Trading opportunity in energy sector

The details of how and why a specific futures contract of West Texas Intermediate (WTI) crude went negative last week have been dissected at many forums. The negative settlement pricing was caused by an extreme case of over-supply. 

This was an unusual situation and it may not repeat. But energy prices have been depressed ever since the crisis started and the scale of the pandemic became apparent. Despite the Organisation of the Petroleum Exporting Countries (Opec) and Russia agreeing to cut production, prices have continued to move down. 

They are likely to stay down for an extended period. While the world is in lockdown, energy demand is down. We don’t have clear timelines as to how long it will take to control this pandemic, develop vaccines, find new ways to do business, etc. Since those variables are unknowns, it’s hard to project any recovery timeline for energy demand. 

The Ministry of Petro­leum & Natural Gas (MPNG) has not yet rele­ased detailed import data for March 2020 (unusual given that it’s late April but presumably it due to the lockdown). But the price of the Indian crude basket fell by 40 per cent in March, according to the MPNG, and consumption was down 10 per cent in March, when the lockdown only affected the last ten days. April will have seen further drastic drops in prices and consumption volume. 

In general, India benefits from low energy prices, and low crude prices in particular, since it imports 80 per cent of crude. However, it might not make too much of a difference now. Exports declined by about 35 per cent year-on-year in March and probably, by much more in April. So the 40 per cent decline in import prices coupled to probable decline in import volume, will be balanced by lower exports. 

The government can raise duties per litre on petro-products, as international prices fall. But the lockdown has meant a sharp drop in consumption of petro products.  Nobody is travelling; industrial usage is down. So the total tax revenue received may still be low. 

The government has several other things to worry about in the energy sector. One is that there are millions of Indians working in the Gulf who are a major source of remittances. Their incomes dip when oil goes down. Remittances could fall this fiscal, causing more stress to dependent households. 

Falling consumption also means lower revenues for the public sector units (PSUs) on the energy chain.  There’s ONGC and OIL at the upstream, and Indian Oil, BPCL, HPCL, etc. in midstream and downstream. There’s GAIL, which markets gas. 

Those companies are taking a beating. Once the oil PSUs release respective Q4, 2019-20 and Q1, 2020-21 (the current quarter) results, we’ll get a good sense of the dimension of the demand collapse. Plans to sell BPCL could fall by the wayside, or be indefinitely postponed. 

Low crude and gas prices also inevitably translate into low investments in renewables. 

Renewables have consistently received investment from private equity (PE) and venture capital (VC) funds, even during the past three years when the rest of the economy saw an investment slowdown. This fiscal, low crude prices could mean a collapse in renewables’ investments. Coal is also likely to see a fall in prices since lack of industrial demand will show up in lower offtake and soft auction prices for Coal India. 

Is there an opportunity here? Certainly for the trader. Energy prices will bounce up and down for months to come. If there is a minor demand recovery, production will also rise, forcing prices down again. The Opec-Russia deal to cut production is a fragile alliance which could easily breakdown. 

Another bout of nominally negative futures prices is perhaps, unlikely. But prices will stay soft with occasional surges. That is clear from the volatility and price trends in long-term futures contracts. Normally this is good for refineries since margins improve but the current extraordinary circumstances suggest lack of demand will prevent refiners/marketers from profiting. Low energy prices could also have an impact on the conventional power sector. Right now there is surplus power because industrial demand is trending towards zero. This means no investments in conventional power either.  (NTPC’s balance sheet will also indicate the level of demand collapse.)

Due to investors shying away from the energy sector, we may be in for a long bear market in the associated commodities.

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