Crude realities: Supply-Demand double whammy crushes oil market

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KIM PARLEE: Hello, everybody. And welcome to the MoneyTalk COVID-19 Daily Bulletin for Thursday, March 19. I'm Kim Parlee. We are having a new format, now, which is going to bring you up to speed on some of the big news of the day and bring you insights from some very smart people, as they navigate through what is happening right now in markets and personal finance.

In a few moments, we're going to sit down with Bart Melek on oil prices. He, of course, is the Global Head of Commodity Market Strategy at TD Securities. Oil is getting to levels we have not seen in 30 years, and before that, the 1940s. And we're seeing out west, with Western Canadian Select being hit particularly hard. We'll get to that conversation in just a second.

But to bring you up to speed on some of the latest news, the ECB, the European Central Bank, has announced massive bond buying programs, $814 billion to calm the markets that support the EU economy. China has reported no new domestic infections, today, so a bit of positive. Alberta is to offer $572 per week to citizens, based on government criteria for self-isolation. Air Canada's gradually suspending its international service by March 31.

The New York Stock Exchange is closing its trading floor, temporarily. It's shifting to electronic trading after positive coronavirus tests with some of their traders. GM, Ford, and Chrysler to close all Canadian and US North American factories to March 30th. Canadian finance minister, Gilmer Noel, is saying there still is an option of further fiscal stimulus, which has not been taken off the table.

And I'm going to have a little bit of good news in here. We actually are seeing some news of dolphins swimming in the canals in Venice, because there's less traffic there. So it's an interesting thing happening on that front. We're also seeing, just out right now, that the New York government has ordered 75% of nonessential workforce to stay home as their cases are surging to just about 4,000.

A lot going on, changing by the moment. And as I mentioned, oil prices are at historic lows. So let's bring in Bart Melek to talk a bit about what's happening with oil prices, right now. And Bart, the last time we saw these levels of prices was, as I mentioned, 30 years ago. Before that, you have to go back a long way to see that. So can you just give us some perspective on why we're seeing such a magnified collapse in oil prices, right now?

BART MELEK: Well, certainly, the big driver is the expectation of a collapse in demand over the next few months. Social distancing in North America starts taking hold. As we're seeing airlines being grounded, we're expecting a very large decrease in demand, globally. In fact, we're estimating as much as 10 to 11 million barrels over the next few months of lost demand, possibly even more.

And that will, essentially, mean that very rapidly, we're going to have accumulation of inventory. And if the demand side wasn't bad enough, we had a falling out of Russia and Saudi Arabia. And what they didn't do, essentially, is agree on a supply management deal. In essence, they were, we all thought, supposed to cut production in response to weaker demand. But what happened instead, they got it into a price war with Saudi Arabia, not only not decreasing supply. They've decided to burn the house down, as one would say, and ramp up production aggressively, from just under 10 million barrels to possibly over 12 million barrels.

This means we are going to have a very large inventory [? calculation, ?] and possibly, a lack of storage capacity in North America and globally. And this is why, in addition to all the volatility in the market and financial markets broadly, and the selling of equities and risk [INAUDIBLE], we have this issue on top of it. And here we are. Price of WPI, very low.

KIM PARLEE: Bart, let me jump in, here. Because there's so many things to look at, in terms of illiquid markets and volatility, which I will get to the financial aspect in just a second. But when you look at the supply overhang, you mentioned that storage could become full. And I even heard some people talking of negative pricing as producers just need to find a way to offload some of this. Because there's just nowhere to put it.

BART MELEK: That surely is a risk, and it's not unprecedented. We've seen something similar to that in natural gas markets, where natural gas was negative priced. We've seen some incidents in crude, as well, but only in very, very unique circumstances. But this certainly is a possibility. These, we have to remember, are very much regulated commodities. You have to have particularly designed and approved storage facilities. And if you have supply, you just may not be able to shut it off on a dime. And you're going to have to put it somewhere. And then if nobody wants it, you might have to incentivize someone to take it off your hands. So it's very dire, indeed, at least in the next little while.

KIM PARLEE: Let me ask you about it. The hard part about this, of course, is the depth and breadth of how long this is going to last. You mentioned dire for a little while. How long can we see that supply overhang last? Will this drop in demand shake up the conversation between Saudi Arabia and Russia? And where do you see that unfolding over the next six months to a year?

BART MELEK: Well, we recently published a piece, yesterday, trying to explore some of it. And we tried to model this. And we're looking just fundamentally at a big decline in demand over the next several quarters. But unfortunately, we don't expect any significant response on the supply side, quite yet. Saudi Arabia has well over half a trillion dollars of funds that can be of foreign exchange. So does Russia. And it looks like they want to significantly hurt the shale producers, because they've been taking their market share. And as OBEK was cutting, they were not.

