OPEC+ provided the energy market with a positive surprise on March 4 with an announcement that it would only bring back a modest level of production in April as the members wait to see signs of a demand recovery. The group’s actions, combined with an improving economic outlook and U.S. producers’ current plans to refrain from meaningful production growth, will keep the global oil market in a deficit over the near term. Following the news, crude oil extended the rally that began in November following the announcement of the first COVID-19 vaccine.
While the expected supply-demand balance in the oil market is supportive of prices over the near term, we do not believe it is the beginning of another super-cycle. A reduction in the outlook for U.S. production volumes relative to pre-pandemic expectations is likely to be more than offset by a structurally lower level of demand resulting from the impact of COVID (i.e., work from home). This is likely to result in a greater amount of OPEC spare capacity, even after economic activity normalizes, than prior to the pandemic. Additionally, non-OPEC production should remain resilient as producers continue to do more with less and demand growth faces headwinds from initiatives addressing climate change. Given that the oil market has historically been unable to realize a secular increase in prices until spare capacity becomes limited, these factors collectively suggest we are not starting a new super-cycle in oil.
The implications vary by asset class—we believe that it is constructive for investment grade issuers as their large, low-cost assets and moderate leverage profile do not require a structural increase in oil prices to deliver on commitments to improve their balance sheets. Conversely, we are less constructive on non-investment grade oil producers as many require a structural move higher in oil prices to support material credit improvement, and non-investment grade investors have the alternative to invest in natural gas producers. U.S. natural gas producers are almost exclusively non-investment grade, where capital constraints restrict incremental supply and excess capacity is limited given the reduction in associated gas due to lower oil drilling. The secular demand picture is also more constructive given increasing export capacity and continued displacement of coal plants by natural gas. We believe these favorable structural dynamics for natural gas, along with more competitive valuations, present non-investment grade investors with an attractive opportunity relative to oil producers.