Send Oilers, Masks & Money: Our Perspective on Coronavirus et al.
With everything going on in the world, we feel compelled to provide our perspective in an effort to help facilitate the asking of the right questions and hopefully offer some context as a means of reducing uncertainty. At Research & Innovation, our clients call upon us to contextualize complex challenges and the risks/opportunities which they are faced with whether it be through providing due diligence, protecting against cybersecurity threats, consulting on strategic transactions, dispute advisory, or generally providing solutions architecture.
What Ails You, Market?
We are reminded of the old joke, “Other than that Mrs. Lincoln, how did you like the play?”. Other than the pandemic risk to the economy posed by Coronavirus and the seismic price war shaping up in the oil industry, the global economy seems to be just fine. If popular sentiment is to be believed, the only two things that separate the value of the markets from the last week of February and the second week of March is Coronavirus risks and oil prices. This should be a relief to all trying to make sense of the economy as the first step in valuation is quantifying the paradigm.
To some extent we are reticent to summarize the history of the Coronavirus given that nearly every thinkable outlet has written about what it is and how it came about. That said, for the sake of completeness we are compelled to offer a brief recitation. The Coronavirus disease 2019 (abbreviated COVID-19) is an outbreak of a new respiratory disease that was first detected in China and which has now been detected in more than 100 locations internationally, including the United States. The virus was first recognized in late 2019 and today was upgraded to pandemic status by the WHO. Anecdotal evidence from China suggests that about 16% of those infected with Coronavirus will result in serious illness, with the greatest risk to older people and those with severe underlying health conditions.
The Coronavirus threat is not a mortality threat from a population extinction or even population reduction standpoint. Even accepting the recent prognostications that the ultimate fatality rate for Coronavirus in the United States will approach 1%, (using a ten-fold severity multiplier from influenza mortality rates), and even if you assume fifty thousand American cases, the global total fatality rate for 2020 would be around five hundred; which according to the CDC is roughly the same as the number of deaths in the United States from domestically acquired food poisoning cases for the first five months of the year.
For a global perspective, if you assume that worldwide cases are less likely to exceed three quarters of a million patients, based upon the same fatality rate as above, the total number of worldwide deaths from Coronavirus is likely to be around seven thousand people. While tragic, this represents less than 1/10 of the number of people around the world who are estimated to have died from snakebites in the first six weeks of 2020, based upon WHO data from the last 12 months.
The Spanish Flu of 1918 had a mortality rate of 2-3% and a 2018 retrospective estimate suggests about 17 million fatalities which would imply an infection rate of about 850 Million people (or roughly one third of the population at that time). Interestingly, the Spanish Flu got its name due to press censorship related to World War I. While most of Europe and North America was embroiled in the conflict, Spain was neutral and therefore the Spanish press was not subject to the same restrictions regarding publishing bad news about death and crisis on top of all of the bad news about death and crisis coming out of the war. Since Spain was the only country significantly reporting on the pandemic, when others started to pick it up, they simply referred to it as a disease coming out of Spain (thus the Spanish Flu).
The Black Death of 1347 to 1351 was easily the deadliest pandemic and killed about 125 Million people, representing nearly 1 in 4 who were alive at the time. Europe took nearly two hundred years to recover and Florence did not recover in terms of population for nearly five hundred years. While the Black Death did not suffer from the rapidity of transmission around the globe due to the lack of transport infrastructure beyond a sturdy horse and a sailing ship; it does provide a framework for contextualizing an extinction level event.
The price of oil is chiefly governed by three things: demand, the cost of extraction, and greed. Demand impacts price through elasticity of price, the cost of extraction represents the input expense of acquiring and delivering the product, and greed is the effect of a producer’s decision-making regarding oil production irrespective of demand the cost of extraction. A week ago, global output of oil was about 100 Million barrels per day. Of this, Saudi Arabia represented approximately 9.89 Million of these barrels. On February 28th, Brent Crude oil was $49.67 per barrel, today it closed at $35.72. On March 9th, Saudi Arabia announced a staggering plan to increase their production by 13 Million barrels per day (nearly a 2.5x jump). We concede that the aforementioned issues of Coronavirus are likely to impact demand although IEA forecasts that demand will only be cut by about two and half million barrels per day due to the economic disruption. If the cost of extraction likely did not change in a week, and demand estimates fell by 2.5 Million barrels, then the resultant change in price is due to greed on the part of Saudi Arabia (and then followed on by Russia and others).
