April 2020
Breene Murphy, Director of Client Experience, recently sat down with Adam Phillips, CFA, CFP®, Director of Portfolio Strategy, to discuss what investors need to know about negative oil prices. Below are the key takeaways from their discussion. If you have further questions, please do not hesitate to contact your Financial Advisor.
Breene: Adam, oil prices recently went negative for the first time in history. How is that possible and what does it mean?
Adam: The recent moves in the oil market are certainly extraordinary, and there is quite a bit to unpack here. Unfortunately, contrary to what the headlines may suggest, American motorists are unlikely to be paid to fill their tanks anytime soon.
Perhaps the best place to start is with the futures market. Many investors and businesses invest in commodity futures to either speculate or hedge against the risk of price swings in an underlying commodity over a given time period. For instance, in the case of oil, a transportation company may hedge against higher fuel costs by using futures to purchase oil at a predetermined price on a predetermined date.
In many cases, these investors have no intention of holding these contracts until they expire, and instead sell them just prior to expiration to avoid having to take physical delivery of the commodity.
As futures contracts approach expiration each month, it is common for investors to sell and “roll” their positions into the following month. In the past, this practice has been very smooth as there were plenty of buyers willing to take possession of the physical oil.
Unfortunately, this implicit arrangement was thrown out the window on Monday as investors who were “long” oil futures contracts expiring in May looked to exit their positions ahead of expiration but found no willing buyers. The price of these contracts cratered and eventually fell to -$37.63 per contract.
One futures contract buys 1,000 barrels (roughly 42,000 gallons) of oil, so it is easy to understand why desperate investors would be willing to pay buyers to take the oil off their hands.
At the risk of confusing things further, I should note that the type of oil we are referring to here is the U.S. benchmark known as West Texas Intermediate (WTI). It is important to highlight that the contract price on the global benchmark for oil (known as Brent crude) only fell as low as around $19 per barrel earlier in the week.
The collapse in oil prices was driven largely by limitations on storage capacity. After all, it doesn’t matter how cheap oil is – if you don’t have a place to put it, why would you buy it? In fact, a major storage hub in Cushing, Oklahoma, is now nearly 80% full after being at just 50% capacity in February. Meanwhile, a recent Wall Street Journal article noted that roughly 150 million barrels of oil are currently being stored at sea, as oil tankers have been repurposed as temporary storage facilities rather than being used to transport the commodity.
Breene: It sounds like this is part of a larger story. What is that larger story?
Adam: The problem stems from a mismatch between supply and demand. Oil prices started the year at around $60 per barrel, before plunging in March at the outset of the price war between Russia and Saudi Arabia.
The oil industry saw a glimmer of hope last week when global producers agreed to cut daily production by 9.7 million barrels per day, representing roughly 10% of total production. Enthusiasm around the deal soon faded as many realized the cuts, while historic, would not be enough, and prices eventually fell below $20 per barrel. Unfortunately, it is both difficult and costly to shut down and restart wells, so many oil companies prefer to continue pumping oil even if it is unprofitable at current levels.
Normally, oil consumers serve as a stabilizing force when energy prices decline. However, with most of the world still under some form of lockdown, there is less of a need for oil. In fact, the International Energy Agency expects global oil demand in April to decline by 29 million barrels per day over the prior year, providing additional support to the argument that the 10 million in production cuts will do little to bring supply and demand back into balance.
Breene: Has the Investment Committee made any recent moves to address this?
Adam: It is worth noting that recent chaos in the oil market did not lead to a sharp selloff across the energy sector. In fact, the sector only declined by around 3% on Monday as oil prices went into negative territory, which some could argue is a normal day given recent swings we have experienced in the equity market.
That being said, we recently reduced energy exposure within portfolios that contain individual stocks. These moves included reducing our holdings in oil producers and reinvesting a portion of the proceeds into an oil refiner that is expected to be better insulated from the current price shock.
However, recent events surrounding oil are less significant in the context of our broader portfolio strategy. After all, energy companies now account for just 3% of the S&P 500 and contribute less than 5% to corporate earnings.
Breene: The oil markets appear to have stabilized but where do we go from here? What should investors be focused on?
Adam: Oil prices are likely to remain depressed for the foreseeable future and will be driven largely by supply and demand dynamics. Importantly, the futures market is suggesting higher prices going forward even if that recovery is slow to materialize. For instance, futures contracts expiring in the summer of 2021 are currently pricing in the mid-$30’s, compared to the current price of $18 for WTI oil.
As headlines persist in the coming days and weeks, we expect global oil producers to come under increasing pressure to make additional supply cuts.
On the demand side, oil consumption will not be restored to normal levels until economies can re-open. In the meantime, we could see countries provide interim support by purchasing oil directly. In fact, President Trump recently announced that the U.S. could potentially top off its Strategic Petroleum Reserve by purchasing 75 million barrels of oil. Unfortunately, the reserve can only absorb 500,000 per day, so there does not appear to be a quick fix.
Breene: Thanks for your time and insight, Adam!
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