The year 2021 was a year of recovery for the energy sector as the industry
rebounded from the devastating impacts of COVID-19 during 2020. Shortly after
our May 2020 article was published, energy prices increased as demand returned
amid the loosening of lockdown efforts and the eventual rollout of the COVID-19
vaccine. As a result of price recovery, the outlook for the industry has
drastically changed since our previous article.
Acknowledgment
Thanks to Afshin Sayani, Chartered Financial Analyst,
and Matt Burton, of BVA Group LLC, for their help authoring this article.
Although the outlook has improved, companies have generally adopted a
defensive position to counter market uncertainty as new variants of COVID-19
emerge. The purpose of this article is to provide an update to our
May 2020 article, reflect on the changes in the industry during 2021, and
discuss the impact on insurance offerings as a result of recent events.
Energy Prices
West Texas Intermediate (WTI) monthly average crude oil spot prices
increased substantially since the beginning of 2020 from a low of approximately
$47/bbl on January 4, 2021, to a high of approximately $86/bbl on October 26,
2021.1 As the global economy continues to recover
from the COVID-19 pandemic, the growing demand for oil has outpaced the supply
growth. Moreover, bad weather and lower oil production have hurt supply.
Hurricane Ida impacted operations in the Gulf of Mexico in August 2021, while
snow and ice storms in early 2021 froze natural gas pipelines in Texas.
The Organization of the Petroleum Exporting Countries (OPEC) has been slow
to bring crude production back to prepandemic levels, while analysts predict
OPEC production won't return to prepandemic levels until mid-2022.
Furthermore, as the year drew to a close, the potential for supply disruptions
increased, particularly with respect to natural gas, as Russian troop buildups
near the border with Ukraine increased the possibility of hostilities between
those countries, along with possible sanctions that could limit Russia’s energy
exports. Overriding all of these events are the longer-term trends as the world
has continued to shift to clean energy, which may also dampen supply in the
long-term.2
Despite the supply and demand imbalance experienced through 2021, OPEC cut its
world oil demand forecast for the fourth quarter of 2021, citing high energy
prices to curb demand. Additionally, OPEC also increased its supply forecast
from US shale producers into 2022, suggesting a return to balanced levels of
supply and demand in the market.3 The December 2021
Energy Information Administration (EIA) forecast considers its near-term
outlook as subject to heightened levels of uncertainty as the emergence of the
COVID-19 omicron variant increases uncertainty about the level of energy
consumption throughout the world but still predicts $73/bbl in the first
quarter of 2022.4 Similarly, the International
Energy Agency (IEA) predicts the average crude oil price for 2022 to reach
$79.40/bbl; however, the IEA acknowledges that the recent price rally may
falter as record-high prices begin to increase global production.5 Additionally, the EIA revised down the consumption forecast of
petroleum into the first quarter of 2022 as a result of additional travel
restrictions following the outbreaks of the omicron variant of COVID-19, while
US production is forecast to increase throughout 2022.6
"WTI Price and Forecast for 2012–2026" highlights historical
average monthly pricing between 2012 and November 2021, as well as the most
recent New York Mercantile Exchange forecasts available as of December 17,
2021.
WTI Price and Forecast for
2012–2026
Regarding natural gas, Henry Hub spot prices have increased approximately
149 percent from the 2020 average spot price of $2.037 per million British thermal units (MMBtu) to $5.05/MMBtu in
November 2021.8 After rising throughout 2021,
natural gas prices declined in November due to mild weather across the United
States that resulted in less demand for natural gas used for heating than
expected.9 Despite the slight decrease in natural
gas demand at the end of 2021, global demand for US liquified natural gas (LNG)
has remained high, limiting downward pressure on natural gas
prices.10 The EIA's December 2021
"Short-Term Energy Outlook" predicts that natural gas prices will
generally decline through 2022, averaging $3.98/MMBtu due to rising US natural
gas production and slowing growth in LNG exports.11 Not all commodity traders agree with the EIA, though, as,
for example, NYMEX futures indicate prices between $3.49/MMBtu and $4.02/MMBtu
in 2022.
"Henry Hub Price and Forecast for 2012–2026" highlights historical
pricing between 2012 and November 2021, as well as the most recent NYMEX
forecasts available as of December 17, 2021.
Henry Hub Price and Forecast for
2012–2026
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 and plan or initiate projects during periods of sustained
increase. Although 2021 is primarily a recovery year, as indicated by a general
increase in prices compared to the historically low prices in 2020, continued
market uncertainty leads to a skeptically optimistic view of the industry. The
following are examples.
