Recently a lot of my clients and subscribers have asked if there is any investment opportunity given the collapse of oil prices. Is it time to buy oil ETFs or energy companies, or is a recession imminent?
We all know the world has become chaotic, and 2020 is a year of miracles in financial markets. We have witnessed the
- Unprecedented stock market crash,
- Unprecedented zero interest rate in the US,
- Unprecedented global lockdown,
- Unprecedented numbers of circuit breakers,
- And now the unprecedented negative oil price. Yes, that is not a typo. Oil prices just fell to a negative $37.63 as shown below.
What the heck is going on in the world now? Let’s discuss in this article.
Why did the price of oil fall?
Oil is an essential commodity which is used in our daily lives. From powering our daily transportation to industry usage, modern life cannot exist without oil. There are essentially two things affecting the oil price: Supply & Demand.
Supply is determined by the major oil producers. The three top oil-producing countries are the US, Saudi Arabia & Russia. But they produce oil at different costs as shown below. Obviously the US has the highest production cost among the three.
Demand is determined by oil consumers. The top three countries, the United States (20%), China (13%), and India (5%) account for more than a third of the world’s consumption.
In an earlier article, I explained why the March stock market plunge was not caused by COVID-19, but rather the debt crisis. The debt crisis was triggered when the Saudis started the oil price war to attack mainly the US oil producers. Unfortunately, the consequence of this attack would be that if the US energy companies started to fail and started to default on their debts, the world financial system would be in danger.
Even Opec+ reached a deal to cut global oil production by 10%. But they can only affect the supply side, not the demand side. With a global lockdown, the oil demand has become historically low. Nobody needs oil right now.
So with higher supply and lower demand, the oil price is guaranteed to fall.
How can the oil price go below zero?
In early March, the oil traders rejoiced as they foresaw a “contango”. It seemed to be a once in a lifetime opportunity to make easy money by buying crude cheap, storing it, and selling it forward. Sounds like a plan right?
There were even rumours that China, the second-largest consumer for oil, had sent all their supertankers (a ship designed for the bulk transport of oil) to the Saudis to buy cheap oil.
However, oil production is not like mining. Once the oil well starts to produce, you don’t have a button to stop it. The oil keeps on sprouting out. But there are no more takers.
Can you picture how Singapore island looks today? It has become a giant car park. Almost all the cars are parked, with only a few moving. That is what is happening in the oil industry.
What will happen next is there will be an impact on the oil futures market, which is composed of physical players, hedgers and speculators.
This is what happens in the futures market: when a buyer and a seller enter into a “futures contract”, they agree to transact the oil at a fixed price on a “future” date. Many speculators buy and sell futures contracts every day, but there are also commercial players who need to take the oil.
But, if you are selling oil, what happens when there are no buyers? You have to keep it somewhere. You can’t store oil at your home or just some empty factory. You need specialized facilities.
What has happened now is that not only have oil storage facilities reached full capacity globally, it has also become very expensive to transport oil. A negative $40 oil price essentially means the seller has to pay the buyer $40 per barrel just to take away the oil.
This concept is not difficult to understand. Here’s a personal example of how supply and demand works. Some years ago, I was replacing my mattress which was still in good condition. I thought I could give it to the delivery worker for the new mattress for free. But it ended up that not only did I have to give it for free, but I also had to pay an additional $10 to him for the “transportation fee”.
Well, this is a widely accepted explanation. But if you ponder for a while, you will realize it is not so simple.
Who was on the buy-side and who was on the sell-side of oil futures? Who made money and who lost money?
After all, we’ve known for weeks that demand for oil is low. Storage issues in Cushing. And the actual expiry date of the May contract (April 21) was on every trader’s calendar. Everything should have been priced in, yet the contract fell as low as minus $37.63 on Monday. Why?
Let’s move on…
How long will the price of oil stay low?
Theoretically, oil as a tangible commodity, shouldn’t have a zero price. You always complain that the petrol price is expensive right?
The price of oil is in barrels. One barrel is 159 litres. Today, oil, which used to be called “black gold” is cheaper than a litre bottle of coke!
So it is natural that you feel there is a golden opportunity now. For a lot of investors, the first thing that comes to their mind is Exchange Trade Funds (ETFs).
The most popular oil ETF is the United States Oil Fund (USO). If you google “oil ETF”, USO will definitely come out. And it is reported that $1.6 billion has already been piled up in this largest oil ETF.
However, most people stop at the surface and never dig deeper.
As a start, USO tracks only WTI Crude Oil, which is just one kind of oil.
Secondly, when you buy USO, you are not buying an oil investment at $3 (which is the ETF price), nor are you buying at a NAV which reflects the current oil price. Rather, you are buying oil at a future price of $20+ because the underlying basis of USO is a portfolio of June futures contracts and July futures contracts that are offered now. In fact, USO is the culprit which caused WTI May futures to drop to this level (I will talk about this later).
I wonder who was buying USO?
Was it retail investors or institutions who herded into this “opportunity”?
Then you might ask, “How about investing for the long term? I am not speculating.”
