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With the current crisis driving oil prices to their lowest level in decades, and oil piling up in barrels and tankers around the world, investors, including owners of oil and gas rights, may have to consider their options
Oil prices were already tumbling in early 2020, thanks to a price war between Saudi Arabia and Russia. Then as the coronavirus spread across the globe in March, oil had a second major shock—one so severe that by April 20, short-term futures contracts for May went negative for the first time ever. Though that anomaly only lasted a few hours, the symbolism was far-reaching, says John J. Kelley, National Specialty Asset Management Executive for Bank of America Private Bank.
“For oil and gas investors, volatility is nothing new and price fluctuations are part of owning these assets,” Kelley says. “What’s different this time is how far it’s fallen and how fast it’s happened. Oil fell from over $60 per barrel at the end of December to just over $11 per barrel on April 21. Since then it has recovered to over $40 per barrel as of the end of August for the October futures contract for West Texas Intermediate crude oil.” For investors, this all calls for a careful re-evaluation—not just of energy holdings but of their overall portfolios.
"For oil and gas investors, volatility is nothing new and price fluctuations are part of owning these assets. What’s different this time is how far it’s fallen and how fast it’s happened."
In more normal times, an oil glut might be eased by a spike in consumption by businesses, and waves of travelers driven by cheap gas. Yet now few people are traveling, and businesses are scaling back. “The current economic crisis has been driven in part by a collapse in mobility,” says Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. “This is not a normal recession.” Hyzy outlines three potential scenarios for the economy and oil markets during 2020 and 2021.
The first and most optimistic involves a relatively straightforward economic recovery, with normal life, travel and consumption approaching pre-virus levels in 2021. The second scenario also involves recovery, but with consumer behavior and many industries fundamentally changed and energy consumption reset to lower levels. In the third and riskiest scenario, attempts to return to normal life result in new outbreaks of the virus, rolling lockdowns, and ongoing volatility and economic disruption.
While it’s too early to say which will come to pass, oil prices in any scenario are likely to remain low for the foreseeable future. BofA Global Research forecasts West Texas Intermediate prices at $39.70 per barrel for 2020 and $47 for 2021, and Brent crude prices at $43.70 for 2020 and $50 for 2021.1
Most investors who own oil and gas interests lease to producers, who then pay monthly royalties. Because of the natural time lag between production and payment, the initial impact of the plummeting prices has been delayed, so many investors received healthy royalty checks for December, January and February production—before the coronavirus crisis escalated, Kelley says. As new royalty checks for March production onward reflect the deeply lower prices, investors will begin to feel the effects. “It’s important to understand the dimensions of that decline, take it into account when making decisions, and think about how to position one’s overall portfolio,” Kelley says.
One of the primary considerations is how to make up for lost income—a special concern for families with oil and gas interests held in trust to support individual members. In some cases, immediate liquidity needs could require selling non-oil and gas assets. “The reality may be that for the safety, care and wellbeing of the beneficiary, you have to think about a special distribution of principal if the trust allows that,” Kelley says. “If you haven’t done so recently, reexamine the trust’s overall asset allocation with its long-term goals in mind.” A rebalancing analysis may reveal if the portfolio is over weighted in a particular direction and which assets might be sold to help keep the portfolio in balance.
Investors should also consider the longer-term implications, Kelley suggests, noting that “this is not something that’s going to blow over in a month.” Whether investing inside or outside of a trust, consider the ongoing role that oil may play in your portfolio, and what other kinds of investments might help replace royalty income as oil prices likely recover over the next year or two.
For oil and gas companies battered by the plunging prices, survival and long-term prosperity may depend on their financial condition going into the crisis, Kelley says. “Energy companies that were over-leveraged may struggle to survive. We’re likely to see a lot of industry consolidation, as smaller and mid-sized energy companies are bought out by much larger ones,” Kelley believes.
Large, stable energy companies could be attractive for long-term investors to consider looking towards an oil recovery that will likely take several years to play out, Kelley says. And their potential dividends could help replace income from bonds at a time of extremely low interest rates. Yet considering the ongoing volatility in energy, such investments may only be appropriate for investors willing to tolerate elevated risks, he adds.
Beyond energy, investors may find income opportunities in dividends from other major U.S. corporations, says Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. While the pandemic has created huge challenges for businesses in most sectors, large companies in areas such as technology and healthcare, among others, are likely to see rising demand, and present long-term growth potential. “As the world heals from the coronavirus, a shift towards ‘e-everything,’ from e-commerce to e-sports, should take hold,” Hyzy says.2
In the short term at least, depressed oil prices may slow demand for alternative energy sources, Kelley believes. At the same time, many investors remain committed to supporting alternative energy in the interests of a cleaner environment; and many companies have committed to the use of clean energy sources in their own operations. Yet the vast supply of cheap oil is likely to make alternatives more expensive by comparison for the next several years, Kelley says. Looking beyond the next decade, he adds, “alternative energy is going to be more and more of a factor.”
Information is as of 08/27/2020
Opinions are those of the author(s), as of the date of this document and are subject to change.
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The Chief Investment Office (CIO) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., (“Bank of America”) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S” or “Merrill”), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of Bank of America Corporation.
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