Why the worst is yet to come for the energy sector

The Covid-19 pandemic may have passed its peak in Europe but the full impact of the virus and the lockdown policies adopted across the world have only just begun to be felt. What has happened so far is triggering a chain of further events and consequences. The energy sector, starting with the oil and gas business, is a prime example of this process.

The immediate impact of the lockdown, first in China and then in March across Europe and parts of the United States, was a 3.8 per cent fall in global energy demand in the first quarter according to the latest authoritative estimates from the International Energy Agency. That figure is likely to be many times higher in the current quarter as a result of the lockdowns which at one point affected more than half the world’s population.

Oil demand alone fell by 29m barrels a day in April. The impact of the lockdown was compounded by the competition for shares of the market between the members of OPEC, Russia and the United States. An excess of supply met falling demand and the result was a halving of prices. Shares in the major producers collapsed. Shell and Exxon, two of the strongest companies in the world on most measures, both saw their valuations drop by more than 50 per cent in a matter of days. In the US oil prices even briefly turned negative in April, as local storage facilities filled up and buyers disappeared.

Since then, prices and valuations have risen a little as lockdowns have been eased and as production has begun to fall. OPEC and other producers have reached a partial agreement to take supplies off the market. In the US the production of oil from tight shale rocks has started to decline as producers shut in uneconomic wells.

The problems for the energy business, however, are far from over.

The first of these is likely to surface over the next few weeks. Supply continues to exceed demand. April and May saw the sharpest falls in demand but the agreed supply cuts are being implemented more slowly. The result is that stocks on a global basis keep rising week by week, to the point where there are now 90 days of supply in storage. Some countries including the US, India and Korea have promised to absorb more into their strategic stockpiles, but the terms of that arrangement have yet to be finalised. The result is an increasingly urgent search for storage capacity. If that capacity were exhausted in particular locations over the next few weeks the collapse of the price seen in the US in April could be repeated.

The second challenge is the loss of revenue for the members of OPEC and other oil producers. The worst affected will be countries with little in the way of alternative export revenue and substantial spending commitments to meet the needs of growing populations. Nigeria, Libya, Iran and Iraq all fall into this category. According to analysis by the IMF, Algerian GDP could fall by 17 per cent this year. In each case the loss of export revenue and the growth of unemployment could trigger a new wave of political instability in already fragile states.

Third is the impact on investment plans. Between them the five largest private international oil companies have announced cuts in planned spending of over $26bn since the beginning of March. Comparable cuts will follow from the state-owned companies who run the oil and gas sector in most OPEC countries and in Russia. One estimate suggests that there will be over a million job losses in the worldwide oil and gas service sector over the next year. That is not the limit of the pain. The renewables business has also been hit. Wind and solar capacity will continue to grow but the amount being added is expected to be sharply reduced. Capacity additions in Europe this year are set to fall by a third. Electric vehicle sales worldwide are down by a similar amount. Across the world the energy transition is being held back by a recession which reduces the turnover of capital stock.

The fourth set of losers are those with investments in the sector. Last year BP and Shell accounted for 25 per cent of all dividends paid by firms on the London markets. Shell has already announced a cut of two thirds in its dividend—the first cut the company has made in the last 75 years. The direct victims of such cuts are pension funds, many of which are already overstretched.

Many of these problems would be mitigated if prices bounced back, but for the moment the idea carries a touch of wishful thinking. Much of the oil and gas supply being cut back now can be brought back onstream quickly. That prospect, along with the exceptional volumes of stocks, will overhang the market for at least the next year and probably longer even if economic growth resumes.

Of course the sector will survive. The world continues to need energy and in particular oil and gas. There will be no dramatic flight to renewables because the cars, lorries and planes we use run on hydrocarbons. So do most of our heating systems, factories and power stations.

In the Darwinian world of the post Covid-19 global economy, the established energy companies are more likely to survive than most. But the retrenchment they must now endure will have painful consequences across the world. As we emerge from the lockdown the bad news is that the worst is yet to come.