Oil price shock: the implications

Oil price shock

The Coronavirus outbreak has caused widespread disruption in equity and bond markets, but it has also had some major repercussions for the oil price. This week, the cost of a barrel of oil turned negative for the first time as demand plummeted. That means oil producers are paying buyers to take the commodity off their hands. What are the implications for investors?

The lockdown measures have decimated demand for oil. At the start of the year, oil demand ran at around 100m barrels a day. Today, it has dropped to just 70m as airlines are grounded, transport systems run on reduced services and manufacturing operates below capacity. This gap has created a surplus, which needs to be stored and there are fears that storage capacity could run out. Far from ‘liquid gold’, oil has become almost worthless.

This hasn’t been great news for the oil majors – BP’s share price, for example, is down over 40% since the start of the year, while the share price for Royal Dutch Shell has seen similar falls. These are two of the largest dividend payers in the market, so their weakness is bad news for those equity income funds that rely on these two behemoths for their income.

However, the oil majors may emerge stronger in the long-term as the weaker price sees off weaker competition, notably the heavily-indebted US shale industry. The shale industry has a higher cost of production and looks extremely vulnerable with oil prices at these levels. Mark Lacey, head of commodities at Schroders says: “Despite many oil companies cutting capital expenditure by up to 50%, many, many companies are going to go bankrupt. Around 80 oil and gas companies filed for bankruptcy in the 2015 sell-off. The current situation is far worse than 2015, so the industry is going to look very different after this wash out.” He believes these bankruptcies will not be limited to the US, but will also likely occur in Asia, Latin America and Europe.

In normal circumstances, a lower oil price would give a boost to the global economy. However, it is difficult to take advantage of lower oil prices when economies are in lock down. As such, it may not help as much as in previous shocks.

Many do not expect the oil price to remain at these levels indefinitely as companies adjust production to match the new reality. However, its ongoing volatility may unsettle financial markets at a time when they were already finding plenty to worry about.