By Matthew Gaude & Shawn McGuire
We are witnessing a number of historic moves in the stock market, commodity markets, most notably the crude oil market, our economy and the dramatic change in the way we are living our lives currently. You probably have seen the headlines regarding the decline of crude oil and going “negative” in prices. Here is what is happening.
Why Did the Oil Market Crash?
History was made in the energy markets Monday as the May crude oil futures contract crashed into negative territory for the first time ever, a day ahead of its expiration. So we wanted to take time to explain: 1) Why oil prices turned negative yesterday, 2) What that means from a macro standpoint (beyond the short term), and 3) Is it a bearish influence on stocks in the short and longer term?
Why Did Oil Turn Negative?
This will get a little complicated as the dynamics of the physical oil market are intricate, but from a 10,000-foot view, the reason May crude oil turned negative was because: 1) Demand has been destroyed, so no one needs oil right now, and 2) There’s still a lot of oil in the market, and there isn’t enough storage (literally no place to put it). Storage has become so expensive, given the huge supply and low demand, that prices for May delivery of oil turned negative.
For the first time in history, producers were willing to pay traders to take oil off their hands. This oddity is partially a function of the particularities of futures contracts:
- Buyers Wanted (At Any Cost!)
Futures contracts normally rollover to the next month without much happening, but in this case traders saw the May contract as a “hot potato”. No one wanted to be stuck taking delivery of oil when the world is awash in it and the country is in lockdown.
- A Time and a Place
Oil futures contracts specify a time and place for delivery. For WTI oil, that specific place is Cushing, Oklahoma. With most storage capacity booked already, taking physical delivery wasn’t even an option for many players.
In other words, sellers outnumbered buyers by a crazy margin — and because oil is a physical commodity, someone has to ultimately take the contract.
So, with it becoming apparent that no physical players were in the May contract yesterday, speculators began to crush a market with no buyers, making history as a live crude oil contract turned negative for the first time on record. In fact, Crude Oil had it’s largest 1 day % decline ever, closing down -43.4%.
Bottom line, the negative oil prices that splashed across the financial and mainstream media were the result of a unique, short-term supply and storage issue.
What does the oil decline mean from a broad economic standpoint?
Oil remains under extreme pressure because there remains a massive imbalance between supply and demand right now. The timing of the “price war” between Saudi Arabia and Russia (which was to a degree a front for a war on the previously booming U.S. shale industry), could not have come at a worse time as global oil production surged in Q1 while consumption of refined products, namely gasoline, evaporated due to sweeping shelter-in-place orders that resulted in economies around the world effectively grinding to a halt. By some estimates, gasoline demand has dropped to levels last seen in the 1980s, while jet fuel demand is at multi-decade lows!
Following is a chart showing the huge drop in demand for gasoline.
In fact, Crude Oil prices are back to where they were in 1999.
Following is a chart of the drop off in crude oil demand, from a previous global demand of 105 million barrels of oil daily.
Now, even though the price war has “ended” with the recent OPEC+ and G20 agreements to reduce pro- duction by upwards of 20MM b/d, demand has shown little signs of recovering yet. (1)
And, there in lies the more important point: The oil market is sending a bold warning that economic growth may not recover nearly as quickly as some equity investors would hope.
The OPEC+ supply cuts provided an opportunity for oil to rally, but until there is clarity on demand, it can’t. And, demand will only increase once people start driving again, airlines are back to full capacity and general global transportation has been restored.
Overcoming the Supply Glut
What do you do when oil is practically free?
You store as much of it as you can, and hope that at some point you can sell it for more. Unfortunately, everyone has the exact same idea, and as a result there is an historic glut that is filling up the world’s storage capacity, both on land and at sea:
- In March, it was estimated that 76% of the world’s available oil storage capacity was already full. (2)
- A record setting 160 million barrels of oil is being stored on tankers at sea, according to Reuters. (3)
- The cost of renting an oil supertanker has gone through the roof. Rates have jumped from $20,000 per day to $200,000-$300,000 per day, according to Rystad Energy. (4)
What does this mean for stocks?
Tuesday’s negative oil price implosion is not a bearish gamechanger for stocks outside of the energy industry. We have not been invested in energy or energy equities for a long time due to the poor performance of energy stocks in general. In addition, this decline in crude oil will have a major impact on energy companies that supply drilling products, companies that drill for oil which are not profitable with oil at current levels and are slashing their drilling budgets.
The headline negative oil prices were historic, confusing, and to some, scary. But they were caused by a very short -term lack of storage, not a sudden implosion of demand that would send risk assets lower. At the same time, oil is still under pressure and the production cuts by OPEC+ have yet to make a difference, because the oil market does not have any confidence when demand will return, which is another way of saying the oil markets are not confident the economy will return to normal anytime soon. We think that’s a signal that people should be aware of (and make us a bit more cautious) as hype regarding the reopening of the economy builds.
I recommend this great Infographic from Visual Capitalist detailing “How Prices Went Subzero: Explaining the Covid-10 Oil Crash” Click on the following link to view the Infographic https://www.visualcapitalist.com/subzero-oil-price-crash-covid-19/
Matthew Gaude is an *investment advisor representative and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. Working first as a commodity broker and then as a Business Development Manager for a national broker-dealer in previous jobs, he has the insight and experience to help clients understand the complexities of the market and implement strategies to minimize risk. To learn more about Matthew, connect with him on LinkedIn or visit www.liveoakwm.com.
Shawn McGuire is a financial advisor and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. He has worked in financial services since 2002 in positions ranging from financial advisor to stock broker and portfolio manager. As a CERTIFIED FINANCIAL PLANNER™ professional, he is trained to help clients with virtually all their financial needs. To learn more about Shawn, connect with him on LinkedIn or visit www.liveoakwm.com.
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