Demand Recovery

CHICAGO–A new Morningstar report about the energy sector’s short-term outlook foresees inevitable recovery and strong catch-up demand, with a global V-shaped economic recovery in gross domestic product expected to drive 2021 demand to a strong rebound.

“Overall, we expect the impact from COVID-19 to reduce global crude consumption by 10 million barrels a day (or 10%) in 2020,” the company’s equity research team states in “Epic Oil Crash Sets Up Brutal Downturn for Energy Sector.” “This decline in crude demand eclipses the 5% hit we model for global GDP, given the disproportionate impact of COVID-19 on transportation. But the virus is not expected to permanently impair the world’s productive capacity, which means the long-run intensity of crude consumption should be unaffected.”

The pandemic’s impact on GDP will be modest in the long run, the report predicts, with most oil-related items, including air travel, fully returning to normal once a vaccine is developed. If the intensity of consumption isn’t severely affected, Morningstar says strong catch-up demand is likely.

It will take contributions from U.S. shale producers to satisfy that demand, but Morningstar cautions the business model doesn’t work at this spring’s strip price. “The marginal cost for shale producers is $55 a barrel (West Texas Intermediate), and without a recovery to that level, shale investment will fall far short of what’s necessary,” the report argues.

Morningstar forecasts a 1.4% drop in global real GDP in 2020, noting oil demand growth typically has a 1-to-1 relationship with GDP growth. The firm says that because of a lopsided hit to the transportation sector from COVID-19, the forecast expects a much greater hit to oil demand than overall GDP in 2020.

Not Time For Panic

It’s not time for investors to panic on oil demand, “Epic Oil Crash” asserts, basing its optimism on predictions of a modest long-run impact on global economies. That implies a V-shaped recovery. The report expects the virus will leave the world’s productive capacity largely untouched, and economic confidence should rebound quickly once it subsides.

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The pandemic’s impact on GDP will be modest in the

long run, the report predicts, with most oil-related items,

including air travel, fully returning to normal once a vaccine is developed.

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Jet fuel and gasoline (8% and 26% of global oil demand, respectively) are responsible for more than 70% of the hit to 2020 oil demand, the analysis calculates. Those products mainly are influenced by passenger transportation, which COVID-19 has curtailed. Morningstar foresees the second quarter of 2020 will drive about half the year’s impact, as those three months are when social distancing probably will crest. The fatality rate will decline rapidly in the second half of 2020, after effective drug treatments are employed, its model suggests.

2021 will see some lingering impacts from the pandemic because a vaccine most likely will not be available until midway through the year, but Morningstar predicts the bulk of lost demand will be recovered by the end of the year. The analysis predicts a nearly complete GDP recovery from the COVID-19 impacts, with a mere 0.9% impact to the long-term trend of real GDP. Therefore, Morningstar suggests, oil demand should likewise recover nearly to its pre-pandemic trend, assuming the oil intensity of GDP isn’t affected by the crisis by changes such as U.S. workers shifting to more time out of an office environment and more time working at home.

Growth After 2021

Morningstar predicts U.S. oil supply will need to return to growth after 2021 to balance global supply and demand. World oil supply grew by an average 1.2 MMbbl/d from 2017 through 2019, while the United States increased by 1.5 MMbbl/d during those two years. Not only did the United States account for all incremental global oil supply needs, the analysis notes, but it made up for substantial production declines from other producers, notably Venezuela and Iran.

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It’s not time for investors to panic on oil demand,

“Epic Oil Crash” asserts, basing its optimism on

predictions of a modest long-run impact on

global economies. That implies a V-shaped recovery.

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“However, we forecast substantial activity declines in 2020 in response to lower oil prices, commensurate with the deep capital expenditure cuts by exploration and production companies that have been announced so far,” “Epic Oil Crash” states. “This activity decline will put the brakes on U.S. shale production growth. If the U.S. shale growth engine is to restart (which we expect will need to happen by late 2021), that will require much higher activity and spending, which in turn will necessitate higher oil prices.”

According to Morningstar’s forecast, the U.S. light tight oil rig count will recover to about 620 by 2023, which it calls a sustainable, long-run equilibrium level. It points out this is in line with average 2019 levels, when oil prices averaged $57/bbl. That activity level will allow domestic producers to account for about 1 MMbbl/d in average annual supply growth from 2022-25, which the analysis notes is in line with the growth in global oil supply.

“Looked at from another angle, we still think the long-run break-even cost of U.S. shale is $55/bbl. Historically, U.S. shale production has contracted when oil prices have been below this level and grown rampantly when prices have been above it,” the analysis says.

There is little reason to change this long-term expectation, Morningstar argues, adding that in the short turn, temporarily low activity probably will push service pricing below its long-term expectations. The analysis foresees the activity rebound it anticipates through 2023 reversing those short-term savings. Pricing already was quite weak in 2019 for many U.S. shale oil service markets, it notes. Many service companies in those markets, including pressure pumping and land drilling, were earning returns on capital far below the cost of capital, the analysis points out, adding it is unlikely that pricing can remain sustainably lower than levels seen in that year.

Morningstar says it has considered the potential for efficiency gains to lower break-even costs in the U.S. shale space, including a 15% reduction in drilling days per horizontal well.

“U.S. shale operators already were prioritizing high-efficiency development before this year’s downturn,” the analysis concludes. “We don’t think operators will be able to (sustainably) eke out even more efficiency gains in response to the lower prices. The low-hanging fruit is gone.”