As the COVID-19 pandemic continued to spread, economic activity slowed as policy makers around the world locked down, attempting to contain the virus. This has reduced global demand for oil and against this backdrop, the Organization of the Petroleum Exporting Countries (OPEC) failed to reach an agreement in March with Russian oil suppliers to cut production in support of oil prices (this actually lead to an increase in production).
What we have here is a classic demand and supply problem. Despite demand for oil decreasing sharply for the first time in over a decade due to the pandemic, suppliers were still churning out millions of additional barrels per day.
This set the stage for the April 20th crash in oil prices, where futures contracts for West Texas Intermediate (WTI) oil (for May delivery) collapsed to -US$37.63 per barrel. Essentially what this meant was that contract holders (buyers) were willing to pay others to take oil off their hands.
Let’s try to understand how we got to this point:
First, we need to understand liquidity, or the lack thereof
As explained by my colleague Idriss, liquidity is the degree to which an asset can be quickly bought or sold in the market at a price reflecting its actual value. Strong liquidity means it’s easy to do so. Conversely, weak or low liquidity means it’s difficult – it does not mean that assets are not traded, but rather the price at which the trade happens may be unfavourable. For example, in times of crisis, sellers may have to accept much lower prices to facilitate trades.
The lack of liquidity in capital markets has been a key theme that we have been assessing at MD Financial Management for the past few years due to a number of intersecting factors:
- Increased liquidity requirements – Since the Global Financial Crisis, regulators have limited proprietary trading (banks investing for direct gains rather than for commissions when trading on behalf of clients) and placed more stringent liquidity requirements on banks and other dealers.
- Increased automation – The trend of market making activities becoming increasingly automated and the proliferation of high-frequency trading.
- The rise in popularity of volatility-based strategies – Institutional investors using automated trading strategies that recognize volatility trends that can actually amplify the trend, particularly during crises.
- Position in the economic cycle – Over the last two years prior to the pandemic, the economy has been in the later stages of the economic cycle, which typically results in fewer strategic buyers in the market.
As the virus spread, liquidity weakened in equity markets first. Towards the end of March, we saw the implied volatility of stock markets rise, as illustrated by wild swings in intraday trading.
While fixed income and credit markets were initially relatively immune, eventually prices for U.S. Treasuries (believed to be THE safe haven asset) experienced dramatic swings. Weak liquidity then spread to credit markets, impacting both investment grade and high-yield bonds.
The lack of liquidity then moved into the commodity sphere as the WTI price dropped into negative territory.
What you get when you have plentiful supply, low demand, and finite storage capacity
There is finite capacity for oil inventories, in particular, in Cushing, Oklahoma, where WTI futures contract holders are required to either take delivery (buy) or deliver (sell) oil. Many hedge funds and other investment strategies trade in this market, with the intention of closing contract positions prior to contract expiration without ever receiving or delivering oil.
When these investors looked to close their positions before contract expiry on April 21st, for the first time, there essentially were no buyers because there was nowhere for buyers to store excess oil inventories. This left these investors in a bind; they themselves have nowhere to store the oil that they were contractually obligated to take delivery of, forcing them to pay others to take the oil. Hence the negative price.
While this occurrence can be attributed to the economic uncertainties caused by the COVID-19 pandemic, it also brings forward some of the limitations of traditional assumptions and risk models during times of crises. Records are made to be broken and this is just another first in a series of events that really have no precedent since the outbreak of the COVID-19 virus. This was amplified by the relative ease for individual investors and hedge funds to speculate using exchange-traded products linked to oil prices; many of these individual speculators may not have understood the true dynamics of the oil market and many hedge funds may not have captured scenarios like negative oil prices in their risk modelling.
It is not certain if we will see negative WTI prices again or if negative prices will occur with Brent Crude (more widely traded internationally), but the volatile mixture of plentiful supply, low demand and finite storage capacity would indicate that it cannot be ruled out.
Continued squeeze on oil prices
Over the coming months, we see immense pressure on oil prices given the ongoing economic contraction caused by the pandemic, the likely prospect of a gradual recovery, and the extreme demand-supply imbalance.
Recent agreements in April by global oil producers to make substantial cuts to production will help stabilize prices at lower levels. However, it remains questionable if a more sustained, coordinated global effort to manage production over the coming months is likely to work. After all, the original members of OPEC – made up of a number of countries highly dependent on oil – often had difficulty complying to production quotas. The introduction of additional international players, many whose economies are less dependent on oil production, will make compliance even more difficult as the economy recovers.
Given this outlook, MD Funds and Portfolios remain underweight the energy sector at this time. As always, we will continue to assess conditions as they develop and make any necessary changes if needed.
If you have any questions about the recent drop in oil prices, how it impacts your investments, or about your portfolio in general, please do not hesitate to contact your MD Advisor*. She or he would be happy to assist.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).