June Market Update

June Market Update

In June 2004, National Geographic magazine’s cover article portrayed a packed interstate highway with bold letters that read “The End of Cheap Oil.” They were not alone in this assessment as the price of oil had been climbing steadily at the time. Yet 16 years onward, we are hearing of negative oil prices in the news. You may have heard about this and have been wondering why we are not being paid to go fill up at the pump as a result. In this market update, I will discuss the mechanics behind this phenomenon that recently shocked the world oil markets.

The price of oil began to fall in early 2020 due to an ongoing disagreement between oil-producing nations as to how much to supply world markets. It came to a head when Saudi Arabia and Russia decided to play a game of chicken and see who could produce more and get the other to blink first. A perfect storm ensued with the arrival of the Coronavirus and worldwide travel restrictions (with demand for gasoline plummeting at the same time there was increased supply).

This perfect storm reached an epic climax on April 20 as something that had never happened before in the oil markets happened: The price of the May 2020 West Texas Intermediate oil futures contract collapsed to a negative price of -$37.63, stunning market observers. Before we go further, let’s cover some terminology. When you hear that “the price of oil went negative,” it requires some clarification. Oil is a physical commodity that is traded on futures exchanges along with other commodities such as wheat, milk, corn, etc. So, what exactly is a “future?” A future is a contract to purchase a commodity at a predetermined date in the near future. There are several futures contracts for each commodity at definitive points in time, usually sequentially at each month into the future (June, July, and August oil futures contracts, for example). One oil futures contract corresponds to 1,000 barrels of the physical commodity. Therefore, due to the delivery size that these futures contracts correspond to, we cannot simply go out and take delivery of this cheap oil ourselves and store it in our garage until the price recovers.

So, why the negative price? As a physical commodity, oil has an implicit cost of carry: It is a physical good that must be stored somewhere. Storage can be in the form of a tank in Cushing, Oklahoma, or on a tanker ship in the ocean, but once it’s out of the ground, it needs to be stored until it’s refined and used by consumers. Normally, excess supply sits in the tanks mentioned above in Oklahoma; however, once that facility nears capacity, storage suddenly becomes prohibitively expensive.

The price of the May 2020 West Texas Intermediate futures contract went into negative territory because that was what it cost to store the physical oil at the time the contract was expiring. As the contract neared its expiration for May, there was a panic from commodity traders who were scrambling to unload their futures positions since many couldn’t take physical delivery of that much oil either. The cost associated with storage had thereby overwhelmed any value that the physical commodity itself had. So, when you hear that “the price of oil went negative” it is only accurate in that the price of the May 2020 futures contract for oil went negative, and the reason was due to lack of storage. Hardly anyone owned that particular contract right at expiration, so it was more of an interesting price anomaly rather than an actual price that someone would have paid for oil. As of late April, the June and subsequent monthly futures prices traded well above $10 a barrel and did not reflect further negative prices.

As of this writing, we have witnessed a rebound in oil with prices rising over $30 per barrel. The June 2020 oil futures contracts did not go negative in price at its expiration, so as of now, negative oil prices appear to have been a short-lived and isolated incident. At FSA, we are always monitoring relevant market trends, including what is transpiring in the commodity markets.

Portfolio Activity
In late May, stocks broke above their long-term trend lines, which is signaling to us that a new uptrend is developing. As a result, in June we will be moving the portfolios from more defensive positions (with money market levels around 50%) to more aggressive levels. As a result, you will continue to see the money market positions coming down as we add various stock and bond funds to the portfolios. As always, however, we have the FSA Safety Nets® in place in case stocks revisit the turmoil we saw in March.

Please don’t hesitate to reach out to us with further questions.

Derek Kravitz
Investment Analyst

 

 

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FSA’s current written Disclosure Brochure and Privacy Notice discussing our current advisory services and fees is also available at https://fsainvest.com/disclosures/ or by calling 301-949-7300.

 

 

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