April Thoughts from the Research Desk
April 24, 2020 | Simon A. Tryzna
On Monday April 20th, West Texas Intermediate (WTI) Oil was trading as low as -$37 a barrel - the first time in history that oil has traded below zero. In an unprecedented economic environment, this was the latest "for the first time in history" moment. From a viewpoint of a long-term investor, it is important to understand why this occurred, what it means from an economic perspective, and what it means from a capital markets perspective.
Why did this happen?
When investors see or talk about the price of oil, they are usually talking about the price of a barrel of West Texas Intermediate (WTI), the U.S. crude oil benchmark. The price is determined by WTI futures contracts trading on the Chicago Mercantile Exchange (CME). A futures contract is a way for a buyer to lock in a price of a good to be delivered at a pre-determined date. As an example, an oil buyer, such as an airline, typically locks in the price of oil well in advance – they can do that by going directly to an oil producer and locking in a price via a new futures contract, or by going to the futures exchange, like the CME, and purchasing contracts there. Oil producers are incentivized to sell to protect themselves against drops in price. The way the contracts are designed is that on a certain date, the holder of the contract must take delivery of the oil. The standard contract – 1,000 barrels – is about five tanker trucks worth. If you are a user of oil, you are typically okay with oil being delivered – more often than not, that is the reason for purchasing the contract in the first place.
Now, futures also offer an opportunity where traders can participate for speculative or long-term investing purposes. Instead of taking physical delivery at the end of the month, they might roll the contract over to the next time period or exit the contract depending on their strategy. Contract owners sell the contract and purchase the next one simultaneously to maintain their exposure to the asset (in this case oil) without needing to take physical delivery of it. On Monday, the rolling of the contracts became a game of “hot potato.” With the price going negative, oil sellers were literally paying buyers to take oil off their hands. If you were in a position to take delivery of 1,000 barrels of oil, you would have been paid $37,630 to do so.
This all came into fruition as retail investors attempted to buy the March dip in oil, flooding quickly into the United States Oil ETF (USO). On March 9th, the day that oil plummeted following Russia’s & Saudi Arabia’s decision to not cut back production of oil, USO had $997.93 in AUM. One month later, on April 9th, it had $3.17B. The fund was initially set up to invest in front-month contracts until two weeks before expiration. Without going into too much details about ETF mechanics, USO was the primary culprit of the “hot potato” game. The ETF began dumping the contracts with very few buyers. The primary reason is that U.S. storage is almost at capacity. The storage facilities in Cushing, OK (where major pipelines intersect) were at 40% capacity to start the year; currently they are at 70% and it is forecasted that they will be full by mid-2020 based on current production levels. In fact, it is now cheaper to store oil in a tanker at sea then on land. At the moment, there are about twice as many barrels of oil at sea than in normal conditions.
With oil prices recovering from Monday’s trading, ending the week at $17.15, the issue at hand is a critical one – there is simply a lot more supply than demand, and, at least as a country, we are running out of places to store it. While there is a plan in place to cut back on oil production, it does not go into effect until May 1st. Even then, it is not a guarantee that oil producing countries will be compliant.
What does this mean from an economic perspective?
When the U.S. economy began to close in March, the industries that were almost immediately affected were retail, restaurant & bars, entertainment, airline & cruises, and hotels & tourism. We can now add oil to that list as U.S. oil producers are slashing salaries, new projects, and jobs. Even before the oil price collapse, Exxon Mobil slashed their 2020 expansion and production budgets. Smaller oil companies may look to seek bankruptcy protections, others will apply for small business loans, and laid off employees will join those already applying for unemployment benefits. As Congress is working on CARES IV, a possible stimulus for oil companies is now being discussed. For the U.S. oil industry to be profitable, oil needs to be around $40 / barrel.
From a global perspective - the lack of demand is a clear and obvious sign that the world economy has come to a complete standstill. For countries whose economies revolve around oil production, the impact will be painful for the foreseeable future. A quick run-down:
Iraq - About 90% of Iraq’s government revenue comes from oil. The government could meet its costs when oil was trading at about $61 / barrel.
Mexico - The federal budget relies heavily on oil production and exports. Pemex, the state oil company, has had its own share of issues (like corruption) even before 2020 and President Lopez Obrador has put together an ambitious plan to revive. But now, Pemex has had difficulty raising money as agencies have downgraded the company’s credit. That said, Mexico wants to revive Pemex with hopes that they will rescue the economy. Time will tell how this will play out.