We're imagining it has to take at least a quarter, maybe two quarters, for that to manifest in enough pressure to force capital expenditures to go to 0 at the shale producers. We estimate that 80% of these will not be able to cover their all-in cost. And they will not all be able to cover cash costs, C1 cost, maybe as much as 50% of the industry.

But it will take time for them to actually reduce supply. They're not going to do it voluntarily. They're going to want to get as much cash as possible. They're going to, basically, run out of resources as [? Quebec ?] stops. And that may take a while. And Russia and Saudi Arabia are very much unlikely to do this, unless they see evidence that those shale producers are on a downward trajectory in production. So this could take a couple of quarters, I'm imagining.

KIM PARLEE: Let me ask you, bring this mobile for a second, in terms of Western Canadian Select. I mentioned yesterday that the pricing hit a low of, I want to say, $7 and change, which was a jaw dropping low. Western Canada was already facing its own challenges, obviously, for the pricing. Do you have any sense of what could be happening with that pricing?

BART MELEK: At least in the short run, it will continue to be under duress. The problem is these markets are going to be flooded with crude. And with all the social distancing we're seeing, it's unlikely that we're going to see demand. In the refineries that use this, the product to make diesel and to make gasoline, we've seen the crack spreads collapse here, meaning that there might not be demand for this crude. It's no longer a capacity constraint. It is now a demand constraint and overhang of inventories in the United States.

So I'm afraid there's probably not a lot of reasons to think that this is going to bounce higher. It could very well be that governments in Canada are going to have to, again, restrict supply of this product to bring the prices up, as has been done by Alberta a while back, as you know.

KIM PARLEE: Let me ask you about the markets themselves, in terms of are the markets feeling illiquid, right now? We're seeing a lot of volatility in everything, and oil is no exception. What do you think from the trading standpoint of oil?

BART MELEK: Well, volatility is huge. We've been reaching record levers. When you adjust for the new methodologies for the fix, it's even been higher than during the financial crisis. And it means that a lot of CTAs, a lot of other systematic funds, the algorithmic funds where volatility is a big determinant of how they position, will reduce their exposure to all sorts of products. We're certainly seeing that in gold, where it's seen to be a hedge. And people are selling it, not because there's anything wrong fundamentally with it, but because volatility and selling for liquidity-sake is driving us there.

So markets are very erratic. And it's very much a problem surrounding uncertainty. We don't know what the end game here is. We're not sure of what the fiscal side will be. Now, we're finding out that all these massive stimulus programs from central banks from the Federal Reserve, for example, or the repo-market, $5.5 trillion. They're backstopping. They're setting up new facilities, as they did during the financial crisis, to make sure that there is liquidity in the market. None of that has really helped.

And fundamentally, the reason is, in my opinion, we don't know how bad this COVID-19 situation is going to get, and if we recover, and if we'll have enough solvency on the corporate and individual side to have a healthy environment that will get us into growth once the virus crisis passes. So a lot of uncertainty, and a lot of it is on the policy side. And it is very much a health issue that central bank liquidity isn't going to help.

KIM PARLEE: Let me ask my last question for you, Bart. I appreciate the insight. Nobody has a crystal ball. But when you look out a year or two-- I don't know if people have the capacity to do that, right now-- do you foresee structural changes that are happening because of what's happening today that could be impacting oil markets in the future?

BART MELEK: I think so. I think one major change will be that a lot of the high cost swing producers that rely on constant CAPX to keep them going will probably represent a smaller share of the market than today. We have, already, a problem with attracting risk capital to oil companies of all sorts because of environmental concerns, because of decarbonisation issues, and that is already happening.

Now that we have introduced yet another massive set of volatility and risk into this market-- remember, now, an investor is going to have to consider that we could see Saudi Arabia and other state players, like the Russians, mess with the market and cause them harm. And a little question, the wisdom of sinking capital to high cost producers, like a lot of the shale and other unconventional players, like the oil sends, are.

So we probably will get less growth and probably a smaller market share than we have today.

KIM PARLEE: Bart, great insights, and I do appreciate your time. And I'm sure it was a very busy time for you. Thanks so much.

BART MELEK: It was my pleasure. Thank you so much.

KIM PARLEE: Bart Melek, the Global Head of Commodity Market Strategy at TD Securities. And that wraps up your MoneyTalk COVID-19 Daily Bulletin for today. Be well.

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