History has shown indicia of a “Law of Conservation of Upstream Oil Assets”. This law appears to state that oilfields (generally) cannot be created or destroyed, only transferred. While rig counts, which is a measurement of how much oil production is occurring at any given time can vary dramatically (Baker Hughes publishes a weekly rig count survey which shows a historical high of 1609 rigs in 2014 and a low of 325 in 2016), it does not mean that the amount of oil recoverable changes just the rate at which it is being recovered. Notwithstanding advances in technology which improve viable recovery rates, the terminal value (no pun intended) of oilfields ought not move nearly as dramatically as the moment to moment value of oil given the amount of time it is going to take to extract the resource.
The true risk to the US oil industry comes not from the daily price of oil but rather from the expense of leverage and overhead commitments of each oil company, which necessitates that they meet fixed cost obligations on a daily basis irrespective of price. This is a story that is as old as time, and draws direct comparison to the Biblical Parable of the Bridegroom where there were ten virgins who were supposed to bring oil filled lamps to meet the bridegroom upon his arrival. The foolish ones did not pack any oil reserves and the wise ones took extra oil reserves with them (and thus were not under timing pressure); when the bridegroom was delayed they all became inattentive. A little while later when the bridegroom was spotted on the horizon, the foolish begged the wise to subsidize them with some of their liquidity. The wise ones indicated that if they did that, there would not be enough for everyone and they should go into the market and attempt to secure oil last minute. By doing this, the foolish ones were away when the bridegroom finally arrived and thus were shut out of the ensuing banquet.
Like in the parable, the profligate of the oil industry are over-leveraged and have high committed fixed expenses; and they will be caught without capital to ride through this delay in the return to rational oil prices. Given the precipitous drop in oil prices, they will find themselves having to go to the markets of selling assets, borrowing money, and bankruptcy in order to cover the difference between their inflows and outflows. The wise, understanding that the price of oil is notoriously fickle, will have planned ahead and set aside reserves in the form of cash and available credit, and will not have to go out to the market. Avoiding having to go out to the market will allow them to be prepared for what is to come and enjoy the feast (which will come in the form of inevitably higher oil prices and the ability to pick off the assets of the foolish at distressed prices).
What the broader markets seem to have forgotten about the value of domestic oil companies is that they can only pump so much oil at any given time. Even if their cost structure cannot support pumping oil today it does not mean that the value of the resources in the ground will not have a future value and thus are an asset (much like undeveloped land) to be exploited by future drillers.
Greed based dislocations cannot last forever because ultimately even the most stalwart of trade war advocates will have to bend to the practical realities of selling too inexpensively. While increasing oil production by more than double might result in higher absolute dollars, it also will likely result in a glut of oil being produced and not sold to the extent that other players do not actually wither and die but rather reorganize through strategic acquisition. We have indulged the speculation that Saudi Arabia may believe that this increased cash and pressure on the US oil industry will give them the opportunity to be the wise among the virgins and scoop up domestic oil assets at a relative discount – that said we do not believe this is feasible given the impediments posed by factors such as US Antitrust Laws.
Contextualizing Fear & Liability
All of this is not to say that Coronavirus does not pose a significant pandemic risk to the economy. The risk to the economy is the breakdown of commerce not the breakdown of health. While over half of Coronavirus cases recover within ten days, the lingering reticence of people to travel and congregate is likely to last into the second quarter of this year.
We believe that the risk to the economy due to lack of trade is functionally analogous to that of a natural disaster. People will not go about their normal business because of an environmental impediment that increases their fear of unsafe conditions and they will wait it out until the impediment subsides. Hurricanes, Earthquakes, Wildfires, and Tsunami recoveries all operate under the same conditions and the catastrophe modeling available for issues of business interruption due to cat events provides a very reasonable yardstick with which to quantify the cost to the economy from this unscheduled interruption.
On a long-term basis, the cost of Coronavirus can be seen as the net effect of the lost opportunity, less the sum of the replacement transactions when the epidemic dissipates plus the value of the stimulus from governments and central banks. Any discounting beyond this is simply an overreaction that should prove shortsighted in nine to eighteen months.
