The first quarter of 2020 was a challenging time for the energy sector, and
this challenge does not appear to be dissipating anytime soon. Since our
March 2020 article, which we authored in February 2020, much has changed.
Shortly after our March 2020 article was published, energy prices collapsed as
a result of the Saudi Arabia/Russia price war and the ongoing effects of the
COVID-19 pandemic on worldwide energy demand. Even with an agreement in place
resolving the Saudi Arabia/Russia price war, front month prices of oil in the
United States turned negative for the first time in history on April 20, 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.
As a result of energy prices collapsing, the energy industry's
projections for 2020 changed dramatically, which will trickle down to other
industries, including the insurance industry. The purpose of this article is to
provide an update to our March 2020 article, reflect on the recent changes in
the energy industry, and discuss the impact on demand for insurance offerings
as a result of recent events.
Energy Prices
West Texas Intermediate (WTI) monthly average crude oil spot prices dropped
substantially in the first quarter of 2020 from a high of approximately $63/bbl
on January 6, 2020, to a low of approximately $14/bbl on March 30,
2020.1 The second quarter of 2020 is not showing
signs of improvement even with the April 12, 2020, agreement to limit
production among OPEC and other energy exporters. On April 17, 2020, May WTI
futures dropped below $2/bbl, and on April 20, 2020, for the first time in US
history, front month oil prices were negative.2
The price war, coupled with the COVID-19 pandemic, led to the perfect storm
of an excess global supply of oil as a result of the suspension of previously
agreed-upon production cuts by OPEC and other countries and a significantly
lower global demand as a result of various lockdown and stay-at-home orders
around the world. The April 2020 forecast by the Energy Information
Administration (EIA) considers its near-term outlook as subject to heightened
levels of uncertainty as COVID-19's market impacts are continuing to evolve
but still predicts $30/bbl oil prices in the second half of 2020.3
The International Energy Agency has more dire predictions than the EIA for
2020, with an expected drop in demand of approximately 20 percent due to the
COVID-19 pandemic.4 There is also concern that the
agreement reached on April 12, 2020, to cut oil production in May and end the
price war is too little to address the reduced demand levels around the
world.5
"WTI Price and Forecast for 2012–2025" highlights historical
average monthly pricing between 2012 and March 2020, as well as the most recent
Nymex forecasts available as of April 24, 2020.
WTI PRICE AND FORECAST FOR 2012–2025
Regarding natural gas, Henry Hub spot prices have decreased by approximately
25 percent from January 2020 levels to a monthly average of $1.74 per million
British thermal units (MMBtu) in March 2020.6 The
March 2020 price level is the lowest average monthly price since
March 2016.7 Citing warmer-than-normal weather in
the first quarter of 2020 and the slowing economy as a result of the COVID-19
pandemic, EIA expects residential and commercial consumption of natural gas in
2020 to be down compared to 2019 averages by 5.8 percent for residential and
7.1 percent for commercial. The EIA's April 2020 Short-Term Energy Outlook
predicts that prices will begin to rise at the end of the second quarter of
2020 as US natural gas production declines and demand for natural gas used for
power and generation increases.8
Prior to the COVID-19 pandemic, the EIA anticipated Henry Hub spot prices to
increase slightly to an average $2.33/MMBtu in 2020 and $2.54/MMBtu in
2021.9 The EIA now anticipates Henry Hub spot
prices to average $2.11/MMBtu in 2020 and $2.98/MMBtu in 2021, increasing in
2021 due to lower natural gas production compared to 2020 as a result of the
energy industry adjusting production for reduced demand.10 Not all commodity traders agree with the EIA though as, for
example, NYMEX futures indicate prices between $2.00/MMBtu and $2.50/MMBtu in
2021.
"Henry Hub Price and Forecast for 2012–2025" highlights historical
pricing between 2012 and March 2020, as well as the most recent Nymex forecasts
available as of April 24, 2020.
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. For an industry heavily loaded with debt, the recent
downturn bodes poorly for prospects in the near-term and beyond. By way of
example, the last downturn in 2016 led to approximately 70 of the 215 oil
producer bankruptcies in North America between 2015 and April 1,
2020.11 It is still too early to tell how many
bankruptcies will occur in the energy industry as a result of recent events,
but if the 2016 downturn is indicative of upcoming events, the outlook is
grim.
