This week the oil markets experienced the most unusual collapse ever. There was hope that oil prices would stabilize after the April 13 announcement of OPEC+ production cuts, which are set to take effect May 1. However, the almost 30% drop in global demand from the pandemic shutdowns has so altered what was already an oversupplied market that the world has run out of room to store any more oil. This dynamic came to a head on Monday as the oil markets just broke down. The market has since stabilized to some degree, and the shares of energy companies are actually performing relatively well this week.
Why the breakdown?
Oil is traded by monthly contracts. When the current month contract expires, the buyer has to take possession of the underlying oil. Traders trade the contracts without the expectation of actually taking possession of barrels of oil — instead they sell the contract and either rollover to later months or not.
On Monday the May contract, which expired Tuesday, crashed to well below zero for the first time in history; traders were willing to pay to get rid of rather than take possession of oil.
One of the factors for the wild price action was the challenge faced by the Exchange Traded Fund (ETF) that attempts to track the current price of oil by buying near term futures contracts. The fund, which is known as USO, recently saw a big uptick in demand by retail speculators betting that the low oil price was due for a bounce. This forced the ETF to issue more shares in order to buy more near-term contracts in spite of the massive oversupply and storage problem around the globe. As we neared expiration of the May contract, the price crashed below zero as traders got stuck. USO, unfortunately for its holders, dropped in price accordingly.
At Team Hewins we have avoided allocating directly to commodities as they provide no underlying cash flow and fall into the realm of speculation rather than investment. We also have avoided ETFs that trade like an equity listed on the stock exchange but actually own securities like futures contracts, whose structural dynamics are very different from stocks. We’ve felt that the mismatch of futures markets and the stock market could be problematic in stressful times. USO is now being restructured, but its shareholders have learned a difficult lesson.
Ultimately, the cure to low prices is low prices. Production will fall as smaller producers fail, and ultimately demand will rise as we get past the virus. In the meantime, at least high gas prices will not be an obstacle to consumers as we recover. Of course, the pain in the energy sector is enormous, and many jobs are at stake.
John Bussel, Chief Investment Officer
John Bussel is the Chief Investment Officer of Team Hewins and served in that role at Hewins Financial Advisors. As CIO, John is able to utilize his extensive investment experience while providing our clients with a very high level of care and dedication. It is his goal to bring the financial professionalism and expertise used by great institutions to our individual and family clients.
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