Introduction

The oil market and oil stocks already looked poor entering 2020, and in Q1 they were impacted by not one, but two black swan events; an unprecedented demand collapse due to COVID-19, and the breakup of the OPEC+ cartel. In the following section we recap the outlook for the oil sector and how we see it effecting the energy transition, with a particular focus on the move to EVs, the area most obviously impacted by sustained low oil prices.

Our main conclusions are:

• The oil sector has been a slow moving ‘train wreck’ since the emergence of US shale and the global energy transition. The COVID-19 demand crisis has only exacerbated this.

• Ultra-low oil prices and widespread energy sector bankruptcies make the oil sector susceptible to political intervention which can create short term ‘pops’. However, in the face of so much demand disruption, political actions will struggle to reverse the oil price downtrend. Therefore the sector remains an unattractive asset class for now, from which we can identify some good short opportunities.

• Today oil is mainly a transport fuel, and thus renewable generation is largely unaffected by low oil prices. Low oil prices could have a negative impact on alternative drive trains, EVs, biofuels, hydrogen – in the transport sector, particularly in the US where relative fuel cost has been more of an incentive to switch than in other parts on the world.

The Oil Sector Entered 2020 in a Poor State Already

The global energy industry has been in a crisis for the last few years. Negative equity returns have caused capital to flee the space, stretching balance sheets and creating distress.

Nowhere is this more pronounced than the US energy sector, which, on average, sits higher on the cost curve than most other international assets, both onshore and offshore. US E&P is the worst performing sector in the equity market over the past decade, with energy now representing less than 3% of the S&P 500 Index, an all-time low. The international energy sector has not fared much better; last year the Stoxx Europe 600 Oil & Gas Index capped off a decade of underperformance vs. the Stoxx 600 Europe Index (the "lost decade").

The energy business model is based on resource scarcity, and that premise drives capital allocation decisions, executive compensation schemes and valuation methodologies. With ample production and weak demand, there is currently no scarcity, and it is unlikely to materialise on a sustained basis. Growth in production was fuelled not only by equity capital, but also debt from banks and high yield offerings. To make matters worse, this era of plentiful supply is concurrent with growing uncertainty around the trajectory of long-term demand growth. This has been emphasised further by increased climate awareness, resulting in only a limited role, if any, for oil in a climate sustainable world.

COVID-19 Has Created an Unprecedented Demand Destruction

COVID-19 related issues have impacted over 90% of global GDP, causing oil consumption to plummet. On our analysis, we believe peak demand destruction in April could exceed 30mn b/d (c.30%), an average 20mn b/d lower y-o-y (and 18 mn b/d lower on a q-o-q basis for Q2). We assume Q3 is around 8mn b/d lower y-o-y, though it remains unclear how quick the recovery will be, and second round effects may indeed impact demand for many quarters to come.

These numbers are simply off the scale. Since oil made its debut in the late 1800s, the oil market has not experienced anything even close to this, including during wartime. As a comparison, at the peak of the GFC, demand destruction was c.2.9mn b/d for two quarters, around 10% of what we are likely to experience in April alone. Production cuts cannot offset this until the lockdowns end and the economy comes back meaningfully.

The current rate of oversupply means global inventory storage is building at an unprecedented rate. The c.1bn barrels of combined OECD and non-OECD spare storage will fill to capacity by summer, however the problem will become much more acute before then. Inland pricing for some crudes is already trending towards zero due to a lack of demand from refineries and localised storage/pipelines reaching capacity. Major shut-ins are required over the course of Q2 (our running total suggests only c.1mn b/d has been shut in (mostly in Canada) as at early April).

We believe global inventories will be full by mid-2020, however some localised storage will fill long before then e.g. Saldhana Bay in South Africa (the largest oil storage facility in the Southern Hemisphere), is already close to tank tops.

Oil Politics Attempt to Adapt to the New Reality But Cannot Change the Outlook

Oil is the most important commodity in the world and the future of many countries and regions depend on it. Therefore since the 1970s we have come to accept an order which would not be accepted anywhere else; a cartel that dictates the supply for a significant part of the market, keeping the oil price artificially high. The argument being, it is this cartel rather than the market that has ensured stability to supply volumes and prices.

Over the last decade US oil supply has grown almost exponentially. The US global market share nearly doubled from 8.9% to 17%, reaching a production peak of 12.9mn b/d in November 2019.

In 2014 Saudi decided it could no longer hold back production to artificially inflate prices and started to flood the market with low cost barrels. The solution to this came in 2016 when the OPEC+ cartel was formed i.e. a direct cooperation between the then two largest oil producers in the world.

