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Weekly Market Commentary & Update - April 24, 2020

Weekly Market Commentary & Update - April 24, 2020

| April 27, 2020
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Vaughn Asset Advisory Weekly Market Commentary & Update

In a shocking event this week, the benchmark price for oil fell below zero for the first time ever — and then kept falling! Does a negative price mean gas stations will pay you to top off your tank? No, but it should be cheaper to fill up. The problem is, with the pandemic-imposed lockdown, people have nowhere to go. 

In this special report, we’ll break down what happened with oil this week, why it happened, and offer you a long-term perspective on what the future could look like.

What happened? 

The price of oil went negative!
The most widely quoted crude oil futures contract in the U.S., which is the front month West Texas Intermediate (WTI) oil futures, fell $55.90 from last week’s close to settle at -$37.63 per barrel on Monday. In a never-before-seen event, one that few imagined could even happen, the May crude futures contract went into negative territory. After trading as low as -$40.32 the day before, the May WTI contract settled up at $10.01 on Tuesday, April 21st. As Vice Chairman of IHS Markit Ltd. Daniel Yergin aptly put it, the May crude oil contract didn’t go out with a whimper but rather “a primal scream.”

The June contract is now the front month crude oil contract that is widely referenced in the media. On Tuesday, the June contract traded as low as $6.50 after closing at $20.43 the day before. On Wednesday, April 22nd, that contract rallied strongly, up to $13.78 after settling at $11.57 on Tuesday, April 21st.  

The selling pressure that we previously saw only in U.S. WTI contracts has now bled over to Brent, the international oil standard traded in London. The June Brent contract closed at $25.57 on Monday and traded as low as $17.51 on Tuesday before closing at $19.33. It rallied in-kind with the WTI June contract on Wednesday, up to $20.98.

Why did it happen? 

No one needs it now and there’s no place left to store it.
Why did this happen? Simply put: extreme supply and demand issues coupled with the mechanics of the futures market, and made worse by retail investors coming in to “buy the dip” via exchange-traded products that weren’t built for negatively-priced markets.

Holders of crude oil futures contracts have to either close out before the contract expires or take physical delivery of the crude oil itself. But due to the economic shutdown, storage facilities are at capacity, and refiners aren’t taking delivery of crude oil for processing. In other words, no one wants the oil. And even if they did, there’s no place to put it. So when the expiration of the May contract drew closer, holders of those contracts who couldn’t take delivery were forced to liquidate at negative prices.  Interactive Brokers, for example, announced a $88 million loss associated with customers trading the May WTI contract, likely the outcome of sellers forced into liquidating at negative prices on Monday. 

These daily moves in oil are huge and the market, illiquid. This is at least partly due to massive inflows into the world’s biggest oil exchange-traded fund United States Oil Fund (NYSE:USO) — a way for retail investors, who have no intention of ever storing barrels in their basement, to “buy the dip” in crude, speculating that it should be more valuable in the future. This is contributing to what makes it so difficult to price oil right now, and what’s driven the so-called super contango, which is when the price of a commodity for near-term delivery (e.g., front month contract) trades at a dramatically lower level than the price for delivery further out in time. The problem is that even though people think oil has value, no one actually wants it right now, at this moment. 

What next? 

Take a longer-term view.
Given the extreme supply and demand imbalance that exists still, there’s reason to believe that something similar may happen again in a few weeks when the June contract is set to expire. And it’s likely why the June contract showed such extreme selling pressure on Tuesday. These violent pricing moves may make for strange headlines in the short-term and cause some tricky problems for issuers of exchange-traded products that track oil futures.

But what about the longer term? The 12th month WTI contract, for delivery about one year from now, may be a better benchmark for assessing the medium-term economic outlook implied by oil prices. And it’s much more indicative than the front month contract of how industry producers are likely to view the oil outlook for investment planning purposes. Right now, the 12th month WTI is actually off the lows that we saw in mid-March and sending a very different signal at $31.99 per barrel than the shorter-dated contracts. Since its trough on March 18th, the 12th month contract is actually up 7%, while the front month is down 30% [Figure 1]. Headlines are likely to focus on the 30% decline in the front month contract, even as the S&P 500 (SPX) gained 16.7%. But that doesn’t even begin to tell the whole story.

What about the market impact? 

Energy securities make up just a tiny fraction of the total equity market in the U.S.. From a sentiment perspective, the equity market appears to be largely shrugging off oil’s unprecedented move. Even on Monday, when WTI futures traded at negative prices, the market’s reaction was tepid, with the S&P 500 off just 1.8% (SPX).

We would recommend that long-term investors not to get too hung up on the headlines in the near-term, but rather focus on the timeline for reopening the economy and the increase in oil demand that should likely follow, which should help to balance out the massive oversupply that exists right now.

 

David V. Thomas, Jr.  offers products and services using the following business names: Vaughn Asset Advisory, LLC – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA/SIPC – securities and investments | Ameritas Advisory Services (AAS) – investment advisory services. AIC and AAS are not affiliated with Vaughn Asset Advisory, LLC.

Products and services are limited to residents of states where the representative is registered. This is not an offer of securities in any jurisdiction, nor is it specifically directed to a resident of any jurisdiction. As with any security, request a prospectus from your representative. Read it carefully before you invest or send money. A representative will contact you to provide requested information. Representatives of AIC and AAS do not provide tax or legal advice. Please consult your tax advisor or attorney regarding your situation.

 The views stated in this letter are not necessarily the opinion of Ameritas Investment Company, LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing. Past performance does not guarantee future results. There is no guarantee that any investment strategy will generate a profit or prevent a loss. Investing in the securities markets involves risk, including loss of principal. The commentary provided should not be considered or used as a substitute for individual investment advice.

 Copyright 2020 Vaughn Asset Advisory, LLC

 

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