This article provides an update regarding the ongoing challenges facing energy insurers under current market conditions, including the impact of the coronavirus (prior article dated August 2018). This update outlines the effects of oil and gas prices on demand for insurance from companies within the industry and evaluates the anticipated impact of current forecasts.
Editor's Note:This article was prepared prior to recent significant developments relating to the COVID-19 virus and breakdown of talks relating to production limits among the OPEC Plus group of petroleum exporters. The authors updated the content in "Update: Energy Insurance Market Conditions: 2020" (May 2020).
Acknowledgment: Special thanks to coauthor Alex Walther, CPA/CFF, CFE, a senior vice president with the BVA Group. Mr. Walther's experience focuses on a wide range of valuation and financial forensic issues that arise in complex commercial disputes such as the preparation of valuations of onshore and offshore oil and gas interests in bankruptcy proceedings, contract disputes, and/or shareholder disputes.
West Texas Intermediate (WTI) monthly average crude oil spot prices remained over $50.00/bbl during 2019, with prices fluctuating between $51.38/bbl and $63.86/bbl;1 however, this is down from a monthly average high of $70.98/bbl in July 2018. The US Energy Information Agency (EIA) attributed the lower average prices in 2019 primarily to weakening economic signals and increasing uncertainty about global oil demand growth.2 Additionally, various international events affected oil prices, including sanctions placed on Venezuela that prohibit many US companies from doing business with the country, the US/China trade war, and the air strike attacks on Saudi Aramco in September 2019.
These issues and events, coupled with strong supply-side growth in the United States, led to increased oil inventories and downward pressure on oil prices for the first 9 months of 2019. While oil prices began to turn around in late 2019 due, in part, to improved global market expectations for 2020 and the possibility of a first phase US/China trade agreement,3 prices fell in late January 2020 over concerns of the global economic impact from the Wuhan coronavirus outbreak. At the end of 2019, the EIA anticipated WTI spot prices to increase slightly to an average of approximately $59.50/bbl in 2020 and $62.50/bbl in 2021; however, the duration and severity of the coronavirus outbreak have led to much uncertainty in oil prices due to the lower demand in China. WTI closed on January 31, 2020, at $51.58/bbl and fell to below $51.00/bbl in early February 2020.4
"WTI Price and Forecast for 2012–2025" highlights historical average monthly pricing between 2012 and January 2020, as well as the most-recent forecasts available as of December 31, 2019.
WTI PRICE AND FORECAST FOR 2012–2025
Regarding natural gas, Henry Hub spot prices have gradually decreased to a monthly average of $2.04 per million British thermal units ("MMBtu") in January 2020 after reaching a 4-year average monthly high in November 2018 of $4.09/MMBtu.5 The January 2020 price level is the lowest average monthly price since May 2016.6 Consumption of natural gas and total production of dry natural gas in the United States grew 3.4 percent and 10.6 percent, respectively, over the 12-month period ending October 2019.7 Working natural gas inventories in the United States were at 3,148 billion cubic feet as of January 3, 2019, representing a 20 percent increase over the prior year's level.8
Prior to the coronavirus outbreak, the EIA anticipated Henry Hub spot prices to increase slightly to an average $2.33/MMBtu in 2020 and $2.54/MMBtu in 2021. These anticipated higher prices were a result of an expected decrease in supply partially offset by falling demand. Unlike 2017 and 2018, combined residential and commercial natural gas consumption is expected to decline in 2020 by approximately 1 percent to an average 23.2 billion cubic feet per day.9 The coronavirus outbreak may result in a further decline in demand for natural gas, resulting in lower prices, depending on the length and severity of the outbreak.
"Henry Hub Price and Forecast for 2012–2025" highlights historical pricing between 2012 and January 2020, as well as the most-recent forecasts available as of December 31, 2019.
HENRY HUB PRICE AND FORECAST FOR 2012–2025
Debt and Capital Expenditures
Large-scale development projects are one of the key drivers of demand for insurance coverage in the oil and gas industry. Directionally, these outlays tend to move with oil prices as companies delay or cancel projects during sustained declines. Having taken on heavy debt loads in the preceding 2014 boom, companies were forced to maintain high production levels from existing wells at lower 2019 prices to sustain cash flows. As the market has sunk from a 3-year high in mid-2018,10 operating cash flows have receded accordingly,11 providing less cash to pay down existing debt. This resulted in a fairly consistent level of debt and a consistent debt-to-equity ratio throughout 2019. In line with second-half 2019 prices and reduced cash flows, capital expenditures were down 8.7 percent in third-quarter 2019 compared to the third quarter of 2018.
"Summary of Year-over-Year Change in Quarterly Cash Flows, Oil Prices, and Capital Expenditures" and "Summary of Net Change in Quarterly Debt Levels" illustrate the relationship between cash flows, oil prices, capital expenditures, and debt levels.
