Thanks to Afshin Sayani, Chartered Financial Analyst, and Matt Burton, of BVA Group LLC, for their help authoring this article.
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.
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.
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.
Regarding natural gas, Henry Hub spot prices have increased approximately 149 percent from the 2020 average spot price of $2.03 7 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. 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.
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.
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
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
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.
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.
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