- Despite cash from operations more than doubling over the past year for
exploration and production companies, capital expenditures have increased by
only 54 percent and remain below the 2015–2019 average capital expenditures
level.12
- North American exploration and production and oil-field services
companies that filed for Chapter 11 bankruptcy in 2020 reached a combined
debt level of $102 billion with an average debt level of a record $940
million. However, should WTI prices remain above $53/bbl, it is expected that
the amount of Chapter 11 filings will return to prepandemic
levels.13
- US shale capital expenditures are forecast to increase 19.4 percent to
$83.4 billion in 2022, the highest level since the onset of the COVID-19
pandemic. However, the 2022 capital expenditure forecast is still expected to
remain below the prepandemic forecast for 2022.14
- The emergence of the omicron variant of COVID-19 could potentially reduce
demand by as much as 2.9 million barrels per day in the first quarter of 2021
if lockdowns or heightened restrictions return.15 However, early indications that the variant, while highly
contagious, may be less virulent than the delta variant allow for cautious
optimism that strict limitations akin to the early stages of the pandemic
will not be necessary.
As demand remains uncertain due to the introduction of COVID-19 variants,
companies are focused on better responding to potential market volatility as
opposed to investing in capital expenditures. According to the EIA, in the
first three quarters of 2021, 47 exploration and production companies tracked
by the administration paid off $15 billion in debt, repurchased $1.9 billion in
shares, and paid out $6.9 billion in dividends bringing their long-term debt
level down to the lowest level since 2012.16
Additionally, bond yields for companies with a credit rating lower than
investment grade were low for the energy sector through the third quarter of
2021, which is indicative of less default risk and reduced borrowing costs;
however, yields slightly increased in the fourth quarter of 2021 to 5.43
percent as of December 2, 2021, in response to recent economic growth concerns
and increased market volatility.17
Developments in the Energy Insurance Industry
For the insurance industry, the COVID-19 pandemic accelerated a hardening
cycle that had already started to take hold at the end of 2019.18 As a result of the hardening markets, a "two-tier"
market is beginning to emerge between those with desirable risk profiles and
premium income and those which the insurers value less without stronger
underwriting measures.19 While capacity is limited
and the industry is generally experiencing rate increases, the increases are
comparatively below what was experienced during 2020.20 In the third quarter of 2021, the upstream market has
experienced rate increases between approximately 2.5 and 10 percent, while the
downstream market has experienced rate increases averaging between
approximately 10 and 15 percent, down from early 2021 increases of 20 to 30
percent.21
Despite the overall hardening of the market, the renewable energy insurance
market continues to stabilize with new capacity entering the sector as insurers
increase their exposure to renewables, particularly offshore wind
assets.22 The trend toward renewable energy is
expected to persist beyond 2021, as evidenced by Lloyd's of London's
commitment to scaling back coverage to companies involved in coal, oil sands,
and Arctic exploration.23
Interest Rates Expected To Increase
Following the marked increase in inflation in 2021, the Federal Reserve, in
its December 15, 2021, press release, elected to keep the target level for the
federal funds rate at 0 to 0.25 percent, citing that it is appropriate to
maintain this target range until the labor market reaches levels of maximum
employment.24 However, the Federal Reserve has
acknowledged that more steps to counter inflation will be necessary in 2022.
Thus, in addition to the ongoing tapering efforts that should result in an end
to purchases of Treasury securities in early 2022, the Federal Reserve is
expected to increase the target federal funds rate in 2022.25
The continued near-zero interest rate environment adds an element of
unfavorability in the short term for insurers, as returns from invested premium
will be limited by the lower federal funds rate. Nonetheless, the anticipated
interest rate hikes in 2022 would be beneficial for insurers, as invested
premiums would be expected to increase with the federal funds rate.
Conclusion
While energy prices in 2021 recovered significantly from the historic lows
seen in 2020, given the economic uncertainty created by the emergence of
various COVID-19 variants, the industry outlook is cautiously optimistic. To
hedge against unpredictable market shocks, industry players are hesitant to
invest significant capital into operations and instead are focused on improving
short-term financial positions and generating returns for shareholders. The
depressed level of capital investment will result in lower demand for insurance
products from the energy sector as the insurance markets continue to harden and
underwriting tightens. Until the uncertainty surrounding COVID-19 subsides
fully and the energy sector returns to prepandemic operational levels, insurers
can expect lower capital investment by energy companies resulting in lower
demand for insurance products into 2022.