While investors around the world have been captivated by the noisy upheaval of the banking system, the energy space has been quietly tanking.
The benchmark for American crude oil dropped as low as US$66 per barrel on Wednesday – a far cry from the US$124 peak hit around this time last year.
Canadian oil and gas stocks have been dinged as a result, with the S&P/TSX Capped Energy Index down by 15 per cent in the last two weeks.
Those who keep a close eye on the energy sector know this kind of reaction all too well. Whenever turmoil strikes, heavy volatility in the energy complex is almost certain to follow. The early days of the pandemic, for example, saw oil prices turn negative for the first time ever.
But the Canadian oil and gas sector sports a much different look than it did at the outset of calamities past. Two years of industry-wide austerity have slashed debt levels, scaled back growth plans and cut costs.
Canadian producers are not as vulnerable to a downturn as they once were, said Randy Ollenberger, managing director of oil and gas equity research at BMO Nesbitt Burns. “They’re at debt levels that provide a lot of flexibility. And their cost structure means they can cover costs and pay dividends even with oil prices in the US$40s.”
Prices that low seem unlikely. But then few forecasts predicted sub-US$70 crude coming this winter after last year saw the biggest oil price shock since the 1970s. The general consensus in mid-2022 was that a demand-supply imbalance would persist, keeping prices high.
Years of low investment in oil and gas production, combined with Russia’s invasion of Ukraine and the subsequent sanctions, were expected to keep global supply tight. Meanwhile, China’s economic revival after lifting its harsh COVID-19 containment policies was seen as boosting energy demand.
But China’s year is off to a disappointing start, with unemployment still high and real estate investment declining. Russia, meanwhile, has managed to sidestep sanctions with oil production rising last month.
Global crude oil inventories surged by 53 million barrels in January, the International Energy Agency reported earlier this month. That means that global supply outstripped demand by an average of almost two million barrels per day.
Which brings us to Silicon Valley Bank. This week, echoes of the global financial crisis have roiled financial markets. Until Thursday’s rally, investment flows have retreated from the market’s riskiest pockets – of which oil is a long-standing member.
For many years, the energy sector was a great place for shareholders to lose money. Growth was the industry’s mantra, with debt used liberally to finance aggressive drilling efforts. This business model, of course, was highly sensitive to bouts of economic weakness. Drastic cost cutting, insolvencies and deep losses in share price ensued whenever a serious downturn hit.
Many investors came to see the oil patch as uninvestable – the result of a toxic mix of mismanagement, pipeline politics and global pressure to end support for fossil fuel assets.
The industry was forced to evolve, largely in ways that make it more friendly to shareholders. “Aside from paying down debt and improving credit metrics, shareholder distributions are the main focus nearly across the board,” Paul Cheng, an analyst at Bank of Nova Scotia, said in a note.
Considering that the average Canadian producer can now make a profit with crude oil as low as US$50 per barrel, there is little risk of seeing a wave of dividend cuts sweep through the sector.
Now consider the likelihood that the energy sector will need to contend with prices that low. Even West Texas Intermediate in the mid-US$60s is commensurate with a recession as severe as the one that followed the global financial crisis, Michael Tran, an energy market strategist for RBC Dominion Securities, wrote in a report.
“The latest market retracement feels overdone, unless a 2008-style contagion runs uncontained.”
Historically, the energy sector is one of the last places an investor would want to be on the cusp of a recession. This time around, it’s a much different bet.