The lost opportunity will come from the expansion of the travel ban to include Europe and the United Kingdom that the President announced earlier tonight. The most obviously impacted will be the airlines, hotels and tourism (looking at you Mickey Mouse). Lost opportunity will also come from cancelled conferences and events (SXSW, Coachella, and major sporting events). We see the greatest risk to the broader economy coming from people simply not engaging in their normal activities and earning and spending accordingly.
The President has indicated this evening that he intends to bring about significant financial resources to ensure the soundness of the economy, from delaying tax payments of affected payers to a potential payroll tax cut, to emergency loan assistance from the SBA, and concessions from the health insurance industry, these inflows will buffer against the outflows. Similarly, decreasing interest rates and a discount on oil prices will serve as an avoided expense, creating additional resources to off-set the impairment of economic activity.
As Macbeth once said, “If it were done when ‘tis done, then ‘twere well it were done quickly”. Scarcely was there ever a more apt summation of the requirement that stimulus be swiftly and decisively implemented. We are concerned that the legislators in Washington may be unable to help themselves from trying to make this an opportunity to score political points and ultimately slow down the process.
Given that the stimulus measures proposed are likely to be temporary, it is more important that the market get a clear indication that governments are acting decisively and assured of help then a dissection of every possible way of compensating the affected that leads to a slow response or worse little to no response.
We see a risk to the economy on a perception basis given the public’s ceaseless thirst for negative news. Inevitably, prominent people will test positive for Coronavirus as we have seen from the stories regarding Tom Hanks and Rita Wilson to U.K. Health Minister Nadine Dorries testing positive. While this will likely lead to much spilled ink, we see the true risk being the shake to market confidence were a structurally vital participant of the economy to be credibly announced as testing positive for Coronavirus. Our short list of these members includes the President, Vice President, Fmr. Vice President Joe Biden, Sen. Bernie Sanders, Warren Buffet and Jamie Dimon (who is recovering from emergency heart surgery and thus more susceptible).
Given that the net effect of the recent moves by Saudi appears to be the opposite of a problem, the oil price wars deserve the opposite of a solution from the larger markets. The benefit of lower oil prices ought to offset the negative effects on the US Economy from the loss of revenue in the oil industry and therefore does not deserve a macro response but rather attention to the reshuffling on a name by name basis.
A View Toward The Horizon
To the extent that the effects of the Coronavirus do not jeopardize broad based productivity for a significant duration (our view is that given the seriousness with which the world is treating this matter and the increasing temperatures in the Northern Hemisphere that will serve as an impediment to the spread of Coronavirus, there is unlikely to be a serious risk of contagion past the beginning of May) then we are left balancing whether the durational effects of some of the stimulus such as low interest rates (which will be much slower to rise again) will end up reinvigorating the economy and markets. Our view is that the indication of this will marked by a push toward companies making use of the discounted borrowing costs and buying back their stock as a means of improving their earnings ratios and enticing investors back into equity positions.
As an aside, in 2017 the World Bank, issued the IBRD Pandemic Bond in the form of two tranches totaling $425 Million (including trades in the derivatives market). The premise is deceptively straightforward: If a pandemic occurs which meets specified criteria (notably number of infections, duration of the epidemic, and geographic diffusion) then the principal of the bond is used to pay for the disaster recovery. Otherwise, the bonds pay 6m LIBOR + 650 and 6m LIBOR + 11.1% based upon different baskets of covered perils of which Coronavirus is in both tranches. If the triggers are hit then one tranche could lose as much as 100% of principal while the other would lose 16.7%.
While the bond has not officially defaulted, this is due to the triggering mechanism which requires that the pandemic be active for twelve weeks and then provides a further two weeks for case growth rate and confirmation data calculation. Essentially, the earliest the bond would pay is April 9th and it will only pay to support the poorest effected countries. Given that the bond was set to mature on July 15, 2020, this was extremely well timed.
As pandemic risk becomes an increasingly prevalent facet of our interconnected modern society, we anticipate seeing parties exposed to pandemic risk continue to seek novel mechanisms of financing their exposure and expect this sort of structuring to expand to other similar maladies.
We welcome the opportunity to engage in a further conversation regarding the greater macro landscape or how we might be of assistance on a more granular level.
This report is a summary of certain developments that may be of interest to clients and prospective clients of Research & Innovation Co. This report is for general information purposes only, is not a complete summary of the matters referred to, and Research & Innovation does not undertake to keep the recipients of this report advised of future developments or changes in any of the matters discussed in the report.