Don’t rush to react to coronavirus chaos

The day that oil prices plunged below zero

21 Apr 2020

Peter Sleep, Senior Investment Manager

I am sure every office has a Yoda-like character like my former colleague Willy Rathaus. Willy, who was from Zurich, used to end every conversation by warning us “never underestimate the markets’ capacity to surprise”. My colleagues and I, being much younger and wiser, used to throw our eyes up at the ceiling and ignore him. Now with a few more years’ experience I am beginning to think that Willy was right. Never underestimate the markets’ capacity to surprise!

Yesterday was one of those days that reminded me of Willy’s catchphrase as Oil made headlines for hitting a negative price. At one point oil for delivery in May reached nearly -$40 a barrel, which is remarkable given how much it still costs to heat our homes or fill our cars.

In order to understand commodities you have to look at the balance of supply and demand. In normal times the world produces and consumes about 100m barrels a day. However with the COVID-19 lockdown, demand has fallen by about 20% as we drive less, fly less and use fewer plastics. Supply however has not reacted to the fall in demand yet, and as a result we have a glut of oil and weak oil prices.

There was an agreement between the Russians and Saudis to cut the supply of oil by about 10% starting in June, but you don’t have to do much maths to realise this is too little and too late to really make a dent in that glut. Consequently a lot of the surplus oil has gone into storage, to be used when things return to normal.

People in financial markets sometimes forget the real world exists. In the real world, if you buy a contract for oil, someone has to actually take delivery of it at some point. But storing oil is difficult! A barrel of oil has nearly 160 litres of thick, smelly, poisonous chemicals in it. You can’t just put it under the bed.

In normal markets, you just sell the futures contract to someone else before the oil arrives. But storage is scarce and so, in extreme circumstances, you’ll pay someone to take it off your hands.

Yesterday the price of West Texas Intermediate (WTI) oil, the US benchmark, went negative. This is the price for delivery at a place called Cushing in Oklahoma in May. Refiners and others went on a buyers’ strike and storage space ran low. However, other oil prices, like North Sea Brent, stayed at over $20 per barrel. At the present time, it looks like the ‘true’ market price for oil is still around the $20 per barrel and is not negative at all. That is still very cheap, but not as cheap as the headlines would have you believe.

There is a good chance that the glut in oil will persist for some time until we start flying, driving and consuming as before. The outlook for oil prices is therefore not great in the short to medium term as supplies in storage continue to build, and are then slowly depleted over time.

The knock-on effects of low oil prices are hard to predict. Oil investment and exploration will be cut. This will be bad for those who work in Aberdeen or the oil industry and ancillary industries. The other side of the coin is that our fuel bills will be lower, which will be very welcome. These are extraordinary times, but as Willy used to say – never underestimate the markets’ capacity to surprise. There will be other surprises to come. Let’s hope they are pleasant ones.

The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.
The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

An error occurred!