SUMMARY OF YEAR-OVER-YEAR CHANGE IN QUARTERLY CASH FLOWS, OIL PRICES, AND CAPITAL EXPENDITURES
SUMMARY OF NET CHANGE IN QUARTERLY DEBT LEVELS
Given that 2019 was not the successful year the industry hoped for, there was hope toward the end of 2019 that 2020 would reflect a turning point for the industry. Given the coronavirus outbreak in mid-January 2020 and the subsequent fall in energy prices, the industry has become more pessimistic due to uncertainty as to when the Chinese economy will become fully operational again. If the coronavirus is short-lived, and the Chinese economy resumes full operation in the near term, the short-term outlook for 2020 and 2021 is one of cautious optimism. The United States has been able to produce record levels of crude oil and natural gas despite the fact that there are less than half the rigs that were operational in 2014.12 Technological advancements and the use of hydraulic fracturing and horizontal drilling, as well as cost-cutting in recent years, have allowed these levels of production. As of the writing of this article, however, a rebound in prices, which could lead to increased cash flows and capital expenditures, is highly dependent on when the Chinese demand for energy products returns to precoronavirus levels.
Impacts on the Insurance Industry
With energy price projections currently in flux due to the uncertainty around the Chinese economy because of the coronavirus, insurers may have premium income challenges during the year. If the coronavirus is short-lived, and Chinese demand for energy products returns without much delay, there is some hope that the predicted increase in earnings and profits (E&P) activity from 2020 into 2021 may still come to fruition.13 Even if Chinese demand returns, however, other pressures for the insurance industry, such as merger and acquisition activity among upstream industry participants and heightened competition from smaller companies aiming to capitalize on new technologies, will remain.
Similar to prior years, overcapacity remained a persistent problem for upstream insurers in 2019 and remains an issue for upcoming years. The overcapacity from prior years, as shown in "Upstream Insurer Capacities and Premium Income," will likely persist as anticipated underwriter withdrawals are insignificant even though estimated worldwide premium income is at its lowest levels since 2000.14
UPSTREAM INSURER CAPACITIES AND PREMIUM INCOME
This significant upstream overcapacity results in intense competition between insurers and an overall soft market. There was a push in the first quarter of 2019 for a slight hardening of the market due to increased energy prices, depleted premium income, the cumulative effects of the unprofitability of onshore E&P portfolios, increased centralization of underwriting authorities, and heightened operating costs;15 however, the subsequent downturn in energy prices, company cash flows, and capital expenditures in mid-2019 limited this hardening effect. Until energy prices recover and increases in capital expenditures return, premiums and insurance demand will continue to come under pressure, maintaining a soft market.
Interest Rates Lower
Citing strong labor market conditions and inflation expectations, the Federal Open Market Committee (FOMC) lowered the target federal funds rate three times during 2019. These reductions were made to maintain the sustained economic expansion, strong labor market conditions, and desirable inflation near the symmetric 2 percent objective.16 These rate decreases reverse the increases enacted in the second half of 2018, during which the FOMC conducted contractionary policies predicated on its belief that economic expansion necessitated rate hikes. FOMC materials released in December 2019 indicated increasing rate targets through 2022, as shown in "Summary of Fed Funds Target Rates and Projections," that approach prerecession levels of 3 percent.17 These rate targets, however, may change in the next FOMC forecast release anticipated in March 2020, given the Federal Reserve's comments during its January 2020 meeting suggesting that a change in rates in 2020 is unlikely.18
SUMMARY OF FED FUNDS TARGET RATES AND PROJECTIONS
Decreases in interest rates are unfavorable for insurers. Insurers benefit by investing the proceeds from premiums in financial instruments, which generate returns often rising or falling in line with the federal funds rate. Accordingly, holding losses constant, the industry stands to suffer further from the downward trend in interest rates until such time that the FOMC begins to raise rates.
While energy prices showed signs of recovery in late 2019, January 2020 has proven to be a difficult month for the energy industry due to lower demand caused by the coronavirus's effective shutdown of the Chinese economy. Given this slowdown and the uncertainty surrounding any recovery, industry players are hesitant to invest capital into operations and instead opt to remain focused on stability in times when funding sources have become a critical issue for many exploration companies. This slowdown in capital investment may result in lower demand for insurance products in an oversaturated insurance market.
Lower investments by the energy industry, coupled with a continuing increase in overcapacity and low insurance premiums, has continued the soft insurance marketplace from recent years. Until the uncertainty surrounding the coronavirus outbreak is resolved, and Chinese demand for energy products resume, energy prices may remain deflated, resulting in lower capital spending and lower demand for insurance products. If the coronavirus is short-lived, however, the industry hopes the decline in early 2020 is merely a one-time event and that the optimistic price forecasts predicted at the end of 2019 will be achieved. This optimistic post-2020 recovery could reinvigorate capital spending and, in turn, demand for insurance products, but it is unclear when and if this may be achieved due to the high levels of uncertainty that currently exist.
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1 "Cushing, OK WTI Spot Price FOB," US Energy Information Administration, March 2020.
2 "Short-Term Energy Outlook," US Energy Information Administration, July 2019.
3 "Short-Term Energy Outlook," US Energy Information Administration, January 2020.
4 "Cushing, OK WTI Spot Price FOB," US Energy Information Administration, March 2020.
5 "Short-Term Energy Outlook," US Energy Information Administration, January 2020.
6 "Henry Hub Natural Gas Spot Price," US Energy Information Administration, March 2020.
7 "U.S. Natural Gas Monthly Supply and Disposition Balance," US Energy Information Administration, March 2020.
8 "Short-Term Energy Outlook," US Energy Information Administration, January 2020.