4/22/2020
The price of oil has moved to a unique position in recent days. Headlines this week point to the price of oil falling to ‘zero’ or even to ‘negative’ levels for the first time. While this is unusual, it’s not as nonsensical as it sounds. No, oil is not worthless or now being given away for free.
Commodities are priced in ‘spot’ and ‘futures’ market terms, depending on the location, type of transaction, and buyer/seller. Futures markets can be complicated, since prices can differ between contacts set to expire at different upcoming dates. When markets are volatile, there can be a flurry of activity when certain futures contracts expire, such has been seen over the past few days. The risk with owning any physical futures contract at expiration time is that you are locked in to receive a large shipment of that particular commodity—in this case, futures owners were on track for delivery of an unusually large number of oil barrels but nowhere to put them. In a frantic effort to unload this unwanted oil, traders were willing to accept a far lower price (or even pay to give it away in some extreme cases at the margin). This isn’t a normal outcome. In fact, looking out over the next several months, futures prices for oil appear much more ‘normal’—in the range of $25-30/barrel.
What’s behind the volatility? Usually, either supply or demand is the problem. Today, it’s both. Due to high levels of production from U.S. shale over the last few years, as well as the recent spat between Russia and Saudi Arabia, the Saudis decided to flood the market with oil. This intentionally-accelerated supply drove down prices, since oil is no longer remotely scarce. In fact, storage facilities in the U.S. are so awash in oil that we’re running out of locations. Some may be used to replenish the national strategic reserves, but not all. Often, as occurred this last week, agreed-upon production cuts can put a damper on plummeting oil prices in order to regain some stability and improve profitability for producers going forward.
The other side of the coin—demand—is usually much more stable and predictable. Energy demand has grown at a steady rate over time, along with the global economy, with an increasing amount being consumed by faster-growing emerging market nations such as China. However, the Covid-19 situation has caused world industry to slow to a standstill. Falling demand during recessions normally impacts impact oil prices negatively, though, causing pauses in this long-term demand trend. This demand shock was rapid, unexpected, and remains open-ended in terms of resolution. So, oil markets have now been hit with a double-whammy in terms of what could cause prices to drop substantially.
There are several negative impacts of cheap oil:
- Lower prices mean lower revenues (and profits) for oil-producing companies. The poor performance of the energy sector is a result of persistently falling prices, which has translated directly to lower reported and expected earnings. Some producers hedge oil prices to mitigate the impact of price volatility, but there can be risks there as well.
- In the high yield bond market, a substantial proportion of the lowest-rated issuers are energy companies. Lower prices and revenues raise the chances for further downgrade or outright default, which can shake confidence of the broader high yield market. (Floating rate bank loans are less affected, with smaller weightings to energy.)
- For producing countries, such as Saudi Arabia, Russia, Indonesia, Iran, Nigeria, Angola, Venezuela, and others, this means lower revenues. This can strain budgets, and if it goes on long enough, it can raise the chances of a debt default or trigger political instability. For many smaller nations, oil exports are a primary revenue source, without which treasuries can run low on cash.
- Oil prices, like those for copper and industrial metals, are seen by some as a gauge of the health of the underlying global economy. If prices stay persistently low, underlying concerns surface about global growth (the current slowdown has manifested from feared to actual).
However, there are also some positives resulting from lower oil prices:
- For consumers of oil and oil byproducts, lower prices are better than higher prices. Obviously. (However, due to refining costs, volumes and transportation bottlenecks, often gasoline prices don’t become as cheap as we’d like when oil prices fall.)
- These represent a lower input cost for companies with high energy usage.
- Countries that must import their oil (like India and Japan) benefit from lower costs.
- It’s often been said that the ‘cure for lower oil prices is lower oil prices’. Lower prices incent more usage, which raises demand, then prices, and eventually more production.
From an investment perspective, the energy sector has been one of the more volatile over the past few years, amazingly falling in size to under 3% of the S&P 500 by market cap weighting as of March 31. Consequently, equity portfolios feature a far lower weighting to energy than they once did. Although it’s been seen as a ‘deep value’ opportunity for some time, it continues to become more of a value as time has gone on—as fundamentals have deteriorated. The commodity asset class also features exposure to energy (weighting dependent on the benchmark index used), and could benefit from eventual higher prices. At the same time, stronger prices for energy eventually could well reflect stronger conditions for the global economy generally, which has historically benefitted equities broadly.