|Forbes.com, Spring, 2020. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.|
On April 20th, U.S. crude prices sold off dramatically. As a result, the futures price for May WTI Crude Oil went negative. Optics aside, this is an unprecedented event that has caused understandable volatility in the markets.
Why it went negative
Simply put, the negative price is an anomaly not seen in modern finance. This can be attributed to collapsing demand under our stay-at-home orders, which is tied to critical oil storage facilities filling to capacity as production vastly exceeds demand in the U.S. Further, the price pressure came as a result of a rumored collaborative or mandated production cut for Texas oil producers stalling and a well-known Hong Kong oil trader “blowing-up”.
So does this mean people will be getting paid to fill their gas tanks? Not quite. It’s worth assessing exactly how a price goes negative.
The price in question is actually for a WTI crude contract in May, and not literally every barrel of oil. That May contract, which is called the “front month” contract, reflected the negative price, but there is more to the story.
If you look at the June contract, the price remained positive. And, in fact, the contract price for May is also now positive. The extreme negative pricing reflected producers overwhelming the famous Cushing, OK storage facility. Without facilities to store oil, it became like asbestos, an albatross, not an asset.
But the logistical issue is fundamentally one of supply and demand. Weeks ago, Saudi Arabia started an oil war with Russia in response to the latter’s refusal to scale back production in light of decreased demand due to the coronavirus. With no end to production in sight, and dramatically reduced demand, we now have a storage issue.
Unfortunately, this is a situation that is unlikely to resolve itself quickly. Eventually, we will come to some sort of agreement on production, but demand is tethered to opening up the economy, which will be a slow grind.
There will be short-term market impacts
Many people are surprised to learn that the United States is the world’s largest oil producer. Indeed, demand for domestic energy production was heretofore an unheralded driver of GDP growth.
For those companies operating in the shale, there are concerns about debt default. Some $86B of debt in the U.S. energy patch comes due within the next four years. These companies depend on high oil prices to be profitable, and were already impacted as oil prices fell throughout the decade. In fact, Russia’s hard stance on oil prices was part of an elaborate effort to undercut the U.S. oil industry.
We can anticipate there will be some restructuring of debt. However, the infrastructure in places like the Bakken formation in North Dakota isn’t going away. These debt burdens will be offset by billions in revenue.
We can fully expect production to resume once prices rebound, which they almost certainly will. But there is no doubt the potential for loan default has impacted bond prices at a time when people are looking to them for security and safety.
Diversification becomes a bit more sophisticated
So, how do we react? I always preach diversification, but even that is an often misunderstood concept.
We tend to think of diversification in binary terms. Stocks are performing poorly? Invest in commodities.
Recent events throw a wrench into that zero-sum approach. In spite of our domestic energy production, our economy is remarkably diverse. In contrast to Iran or Venezuela, or even Russia, we can take a few haymakers without going down for the count.
Looking long term
There is a potential upside. Under ordinary circumstances, the manufacturing sector tends to appreciate lower energy prices. Lower production and lower distribution costs mean more product can get to the market more inexpensively.
Provided the infrastructure remains to provide oil when the economy needs it again, low prices have the potential to spur economic growth.
Eventually, the travel industry will look to rally, and low fuel prices will only aid in this endeavor. However, the pandemic is also causing companies to augment the ability for employers to work remotely. This has the potential to keep demand for fuel (and prices) relatively low.
Even as it pertains to energy, the outlook is not entirely bleak. Natural gas, of which the United States is also the world’s largest producer, continues to displace coal as an energy source, and is less susceptible to geopolitical turmoil.
Of course, as oil prices tumble, along with business losses, come buying opportunities. As I like to remind people, if you invested just before the stock market crash in 2007, you’ve still made money by now. If you invested after the crash, you made money much more quickly.
Whatever the response to the Coronavirus, we will remain a free country with an educated populace and strong economic diversity. To a certain extent, we remain invested in the American experiment. Until someone declares war on that and wins, there will always be a way forward.