Reed Between The Lines

Investment Insights: Oil – What Happened?

21 April 2020

Author: J. Reed Murphy, Chief Investment Officer

Contributions by: Rob Young, CFA 

Reed Between the Lines is a periodic series of topic papers representing the viewpoint of our Chief Investment Officer pertaining to news or market-related events of importance to investors.

Oil prices declined in an epic downward move on Monday, April 20, 2020. West Texas Intermediate (WTI) Crude dropped 188% on its way to a negative price around $37 per barrel - First time ever! Surprising to many, the S&P 500 only declined 1.79%.

On the heels of an OPEC Plus (OPEC nations plus others, such as Russia) recent agreement to cut daily production to curb an oversupply, the demand shock is still overwhelming. Demand shock is the impact of lower demand, due in large part to the COVID-19 induced recession. There is now so much supply that storage facilities are full or nearly full. 

Exhibit 1: WTI Crude Oil Prices Collapse

Source: Bloomberg; WTI is represented by the Generic WTI Crude Oil Index


How Does A Negative Price Work?

An important element in this price movement is the technical natures of how oil is priced – through futures markets. The May futures for WTI crude expires in two days, so investors were trying to get out of their contracts, particularly this past Monday. Owners of oil and oil futures contracts essentially suggested that someone else should take this oil off their hands, so they can make room for more at later date. So, taking a look at June’s futures contracts, WTI were trading at approximately $20 per barrel as we published this commentary.

Oil is also priced in Europe and throughout much of the rest of the world, via Brent Crude futures. Brent Crude finished the day at approximately $26 per barrel. So, when taking a longer-term view and evaluating Brent prices, the oil market will be pricing higher. Guessing where it settles is a fool’s errand, but the following exhibit shows futures markets for both the WTI and Brent Crude oil indices, as of April 20, 2020 were trading at much higher prices for future dates.

Exhibit 2: WTI & Brent Price Expectations

Source: Bloomberg; The WTI Curve is represented by WTI Crude Futures Curve; The Brent Curve is represented by the Brent Crude Futures Curve. As of April 20, 2020.

Potential Ramifications

First, lower oil prices mean lower gasoline prices, lower chemical prices, lower plastics prices, etc. This could benefit companies that rely on these inputs in their cost structure. For consumers, this should translate to lower gasoline prices during a difficult economic time. However, it may be devastating to those working in the energy sector.

From an investment standpoint, a dramatic drop in oil prices suggests a continued major concern regarding economic activity. However, the domestic stock market is simply shrugging this off. In more settled times a fractional move of Monday’s magnitude would have wreaked havoc on the equity markets. While the overall energy sector represents only 2.6% of the S&P 500, this flush-out period could serve as a good buying opportunity for active managers in the domestic equity market. Energy, however, represents a higher percentage of the fixed income market, particularly the high yield market. With oil prices dropping to such low levels, it will force continued production and capital expenditures cuts by energy companies. Lower prices will also put pressure on revenues and potentially push many energy companies into bankruptcy. Reading between the lines, this pain could push us to an opportune valuation level for high yield fixed income managers. Company issuance of high yield debt has been oversubscribed recently suggesting a strong appetite. And, this push up in spreads (yields relative to U.S. Treasury yields) could present an even more compelling valuation. While there are many other issues to consider with this concept, it is important to note that individual investors should not try to buy oil or oil futures. It can be hazardous for the novice investor.

Exhibit 3: Energy Percentage of Domestic Capital Markets

Source: Bloomberg; The S&P 500 is represented by the S&P 500 Index; U.S. Aggregate is represented by the U.S. Aggregate Index; U.S. High Yield is represented by the U.S. High Yield Index.


Definitions & Disclosures:
S&P 500, is represented by the S&P 500 Index, which measures the market performance of 500 large companies on the stock exchanges of the US.
US Aggregate, represented by the Bloomberg Barclays U.S. Aggregate Bond Index, covers the U.S. denominated, investment grade, fixed-rate, taxable bond market of SEC registered securities.
US High Yield is represented by the Bloomberg Barclays US Corporate High Yield Bond Index, which measures the USD-denominated, high yield, fixed rate corporate bond market.  Securities are classified as High Yield if the middle rating on Moody's, Fitch and S&P is Ba1 / BB+ / BB+ or below. 
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