However, the COVID-19 demand destruction means even the OPEC+ cartel is incapable of managing the supply/demand balance. On March 6th 2020 at the 178th meeting of the OPEC cartel, Russia, leading the 10 non-OPEC members of the alliance, refused to sign an agreement to cut another 0.5mn b/d, alongside a 1 million b/d additional cut from OPEC members. Russia rejected being cornered into a deal, putting the alliance forged in 2016 at risk of falling apart for the first time. This set off a chain of events that will change the face of the commodity market for the foreseeable future. Since the meeting, Saudi has, dropped official selling prices, diverted cargoes away from domestic consumption and leased 30 additional crude tankers, signalling an attempt to maximise production. As of April 2020, upon official expiry of the OPEC+ agreement, Saudi has increased production by c.2.5mn b/d to 12.3mn b/d.

In early April, President Trump brokered a rapprochement between Russia and Saudi Arabia which led to an emergency OPEC+ meeting on April 9th 2020, followed by a G20 meeting the following day. Even before the official “tweet” announcement from Trump, we covered some of our short positions in oil companies and oil services with the expectation that some form of a deal was likely forthcoming. As it turns out, the key members of OPEC+ agreed headline cuts of 9.7mnb/d (although we calculate the actual cut vs 1Q20 production to be closer to 7.5mn b/d). Of particular note is that Russia and Iraq are expected to deliver cuts of 3.5mn b/d (out of 7.5mn). Neither country has a spectacular track record of compliance (typically c.60%), even when previous combined agreed cuts were as low as 0.5mn b/d.

Despite the deal driving up oil prices in the short term, we think the underlying problem for the sector remains demand. Demand growth is already softening due to new (often electrical) technologies, but we see this only getting worse. COVID-19 will impact not only air travel, but at the margin road transport demand as well. In a situation where you see essentially no oil demand growth this market will struggle to balance unless oil prices remain low. We would not be surprised to see oil in the $30s or $40s for an extended period of time.

Where to From Here? Long and Short Opportunities

We believe the current oil crisis will result in the restructuring the energy industry so badly needs. As we have previously discussed, what matters is the supply and demand of capital, not the supply and demand of barrels; as long as there is capital, companies can withstand difficult periods. The difference between today and 2015/16 is shale and high-cost oil producers have already been facing sharply higher costs of capital over the past year due to persistently poor shareholder returns. Indeed, these capital restrictions have only been exacerbated by recent events, making the likelihood of capitulation by US E&Ps and EM producers much higher today. This could create some interesting opportunities on the long side.

However, regardless of any potential OPEC agreements, nothing can change the fact that oil is a ‘loser’ in the energy transition. We believe the world will inevitably transition away from fossil fuels and the US public E&P sector is woefully unprepared. In our view, the thesis is very simple, and we apply it broadly across our investment framework: are you 'with' or 'against' the energy transition?

Clearly the business model of most Oil & Gas companies is challenged in supporting the energy transition. Companies should accept this, and look to maximise cash returns to existing shareholders. These companies could be good investments if they focus on selling assets, cutting costs, repairing balance sheets and returning capital to shareholders at an accelerating pace. Despite all the forces conspiring to make the traditional hydrocarbon energy sector uninvestable today, we believe sector disruption presents emerging opportunities on both the long and short side.

Impact on Energy Transition – EV Sales in the US the Main Risk

The chart below shows the distribution of global oil demand. Today oil is mostly used in transport and chemicals. A generation ago oil was a common fuel in power generation, but this is now only significant in a small and rapidly falling number of oil producing nations, notably Saudi and Russia, and some small scale power generation in the world’s poorest countries.

As most of the energy transition until now has been about the decarbonisation and expansion of the electrical system, it is obvious from the above chart that a falling or rising oil price has minimal impact.

While renewables stocks often correlate with oil prices from a trading perspective, the largest renewable sectors (wind and solar) compete in the electrical power market, where oil was phased out as a fuel decades ago. In major power markets the marginal price setter for power is today either coal or natural gas. Historically natural gas prices were heavily correlated to oil prices, but over the last 10 years gas prices in Europe have shifted from oil indexation to spot pricing, while Asian LNG is increasingly priced off American Henry Hub gas prices. Therefore, the oil and renewables correlation is almost entirely a function of index composition and oil prices as a short term risk-on/risk-off indicator. In our view, the main COVID-19 impact on the renewables sector is likely to come from the credit market. The growth has been fuelled by asset rotation among developers and we could see this slowing down as the M&A market weakens.

The same is true for electrical equipment, or energy efficiency focused industrial companies which compete in the electrical (not oil) value chain. As a consequence most of the companies focused on energy efficiency, such as Trane Technologies, OTIS and Schneider, will also see limited impact, as the savings of their products are driven by end consumer electricity prices.