Venezuela - Venezuela was dealing with its own set of issues before 2020, and with oil prices collapsing, the International Monetary Fund thinks that Venezuela's economy will shrink 15% this year, which would be largest contraction in the region.
Nigeria - derives 90% of export earnings and two thirds of government revenue from oil sales.
Saudi Arabia - world's largest crude oil exporter. Projects to diversify away from that are stalled because they need the revenue from the oil to finance those projects. To balance their budget, they need $80 a barrel.
Russia - Russia has built up a "rainy-day fund," as they have been hoarding gold and hard currencies. Their break-even price is roughly $40 / barrel. They should be able to whether this storm better than other oil producing countries as they do have a fund to fall back on.
None of those countries, aside from Russia maybe, are big players from an overall global GDP perspective, so global growth on aggregate may not be impacted by a deep slow-down in those economies. That said, there are secondary ramifications to consider from a geopolitical point of view. At this point in time, the current U.S. administration is under pressure to work out a deal with China so they import their oil from the United States. How our current administration, and global leaders, respond to this with regards to trade deals could have longer term consequences. If China, through their One Belt One Road initiative, starts to bail out Middle East economies - what would the long-term repercussions be? While it is easy to get caught up in the daily headlines, there are major long-term implications that will come away from this crisis. What the spillover is from the oil crash will be just one of them.
What does this all mean for the capital markets?
On the credit side, the high yield market is vulnerable to a prolonged low oil prices, as energy makes up 13% of the broad U.S. market. The positive news is that the Federal Reserve has stepped up and, it appears, put a floor in the market. Despite the fall in oil, the high yield market (represented by HYG) was only down -3.40% this week. Emerging Market Debt (EMB) is only down -1.96%. As the oil story unfolds, we will be paying attention closely to those two sectors.
Because the energy sector makes up only 2.8% of S&P 500 index, the drop in oil has not had a major effect (aside from contributing to the initial market sell-off). In comparison, tech is 25.2% and healthcare is 15.9%. One thing to keep in mind - the way the S&P 500 index rewards winners due to how it is constructed. If a company’s stock price appreciates, that companies market cap (share price multiplied by shares outstanding) goes up, and their weight in the index is higher. On the flip side – if share prices fall, the market cap gets smaller, index weight goes down. With energy being the smallest component of the index, any sector specific move is miniscule. Any directional move in the broader market would be sentiment based, such as if investors realized that growth is considerably worse than what is being priced in.
We were on a call with Mohamed A. El-Erian, the chief economic adviser at Allianz and ex-CEO & co-CIO of PIMCO, and he summarized equity investors as falling into one of two camps: the first – markets are forward looking and we can dismiss earnings, lack of visibility, etc. because the destination is a recovery; the second – if the first camp is wrong, the Fed will step in and that is the reason to stay invested or invest more. At the moment, the stock market appreciation from the bottom is almost dollar for dollar correlated with federal and monetary stimulus. From a forward Price to Earnings as of 4/21/20, the S&P 500 is trading at a multiple of 18.46x. On 3/31/20 the multiple was at 15.43x. For comparison, the 25 year average is 16.33x. At market lows in 2009, the forward P/E was at 10.3x; at the height of the tech bubble (3/24/00) it was 27.2x; at its low point after (10/9/02) it was at 14.1x. In a risk-on environment, fueled by the Fed, investors are flocking to companies they believe will not only survive this, but perhaps even thrive in it. Just this year, Amazon and Microsoft have set new highs. Together, they make up close to 10% of the S&P 500.
So where do we go from here? From a technical analysis perspective, Wellington Management's Director of Technical Analysis thinks that we'll be in a bear market until the S&P 500 closes above 3,200 (or roughly there). His belief is that we "are capped to a 2,900 to 3,000 best-case upside potential (which would match the bear market rally historical average of a 64% retracement)." But as long as the Fed keeps the floor in place, he doesn't envision the market going below 2,600.
All of this that has been unfolding in front of us is a case study in the world of known unknowns. We know there are a lot of unknowns about how the rest of the year plays out, but we also know that we will ultimately get through this and be better off for it.