According to a number of cognitive scientists, mankind uses its unique ability to reason primarily for justifying pre-held convictions, rather than for forming convictions. It is of critical importance for strategists to understand and acknowledge this human tendency, as it causes one to easily fall prey to a number of cognitive biases, which prevent one from seeing things how they really are, and more important for the strategist, how they are likely to become.
One of the most famous cognitive biases is confirmation bias. As we prefer to be proven correct, we naturally incline towards information that confirms our views and try to ignore or reason away information that does not.
This tendency was on full display before, during and after the 2008 Global Financial Crisis. At that time most analysts were continuously behind the facts, consequently underestimating what would happen next, because reality went against ideas and conviction that had become loved in the financial community, such as the perfect market theory and the idea that through derivates risks could be managed away. For most financial strategists, it was simply too painful for many to acknowledge these ideas were incorrect (or at a minimum: contained serious flaws), even though the evidence was there, which would eventually lead Queen Elizabeth to ask them “Why did no one see this coming?”. Of course, not everyone didn’t see it coming. Those who were able to manage their confirmation bias either made a lot of money or became famous…
Now that the world is battling another unprecedented crisis in the coronavirus, the biggest risk for energy strategists is to fall prey to cognitive biases, in which case their forecasts would be about what they would like to see happen, rather than about what is likely to happen. This article is an attempt at forecasting the impact the coronavirus will have on crude oil demand while avoiding such biases.
The Current Situation
First reports of the coronavirus came from China. The first person known to have fallen ill due to the virus was in Wuhan, on 1 December 2019. By the end of that month, the Chinese government realized it was dealing with an epidemic. On 23 January 2020, it implemented its first measures to bring the epidemic under control, which was a quarantine of the affected area. Ever since additional steps have been taken to fight the virus, such as prohibiting large public gatherings, closing schools and universities, and severely restricting travel.
Rather than the virus, it is the measures to contain it that are having a massive impact on global oil demand. As people are forced to stay at home, economic activity essentially comes to a halt. A decline in demand for goods and services, and limitations on the ability of companies to meet the remaining demand for goods and services, affects almost all sectors of the economy. Specifically for crude oil, as demand for transportation-related refined fuels – gasoline, diesel, jet – craters, refineries slowdown or shutdown, which affects crude oil demand. In the case of China, the impact of the slowdown caused by the measures to combat the coronavirus has been estimated to be in the 25 percent to 50 percent range.
China’s measures against the spread of the virus appear to have had an effect, as during March 2020 the number of daily new cases dropped to below ten, most of these being people returning to China from outside, rather than infections caused by a spread of the disease inside China. Consequently, after almost 3 months focusing on stopping the spread of the disease, the Chinese government has switched attention to ramping up the economy again.
However, the virus has spread to other countries. South Korea and Japan reported cases early on. Ever since the epicenter of the outbreak has spread to Europe. Over 80 countries have now reported coronavirus cases, with over 118,000 people affected, forcing the United States also to implement measures to contain a further spread of the disease inside its borders.
The Best-Case Scenario
The Best-Case Scenario assumes the impact of measures to combat the coronavirus is limited, in the sense that they affect the economy while they are in place but not thereafter. Once the measures are lifted, the economy returns to normal.
Since it took China approximately 3 months to bring the virus under control, Best Case Scenario assumes other countries as well will require 3 months. As far as Europe is concerned, it appears to lag China by about 2 months. In most European countries the first cases were reported end-February / early-March, and the containment measures that affect economic activity are currently being ramped up. In the Best-Case Scenario, therefore, Europe should suffer a 25 percent to 50 percent drop in economic activity during March, April, and possibly May. The return to normal would begin end-May, early-June.
The United States is behind Europe, in terms of confirmed cases, numbers of tests performed, and also the implementation of virus containment measures. In the Best-Case Scenario, therefore, the United States should suffer a 25 percent to 50 percent drop in economic activity during April, May and possibly June. The return to normal would begin end-June, early-July.
What this means is that in the Best-Case Scenario, the worst is yet to come for global crude oil demand. Ceteris paribus (all other things equal), the price of crude oil would continue to go down for at least another 2 to 3 months. $20 or even $10 per barrel is a real possibility.
Because the response of the industry to the impact of the coronavirus on the economy is not immediate let alone pre-emptive (that is a cognitive bias in action again, “it won’t be so bad”), inventories tend to fill up as the economy slows down. During ramp-up of the economy following containment of the epidemic, these inventories will need to be drawn down first, before economic activity can really return to normal. For the Best-Case Scenario, this means that crude oil demand will remain affected by the coronavirus containment measures during the third quarter of 2020 also. The earliest possible return to normality globally would be the fourth quarter.