Chemicals

In the chemical sector the main competitor to oil so far has been natural gas, particularly in the US, and the sector was just about to enter the energy transition with more focus on biomaterials. For chemical producers, a lower oil price will have a seismic impact as costs of oil based chemicals are now competitive with cheap natural gas producers from the US and Middle East. There is also pressure on the use of recycled materials due to cheap virgin plastics. As several bioplastics are derived from recycled materials, there would be more supply of recycled materials for this industry and opportunity to increase scale. However given the price drop in virgin plastics (nearly 40% YTD), the price gap between bioplastics and virgin plastics has increased and may slow down the adoption curve. Currently bioplastics production is only around 2.1 million tonnes, 1% of the global plastics consumption (above 350 million tonnes). The production of bioplastics is expected to rise to 2.4 MT by 2024. According to our conversation with companies, there is huge pent up demand for this material. The trend of energy transition towards bioplastics is its infancy and mainly driven by corporate objectives from more ESG innovative companies as well as consumers. We do not think a $10/bbl lower oil price will have a significant impact.

Transport Sector is the Most Impacted

We see limited impact near term for aviation and marine transport as the energy transition has not yet reached these industries. However this was about to happen and it is likely to be somewhat delayed, as many airlines simply do not have the financial resources and the relative cost of going to alternative fuels would be higher.

We see limited impact for buses, as these markets are driven by city regulation and local emission targets. While payback periods will lengthen, we do not believe this will be sufficient enough to change the tender rules. The same applies for rail, where electrified networks in Europe and Asia would simply not allow diesel locomotive operations, and in either case even at spot prices diesel would be far more expensive to operate than electric trains. Rail is also unique in that even with free oil prices, a conventional diesel train would not be able to compete with the technical performance of electric trains. Where the lower oil price might have an impact is in delaying the transition from diesel to hydrogen on long distance freight trains in North America.

Lower oil prices are likely to be a real headwind for electrification of road transport, particularly for passenger EV demand outside China and Europe, as well as commercial vehicles globally. Electric cars and trucks are significantly more expensive to acquire than conventional petrol/diesel alternatives. Fuel costs are major expenses for both the consumers and fleet operators, and the opportunity to save significant monthly operating costs have been a core marketing argument for EVs.

The impact will likely be the largest in the US, where gasoline is lowly taxed, and consumers are already seeing substantially lower pump prices. In Europe, gasoline and diesel are heavily taxed, and hence the impact on fuel substation is somewhat more protected. However in places like Germany, where electricity prices are also very high, the fuel savings from EVs are likely wiped out by a lower oil price.

For customers thinking about buying an EV, they are not only facing a purchase price which is $8,000-$15,000 higher than a similarly sized gasoline car, but are now also facing incremental fuel costs in markets such as Texas and New York, and no or limited savings in California and Germany. While many consumers and corporates may still want to drive an EV for the environmental benefits, the change in total cost of ownership is likely to set back adoption rates several years.

The second, and more important element protecting EV sales in Europe and China is regulation. Both regions are facing strict CO2 regulation, which will force automakers to sell increasing volumes of electric vehicles regardless of fuel price. This however only acts as a floor to volumes, and is not driving mass market adoption anytime soon. The reduced competitiveness of the products is also likely to lead to a downgrade in mix, with automakers focusing more on smaller, city-type EVs. Plug-In Hybrids should also be better positioned, especially amongst fleets, as in a low fuel price environment they offer a good trade-off between purchase price, fuel cost and zero range/charging anxiety. A 20% shift from Pure EVs into PHEVs in Europe and China, and a 30% drop in EV sales in the rest of the world vs. our old assumptions, will reduce global demand for batteries and battery materials such as lithium and NMC cathodes by 10-11% in 2022, extending the current oversupply situation in most of these markets.

While the commercial forces are clear, there is scope for some regulatory tailwinds. For example, governments could offset a portion of the drop in oil prices by increasing taxation, both on the fuel itself as well as on the vehicles.

The consequence of all this, is not only a delay in mass market EV adoption, but potentially also an increase in overall oil consumption globally. Following the decline in oil prices in 2015-2016, we saw a sharp increase in vehicle miles driven in the US, as well as a step up in global air traffic. Short term, the impact on demand elasticity will of course be more than offset by the impact of COVID-19. Assuming Saudi and Russia continues its strategy of increasing market share, global CO2 emissions might jump to new highs as the economy normalizes. Given the already elevated focus on climate change, regulatory risks for fossil fuels will only increase, in our view. Therefore sectors such as wind, solar and HVAC, are not only well protected short term, but might actually end up with increased support medium term.