller production leases with production cessation clauses which normally kick in after 30 to 90 days. Bank lending terms also have covenants that could affect access to credit lines in the event production is shut-in. Whether or not there will be some form of official support for distressed production is unclear. But it is precisely the distressed fields facing a potential breach of one or more legal or financial covenants that are least likely to shut-in.

Shale production in particular is based on a complex extraction process that, once started, needs to continue at a steady rate or it risks damaging the future potential of the field. Already marginal in terms of their profitability at higher average prices, much North American shale production is therefore in danger of not only being shut-in but, when restarted in future, perhaps even more expensive. Producers will certainly try to limit those shut-ins to those wells and fields that offer relatively high production flexibility.

It is worth pointing out that a substantial portion of shale fields were developed with oil price assumptions of $50/bbl or higher and so have never reached sustained profitability. Their survival to date has largely been possible due to the artificially low level of interest rates maintained by the Fed following the financial crisis of 2008. While not intentionally, Fed policy has therefore contributed to large excess capacity for chronically uneconomic oil production. While no one could have seen Covid-19 coming, in a way, the pandemic is revealing what many shale industry analysts already knew: many projects were simply not viable long-term in a sub-$50/bbl world such as we have now inhabited for some time.

 

The Second Wave Danger

While Covid-19 may be a completely one-off event without subsequent waves of infections and lockdowns, this remains highly uncertain. As such, a marginal producer weighing the pros and cons of either continuing production or shutting in must take a view on the longer-term future for demand and storage capacity. Moreover, there could also be lasting socioeconomic changes shifting the demand function for oil, for example a large shift towards working from home for those workers so able. More working from home implies fewer car journeys, the single largest source of demand. Given this outlook, over the coming months some uneconomic producers might choose to shut-in permanently by declaring bankruptcy.

By contrast, lower cost global producers, such as Saudi Arabia, other OPEC, or Russia, do not face the same dilemma. They are likely to continue to be able to produce at a profit, however small, even if global demand does not fully recover over the coming years. While overall lower demand and lower prices are hardly a reason for lower-cost producers to celebrate, these do improve their competitive position and market power in future, something that may have unpleasant geopolitical consequences for US influence abroad.

 

The Evaporation of Liquidity and End of Just-In-Time Production

Another longer-term consequence of recent developments is that liquidity in the US oil market is unlikely to remain as high as it was previously. The price collapse is largely a function of the financialisation of the market through the participation of large ETFs and other non-commercial players in the futures contracts. Market participants normally welcome speculators into a market due to the additional liquidity they provide, reducing the costs associated with hedging production, in particular when volumes are higher than anticipated. Speculators may demand a small ‘premium’ in exchange for providing liquidity, but academic research shows that, as a general rule, market insiders are net beneficiaries of speculative liquidity.

Given the extremely complex nature of the entire oil value-add chain, from production to storage and transport, through to refining and further storage and transport, the ability to hedge both crude and distillates as either a producer or consumer is of central importance to operating an efficient, largely ‘just-in-time’ industry. However, recent developments may well scare a large portion of speculators away, and this withdrawal of liquidity is likely to increase the overall industry costs associated with hedging and general risk management through the available financial infrastructure of futures, options, OTC swaps and other instruments. While some insiders will likely benefit with their ability to dominate specific niches, the overall industry will find it difficult to operate as efficiently as before, with the costs eventually passed along to consumers.

With the uncertainties around Covid-19 increasing the uncertainty around future demand and storage capacity, and the shut-in costs and marginal shale projects increasing the uncertainty around supply, the industry is likely to perceive a large net increase in the overall operational risks. Other factors equal, as operational risks increase, financial leverage must be scaled back. Given that liberal use of low-cost leverage has functioned as a de facto subsidy for marginal supply over the past decade, this is also likely to contribute to longer-term upward pressure on prices.

 

The Permeation of Oil Throughout the Economy

There is a saying in the oil industry that the antidote for high oil prices, is high oil prices. That is, high prices result in more exploration and other investment in future production, which always needs to be replaced as existing fields mature and deplete. But the opposite is also true: the antidote for low oil prices is low oil prices, as exploration all but ceases and mature or declining production is less likely to be replaced. Over the course of a few years, especially if depletion rates are high, the impact on the supply side can be substantial.

If the Covid-19 shock follows the traditional pattern in this regard, then, combined with the new uncertainties and potential market inefficiencies discussed above, the longer-term result could be an overall shift higher in the oil price curve. While supply is highly inelastic in the short term, it will adjust structurally lower over time. But longer-dated prices must encourage the eventual replacement of currently depleting fields. As it stands today, long-dated prices are not high enough to encourage explorers and producers to take the risks and make the investments required to develop replacement fields. Interest rates may remain low but given the perceived higher credit risks associated with the industry post-Covid-19, the actual cost of capital may remain stubbornly high, discouraging new investment.

Consequently, higher prices may be the only longer-term ‘cure’ for the industry. It may seem ironic, but the oil industry is not the only one that tends to go through such boom-and-bust cycles as short-term inelasticities eventually work themselves out. Other highly capital-intensive industries can look much the same. Commercial real estate development also tends to follow this pattern. But as discussed above, oil permeates the global economy to a greater extent than these other industries as it is a key input into all other others and, indeed, the single most important commodity input to growing and maintaining the entire capital stock of a modern economy, even that which is intangible.

 

The Spectre of Stagflation

Given its central importance to the global economy, if the Covid-19 shock results in an eventual shift higher in the overall oil price curve, the net macroeconomic effect will be both negative for growth and positive for prices: a stagflationary mix. When placed alongside the global macroeconomic policy response—to provide unprecedented fiscal and monetary support for demand, while interrupting supply chains with lockdowns—the overall risks of a stagflationary outcome are unusually high.

The global economy hasn’t seen a general stagflation in decades. But as in the 1970s and early 1980s, the implications for stock multiples and bond markets are negative. A rising price level will erode the value of long-dated bonds. As bond yields rise, they may eventually begin to compete with stocks as a source of investment returns. Stock prices may not decline outright as firms can pass along cost increases to consumers to some extent, thereby maintaining overall nominal revenue growth, but due to overall lower economic productivity and compressed profit margins, earnings multiples are likely to decline.

In such an environment, certain commodities may outperform financial assets generally. Oil may have a long way to rise from here as the industry restructures. Precious metals are a well-known, proven source of wealth protection in a stagflationary environment. And certain other industries, such as agriculture, may find that their overall pricing power increases as globalisation generally slows down in a post-Covid world in which pre-existing trade disputes will likely linger.

 

 

 

 

John Butler has 25 years experience in international finance. He has served as a Managing Director for bulge-bracket investment banks on both sides of the Atlantic in research, strategy, asset allocation and product development roles, including at Deutsche Bank and Lehman Brothers.

 

 

 

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)