How the collapse of oil prices could set the stage for the next oil boom

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The impact of the collapse of US oil 2:17

New York (CNN Business) - The oil market, used to having ups and downs, is experiencing one of its darkest moments in history.

Oil demand is collapsing due to the coronavirus crisis. Supply is shrinking, but not fast enough.

The world is literally running out of space to store unnecessary barrels of oil that accumulate during the coronavirus pandemic. That storage problem is so severe that it caused oil prices to turn negative this week for the first time.

The fall is forcing a reckoning in the oil industry, a painful one. Many oil shale producers have canceled drilling plans. Others have been forced to close active wells. Some will not survive at all.

But the violent readjustment in the oil market could be so exaggerated that it will set the stage for an increase in prices. When demand recovers, if that happens, there may not be enough supply to meet it.

"We are in an epic break. As hard as it is to believe, the next step is a boom, "said Pavel Molchanov, energy analyst at Raymond James.

Some 3.6 billion people are under confinement orders worldwide, Molchanov estimates. Passenger flights have been canceled. Many factories are closed. World oil demand is expected to drop to a record 9.3 million barrels per day in 2020, according to the International Energy Agency.

But that will not last forever. At some point, the world will thirst for oil again.

"When demand returns to something close to normal levels, it is very possible that there will be a shortage situation in 2021," said Molchanov.

Prices below zero

OPEC, Russia and a group of other oil-producing countries have already agreed to a record production cut of 10 million barrels from May. Market forces are causing non-OPEC producers, led by the United States, to similarly reduce production.

The shocking collapse of US oil at $ -40 added an exclamation point to the problem facing the industry. Oil futures require contract holders to receive delivery of barrels when the contract expires. But no one wanted to receive the crude in May, when storage capacity may run out. Even if it doesn't run out, storage costs have skyrocketed.

"May contract holders were indeed willing to pay someone to get them out of their long positions ... to avoid getting crude delivered next month," Goldman Sachs analyst Damien Courvalin wrote in a note to clients on Monday.

Paul Sankey, an analyst at Mizuho, ​​said Tuesday that US oil futures could "very possibly" collapse to $ -100 in May.

"The physical reality of oil is that it is difficult to handle, volatile, potentially polluting, and really useless without a refinery," Sankey wrote in a report to customers. "If you had a stinky barrel of oil in your backyard, would you pay someone $ 100 / barrel to take it away? Yes, and you would probably be relieved that they didn't charge you $ 300. ”

Record collapse for US shale

In that context, the oil supply must clearly drop at an impressive rate.

Hydrofracturing or fracking is on the way to suffering its biggest monthly drop in history, according to Rystad Energy. The total number of fracking operations started will drop 60% in April from its peak earlier this year.

"Ultimately, with a limited amount of storage to fill, production will soon have to drop considerably to balance the market," wrote Goldman Courvalin, "finally setting the stage for higher prices once demand gradually recovers."

How high? Molchanov said that oil could hit $ 50 to $ 60 next year and "potentially more than that." Goldman Sachs previously predicted that oil could rise "well above" $ 55 in 2021.

"This inflection will unfold in a matter of weeks, not months, with the market likely to balance before June," Courvalin wrote.

Companies are reducing production in two ways. First, they are cutting their spending plans to drill new and incomplete wells. For example, ExxonMobil cut its spending in 2020 by 30%, including a major focus on the Permian Basin oil shale oil field in West Texas.

Second, and even more importantly, the oil companies are turning off the taps of the active wells through a painful process known as “shut-ins” or “closings”. And there is no guarantee that those taps will be able to run at full capacity again.

“It will take time and money to turn them back on. It's not like a light switch, ”said David Trainer, chief executive of New Constructs, a Nashville-based investment research firm.

Bankruptcies in sight

Some argue that oil shale oil wells will be damaged during force closures, making it more difficult to relight them. That could limit the ability of US shale companies to respond to increased demand.

"That's a wild card," said Jeff Wyll, senior energy analyst at Neuberger Berman. Fracking is a new phenomenon in the oil market. There is simply less data available. ”

And some companies may not be available to reopen the taps.

In a $ 20 oil environment, 533 US oil exploration and production companies will file for bankruptcy in late 2021, according to Rystad Energy. Even in a $ 30 environment, more than 200 US producers will go bankrupt, Rystad said.

Instead of restructuring under Chapter 11 procedures, some of these companies may not be able to obtain financing to stay alive. They will be forced to a total liquidation.

"When demand is back online, there won't be as many people there to produce the oil," said Trainer.

Some companies that survive and have undamaged wells may hesitate to aggressively increase production.

“It is not that the oil companies rush to reactivate supply so that they can end up in the same situation. They will wait to be sure, "said Trainer.

What happens if the demand does not recover?

But this bullish thesis depends on a strong recovery in demand, at around 100 million barrels per day that the world consumed before the crisis. And that is not a sure thing.

There is a real risk of a longer recession limiting demand for oil in the United States and around the world for an extended period. In that scenario, prices could remain low.

One of the big concerns is that a second wave of coronavirus infections will attack during the second half of 2020, making any recovery difficult. The director of the Centers for Disease Control and Protection of the United States warned Tuesday in an interview with The Washington Post that a second wave will be more disastrous because it will probably coincide with the start of the flu season.

That could force a return to the orders of social distancing and confinement that paralyzed the oil market in the first place.

"One of the biggest risks to the oil market is a bogus restart of the economy," said Wyll of Neuberger.

No one knows for sure what the demand outlook will be. Much of it will be determined by the trajectory of the pandemic and people's willingness to return to pre-crisis activities such as road trips, cruises, and flights.

Trainer, the chief executive of New Constructs, is betting they will.

"We are social creatures. We are going to want to return to normality, ”he said. "There is a significant amount of the population that will have fun like it was 1999. They are sitting at home bored."