What the fourth quarter would look like for the crude oil price depends on the outcome of the current Supply War between (primarily) Saudi Arabia and Russia, and the impact of the lower price environment on US Shale production. The Best-Case Scenario assumes the major producers do no actually execute their stated intention to increase production but do not agree on an extension of the 2018 production curtailment either, while US Shale growth shifts in reverse as drilling plans are cut and smaller operators go bankrupt.
This would mean approximately 1 to 2 million barrels of additional crude oil supply to the market, compared to 2018. Or, in other words, a return to the pre-2018 production curtailment environment when WTI crude oil hovered in the $45 to $55 per barrel range.
The Worst-Case Scenario
In the Worst Case-Scenario, the measures to combat the coronavirus are assumed to have secondary and tertiary effects. In other words, not only will the economic activity be impacted 25 percent to 50 percent, but this drop will cause bankruptcies, which in turn will cause further bankruptcies. In China, millions of companies find themselves on the verge after 3 months of coronavirus.
Most at risk of bankruptcy are small and medium-sized enterprises, as these usually have less of a financial buffer and more limited access to capital. Especially the hospitality and tourism sectors are exposed. In China, other sectors also have been greatly affected, in particular the sectors that are about discretionary spending (spending that can easily be delayed without major consequences) and require travel, such as the car sector and real estate – people are delaying the purchases of new cars and homes because they can’t travel to the required location or are fearful to do so.
The worsening outlook for these sectors can have an immediate impact as rating agencies lower their assessment of companies’ creditworthiness, which often triggers clauses in debt agreements causing immediate cash shortages at highly leveraged companies. A drop in the share price of a company, caused by the pricing of the financial market in the worsening outlook, can have a similar effect.
In the Worst-Case Scenario, therefore, the measures to combat the coronavirus cause a wave of bankruptcies, which causes an increase in unemployment. This would limit the ability of the economy to return to normal once the virus containment has proven to be effective. In this case, there is no return to normal during the third quarter of 2020. Economic activity would remain depressed throughout 2020, and quite possibly 2021 as well.
How much exactly economic activity would remain depressed, and for how long exactly, depends on the measures taken by governments and central banks.
The impact of the coronavirus on the economy is not due to a sudden drop in spending power in the economy. It is due to an inability to spend, or unwillingness to spend for fear of catching the virus. While containment measures remain in place neither governments nor central banks can do anything to push up demand. Their only option is to offer support to affected businesses, to help them avoid bankruptcy. Effective measures for this would include delaying the due date of taxes or offering financial compensation to affected businesses, possibly on condition they do not lay off staff. The central bank could push for delays in payment of interest on debt and debt repayments. A lowering of the interest rate would be largely ineffective as it won’t drive demand up nor drive companies’ cash payment out down.
Because global debt is essentially double what it was at the start of the 2008 Global Financial Crisis, helping companies to avoid bankruptcy will be no small task. The governments of a number of countries around the world will simply be unable to provide the necessary support, either for a lack of funds or for a lack of ability to manage the task. Equally, delaying the payment of interest on debt and debt repayments will not be an easy thing to achieve because of the implications for the balance sheets of banks. The Worst-Case Scenario, therefore, assumes that the global economy will not return to pre coronavirus levels during 2020.
This means that the crude oil market does not return to the pre-2018 environment as global demand will be lower than it was during 2017 when WTI crude oil hovered in the $45 to $55 per barrel range. In the Worst-Case Scenario, similar to the Best-Case Scenario crude oil drops further during the second quarter of 2020 when the coronavirus containment measures peak in Europe and the United States. Thereafter there will be a slight recovery, as economic activity increases once measures are relaxed but less than assumed in the Best-Case Scenario, as the global economy deals with a wave of bankruptcies.
The Worst-Case Scenario assumes that the major producers do execute their stated intention to increase production – Saudi Arabia by 2 million barrels per day, Abu Dhabi by 1 million and all other OPEC members a further 1 million barrels – while US Shale holds out as long as its crude oil price hedges last and maintains current production. In this case, demand for crude oil will not only remain down by year-end, but supply will also be substantially higher, which could well cause crude oil to hover in the $20 per barrel range by year-end (it is trading with a $24 handle this morning).
The worst thing oil companies can do in the current environment is to assume that things will soon return to normal, and thus continue normal operations. Whatever the 2019 business plans for 2020 said, they are unlikely to have been based on the current market reality and need to be ignored.
New short-term operating plans need to be developed with the greatest urgency, assuming a further decline in the oil price possible to as low as $10 per barrel. Capex plans are to be reviewed on a similar basis.
Looking for cuts in the price of services from the oilfield service sector to offset the reduction in revenues is essentially pointless at this stage, as after some 4 years of continuous cuts these companies are lean to the bone. A slowdown in both operational and project activity could, however, warrant a reduction in headcount in order to bring costs down.
The biggest cash-saving measure, however, should come from a reduction in dividend payments and share buy-back programs. Increasing debt to maintain dividends would be eating into the future, so while liked by the financial markets, it does not make sense from the long-term perspective of the oil company.