Today, we stand at the cusp of history and witness the effect of the oversupply of oil and collapse of its demand, due to COVID-19, on West Texas Intermediate (WTI) crude prices, which for the first time in history have reached a sub-zero value per barrel. The critical aspect of this data is how we interpret the information today.
The meltdown has created a sense of global shock, especially after the agreement of oil production cuts (up to 10 percent or 9.5 MBPD) agreed between key producers, including OPEC and non-OPEC countries. The general expectation was to see a stabilized crude pricing for both producers and consumers.
To put into perspective, the futures prices for the next six settlements of WTI and Brent as observed on April 20, 2020 have been included (in the graph below).
The divergences in futures prices are substantially lower for June 2020 and beyond. However, it’s also a fact that the collapse was not only observed for May 20, 2020 futures (which closes on April 21, 2020) but also for the next six settlement cycles.
Key question: Where do we go from here? And, the answer lies in:
The current macroeconomic factors affecting crude pricing globally
The potential impacts on the Indian economy
The valuations of crude producing and refining companies
Macroeconomics of Crude Oil
To start with, let’s focus on what caused the mayhem on April 20, 2020.
The WTI futures for May 2020 reached a sub-zero level along with Canadian crude for the first time in history. However, the Brent did not correct beyond 10 percent at the lowest point and settled at $25/bbl.
To understand the divergence in pricings, the focus should be on the main differences between the contracts and the supply-demand imbalance impact they create on pricing.
The WTI crude contracts require futures buyers to take delivery in Cushing Oklahoma Storage Facility, which has no storage space available. This has led to contract holders to sell off their May futures as they cannot take physical delivery. For Brent, the delivery can be to offshore locations where storage spaces are still available.
As evident from the chart above, for June 2020 futures and beyond, the current expectation assumes available of storage space and hence, the WTI and Brent futures are converging.
How the Current Crude Prices Affect India
Based on the data available from Petroleum Planning and Analysis Cell — Government of India, the average crude basket price for India declined from $65.50/bbl in December 2019 to $33.36/bbl in March 2020 (as per data published on April 2, 2020).
To showcase the impact of crude price movements on India’s finances, the total production in FY19 was 250 million barrels and the refining capacity in FY20 is 1,709 million barrels.
The crude import bill for FY19 was $112 billion and the estimated bill for FY20 is $105 billlion, with per barrel price estimated to be higher than $60. The low crude prices offer significant savings for India.
If oil prices stay at $30 per barrel, we are looking at a saving of over $50 billion (approximately INR 3,75,000 Crore) in the oil import bill in FY 21, without even considering the reduction in the quantum of oil consumption and imports.
The above data is a good indicator of how recent downward crude price movements will help India during this crucial time of COVID-19.
Fair Valuation of Oil Companies
Oil-producing companies in India will find it tough as the average market estimated cost of production is around $30/bbl. At present pricing curves for global crudes, the entire set of oil producers may go for a revaluation.
It also has an impact on the capital expenditure spending plans for these companies, which in turn will be negative for a few other sectors.
Oil refining companies in India have endured high pricing environments from 2013 to 2015 and became efficient and resilient. The input price variations (of crude) is not linked to direct output prices of petroleum products due to the existing semi administered pricing mechanism in India.
Also, the storage of crude is a big challenge, however, the output storage is relatively simple. So, oil refining companies tend to order more crude during lower prices, process them and store them, which is India’s policy as well.
The volatilities in crude pricing also helped these companies focus more on the storage of their outputs, which will positively impact them in the current situation.
The recent fall in demand due to COVID-19 is affecting refining companies, but assuming consumption will pick up eventually and challenges with oversupply are more permanent, oil refining companies should see a general uptick in gross refining margins and valuation.
-Pratik Sengupta is Director Alternative Asset Advisory, Duff & Phelps. The views expressed are personal