While 2019 was considered in a light of cautious optimism due to a
consistent debt level and a consistent debt-to-equity ratio for the industry,
outlook revisions with lower revenues and higher debt-to-equity ratios in 2020
lead to a more pessimistic view of the industry. The following are some
examples.
- Oil companies are beginning to cut capital spending for 2020. For
example, 2020 capital budgets for Texas development were slashed by
$8 billion in recent weeks.12
- Over 1 million oil and gas jobs are likely to be cut in 2020, with
contractors scaling down their workforce by at least 21 percent. Of this 21
percent, 13 percent is attributed to oil-price-driven cuts, and 8 percent is
attributed to the slowdown of projects due to COVID-19.13
- Some analysts are expecting active horizontal rig counts in the United
States to fall in the second quarter by 65 percent from 620 active wells as
of mid-March 2020 to a bottom of approximately 200 active wells.14
- On a global scale, exploration and production firms are expected to cut
capital expenditure amounts by up to $100 billion in 2020, down roughly 17
percent from the $546 billion spent in 2019.15
While revenues decline due to reduced demand and lower prices, major debt is
coming due. North American oil exploration and production companies have $86
billion in debt that will mature between 2020 and 2024,16 while midstream companies face $123 billion in maturing debt
during the same time frame.17 With the industry
experiencing reduced cash flows, there is concern that energy companies will
not be able to remain current on their outstanding debt.
Impact on the Insurance Industry
With energy prices experiencing extreme fluctuations, including lows not
seen in over 20 years and the continued economic uncertainty related to
COVID-19, insurers will have premium income challenges for 2020 and likely
beyond. Even if the current economic turmoil related to COVID-19 is resolved in
the near term, the economic slowdown and associated record unemployment filings
it has created will take time to resolve.18 With
exploration and production levels suffering under the wake of current
circumstances, the outlook over upcoming years is negative.
Insurance Overcapacity
Like current conditions in the energy industry, the insurance industry is
also experiencing a period of high supply during a time of slowing demand. As
discussed in our March 2020 article, the upstream insurance market had
significant overcapacity and showed no signs of significant underwriter
withdrawals in the near term.19 This trend
continues today, but at a time with declining demand. Recent shocks in the
energy markets and the ongoing effects of COVID-19 are expected to result in
trauma to the energy industry that exceeds what was experienced in the 1985,
1999, and 2014 price crashes.20
With capital and coverage in the upstream energy market being at an all-time
high before recent events, the falling demand for insurance products will
result in an even softer market than the one that existed at the beginning of
2020.21 Until energy prices recover and increases
in capital expenditures return, which may not take place for years, premiums
and insurance demand will be under pressure, resulting in a continued soft
market for the insurance industry.
Interest Rates Lower
Citing concerns regarding the COVID-19 pandemic and weakening economic
signals, the Federal Open Market Committee (FOMC) lowered the target federal
funds rate twice in March 2020, eventually landing on a target rate of between
0 and 0.25 percent.22 These emergency rate
decreases brought the target rate to levels not seen since the fallout from the
2008 financial crisis.23
The decrease in rates adds another unfavorable variable for insurers as
returns from invested premium will decline in line with the lower federal funds
rate. An increase in the target rate will likely not occur soon until the
COVID-19 pandemic is resolved and the US economy recovers. Due to the many
uncertainties surrounding the pandemic, it is difficult to predict when rates
will recover, but based on FOMC's approach to the 2008 financial crisis, an
increase in rates is not likely to occur in 2020.
Conclusion
While energy prices showed signs of recovery in late 2019, with slight
indications of cautious optimism, any hopes of a near-term uptick are now lost
given the pervasive effects of both the COVID-19 pandemic and the direct and
indirect effects caused by the Saudi Arabia and Russia dispute. Given the
recent halt in oil and gas activity and the expectation of further shutdowns,
industry players are hesitant to invest capital into operations and instead opt
to remain focused on stability in times where finding sources has become a
critical issue for many exploration companies.
The cuts in capital
investment will result in lower demand for insurance products in an already
oversaturated market. Lower investments by the energy industry, coupled with a
continuing increase in overcapacity and low insurance premiums, have further
softened the insurance market. Until the uncertainty surrounding the COVID-19
pandemic is resolved and the world economy recovers, insurers can expect lower
capital investment by energy companies resulting in lower demand for insurance
products.