From an email sent April 22, 2020:

Good evening, IIM investors.

The nationwide shutdown in response to the coronavirus has hit all corners of the economy, including the energy sector. The oil market made historic moves on Monday, as per those breathless headlines about the price of crude falling into negative territory for the first time.

For those of you looking for more detailed discussions about oil, I’d encourage you to join Tarpon Folio investors already discussing much of this on the IIM Message Boards.

For our other Spoke Fund and private account investors, however, I thought I’d attempt to explain in simplified terms what is happening in oil markets this week.

Oil is a critical input into economic activity, with the International Energy Agency (IEA) estimating that global demand was roughly 100 million barrels per day prior to this economic crisis. With shutdowns across the U.S. and around the world, demand for oil has fallen sharply due to the coronavirus – by about a third, according to some projections. The fact that Americans aren’t commuting, airlines have cut flights and businesses have temporarily shuttered means that there’s reduced need for crude oil. While this decline in demand will be temporary, it also creates significant challenges for the industry, nonetheless – which filters over to many other parts of the economy, too.

The oil market is also different from the stock and bond markets. While a share of stock is a purely financial asset, holding an oil futures contract means you are buying 1000 actual barrels of oil to be delivered at a later date. As with other commodities, companies that need physical oil on a future date can use these contracts to lock in prices today – and to hedge price movements, as well.

However, not all buyers of oil futures contracts want physical oil to be delivered to them. In fact, there are approximately 30 times as many “speculators” than “physical market traders” in the oil market today.  In normal times, the speculators who trade oil contracts simply sell their contracts and close out their positions before the expiration date. In doing so, they can notch a financial gain (or loss) without dealing with the logistics of receiving, delivering or storing oil.

There are even ETFs (Exchange Traded Funds) whose purpose is to do this for investors…and one of the most popular, with the ticker symbol “USO,” effectively blew up on Monday, too, prompting calls for further investigations.

Alternatively, there may be situations where oil prices may be much higher at future contract dates (so the oil futures curve, or “strip.” slopes upward). In these cases, sophisticated investors and companies could buy futures contracts at the lower price today, then later take delivery of the oil and store it – either in a storage facility, or on a tanker ship. They can pre-sell this oil by buying longer-dated futures contracts at the higher price and lock in a gain today, after also taking into account the cost of storage between the two delivery dates. Later, they deliver the oil they stored to the buyer of the longer-dated contract, fulfilling their obligation.

Those same dynamics broke down this week, though, for a number of factors.

First, oil demand has declined dramatically, due to the economic shutdown caused by the coronavirus.

Second, supply remained relatively high in spite of this demand drop due to disagreements between two large producers, Saudi Arabia and Russia.

These countries only recently reached a deal with other OPEC countries to cut oil production by roughly 10 million barrels per day. They were joined in that effort to reduce supply by other countries in the G20, too, which contributed additional production cuts – voluntarily or due to production shut-ins. And though those supply cuts are insufficient to fully stabilize oil prices immediately, they do buy significant time, which will help bring the oil market back into balance as the year progresses.

Third, this supply and demand imbalance has resulted in short-term oil inventory increases, which have to be stored.

 And over time, it becomes incrementally more difficult and costly to store each barrel of oil.

Which is why the May WTI futures contract fell to negative levels on Monday – as it approached expiration on Tuesday.

 A negative price means that the holder (or seller) of a contract pays the buyer to take the contract (and physical delivery) off of the seller’s hands. 

This happened Monday because 1) oil prices were very low to begin with, and 2) there was a “squeeze” in the market – very few buyers who wanted to take physical delivery and use or store those barrels. It’s important to note that contracts after May are priced low…but not in negative territory – and that the June contract closed at $22 a barrel on Monday – the same day the May contract hit -$38 a barrel. 

So, there are both short-term and long-term impacts of what has happened in oil markets in recent weeks. The fact that oil prices fell into negative-price territory is an anomaly…a short-term phenomenon due to the mechanics of how oil trades among twitchy speculators. However, the fact that oil prices are low, and the fact that there are significant supply and demand imbalances, could persist for some time. As with everything else at the moment, this depends critically on if, when and how the economy reopens in the coming months.

In general, cheaper energy prices are positive for U.S. consumers and the economy overall. Since lower energy prices reduce the cost of products and services both directly and indirectly, the emergence of the U.S. as a major energy player has been an unambiguous positive for U.S. consumers. For instance, as one of the charts below shows, gasoline prices were already well below average even before this crisis began. Additionally, the White House is planning to buy oil at these low levels to add 75 million barrels to the nation’s Strategic Petroleum Reserve. As taxpayers, we should all be happy with the timing of those buys.

Below are a few charts that may help to put recent oil moves into perspective.

1. Oil prices have plummeted, even falling into negative territory due to technical factors

Oil prices have fallen due to the economic shutdowns that have resulted from the coronavirus pandemic. The drying-up of demand and temporary oversupply have pushed both WTI and Brent below levels last seen during the 2014-2016 period. In fact, WTI prices even fell below zero on Monday, due to a technical squeeze stemming from limited leased-storage availability.

2. The U.S. is a leading global producer

The U.S. energy renaissance of the past decade has seen U.S. energy production climb steadily. The U.S. produced about 13 million barrels per day prior to the coronavirus crisis.

3. The energy sector’s earnings are tied to oil prices

It’s no surprise that the health of the energy sector depends heavily on oil prices. Oversupply and plummeting demand are expected to significantly reduce the sector’s earnings over the next year. Since the last oil price peak in 2014, the sector’s estimated earnings-per-share have declined by about 87%…one reason the U.S. Administration appears to be moving to support this important sector during this COVID pandemic.

4. In general, lower energy prices are good for the U.S. economy and consumers

As an input into almost everything we buy and use, lower oil prices are generally positive for the U.S. economy as a whole. Gasoline prices, for instances, were already below average before the economic shutdowns hit. Cheaper energy prices effectively translate into more money in the pockets of all Americans – good news for when the economy eventually reopens.  
Due to the size of the U.S. energy sector now, however, some economists also believe the drag on economic growth caused by a faltering energy sector will outweigh the positives associated with lower oil prices.  This, too, may explain the White House’s attempts to bolster the energy industry of late.

What’s it all mean further out?

Finally – as per a lot of discussion on the IIM Message Boards, what all this means for the price of oil once the economy recovers is of considerable interest to Tarpon investors.

Because if the cliche that “the best cure for low oil price is low oil prices” is true…then in spite of many recent headlines, the energy sector could finally be an extremely attractive place to be for long-term investors. 

Please let me know if you have any questions.  

Thank you and stay safe.

– Cale

______________

Cale Smith
Managing Partner
Islamorada Investment Management