I wrote this blog article about the contango effect of commodity ETF prices 10 years ago in 2010 (now I start to feel old ^_^). When oil prices recovered from the bottom in the global financial crisis, many USO investors were hugely disappointed with the investment because USO was never an efficient way to track the growth of oil prices.
If you don’t know what you are doing, you should just stay away from it.
However, don’t forget that low oil prices reduce costs to the business. It’s true that today we have a stall in global oil consumption. However, there will be a time when our activities will return to normal. When that day comes, I’d rather bet on equities than oil prices. Remember the US and China are the biggest oil consumers in the world.
How about energy companies?
I have repeatedly said this and I want to highlight it again: We are in a financial crisis, not a COVID-19 crisis.
It is often said that “only when the tide goes out, do you discover who’s been swimming naked”.
You may have heard the recent story about the powerful Singapore oil trader, Hin Leong, who “suffered about US$800 million (S$1.14 billion) in (oil) futures losses”. This happens in every financial crisis. It is not the first time, it won’t be the last.
You may not remember that in October 2007 SembMarine announced that Wee Sing Guan, the former group finance director, “made large unauthorized currency bets in the euro and the US dollar” from 2005 to 2007. And tell me when was the last global financial crisis?
Most importantly, for energy companies, it is not about profit anymore. It is about survival. People talk about Hyflux nowadays, but many have forgotten the energy companies such as Swiber that defaulted on their debt during the 2015 oil crisis.
Let me put this all together for you
Many people talk about bargain hunting nowadays. If you have seen enough history, you will learn to be fearful, not greedy, in the market when others are fearful.
I can very confidently assert that a recession is unavoidable. It is just a matter of scale and duration. The negative oil prices and negative interest rates remind us that we are still in unchartered water.
Unexpected bad things may happen, but almost all crises are man-made. At this moment, don’t get too excited about “opportunities”, you need to survive first.
If you think about what has happened, these devasting days for the global oil industry do not seem to be a coincidence.
- On April 15, CME issued an advisory that certain NYMEX futures can trade at negative or zero prices and they can also settle at negative or zero prices due to the current oil market environment.
- On April 16, United States Oil Fund (USO), the largest oil ETF with an asset size of $3.9 billion, said it will shift from May oil futures contracts to June and July futures, which resulted in a huge sell-off of the May oil futures.
- On April 20, oil futures were traded at negative $40.
- Today, 25% of the June oil futures are owned by USO.
The questions you should ask yourself now are:
- Who benefits from the unprecedented negative oil prices?
- Why did the May oil futures contract ended at $37.63?
- Who was on the buy-side and who was on the sell-side?
- Who plays ETFs and who plays futures?
- How many more margin calls will this trigger?
It seems to me that this is a well planned financial attack by a small group of elite traders. And they have amassed massive fortunes this time.
Most of the time, we tend to think we are smarter and we see “opportunities” in “crises”. But in reality, we are often not smart enough nor powerful enough.
In a 2015 article, I discussed Ray Dalio’s Investment Principles. Given what has happened recently in the financial markets, I begin to understand them a little bit more.
To make money in the markets, you have to think independently and be humble. You have to be an independent thinker because you can’t make money agreeing with the consensus view, which is already embedded in the price.
Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.
The meltdown spreading across global oil markets has already wiped out tens of thousands of jobs and frozen billions of dollars in capital spending. This will, in turn, threaten further the cripple economies around the world which already reeling from coronavirus-fueled lockdowns.
To put it simply, it’s a dangerous market to trade in right now and I will stay away.
What do you think? Comment below for further discussion.
By the way, I will be having a live phone interview on radio station CNA938 to discuss how people can handle a recession. I will talk about
- How does the current situation differ from global recessions of the past?
- Should you cash out of the stock market?
- Is it time to buy REITs and blue-chip stocks?
- Is Dollar-Cost Averaging a good strategy now?
- What do you need to do to ensure that your finances are in good shape if the economy falters?
If you are interested, tune in this Friday (April 24) at 10.40 am via radio or online via this link.
Update: If you missed the session, here is the 15-minute recording.
If you want to ask me any question, you can call 66911-938 or text 96311-938. You can also leave your comment below and I will try to answer them too.
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Hi Ivan, given the unprecedented moves by Fed in tackling the looming crisis, what is the chance for another too-big-to-fail company to go bust? Fed bought into junk ETF (fallen angels). They have not bought into equities, yet. Even if demand saps, and companies couldnt make money, the Fed are there to back them up. And the market is forward looking, Given Covid will eventually pass, or a vaccine will be eventually be developed successfully: at this point we can speak of recovery, in whatever shape it may take. Even though comsumer spending power may dwindle a bit at the beginning of a recovery, the business climate will improve significantly by then. So why would the market still goes down?
Hi, Hilt
That is a good question and there is a lot to discuss.
I agree with you that the broad economy will recover eventually, the challenge is “in what shape”. Every recession or stock market crash is a cleansing process. It washes out weak companies and spares the strong ones. The government will save some companies not because they are “too big”, but because they are “systematically important”. So the government will still allow some “big companies” to fail which we have witnessed in the 2008 financial crisis.
For the second question “why the market may still go down”, it is because even after the recession correction, the stock market is still at a high level. It is nowhere near “value” or “bottom”. Monetary policies help inflate the bubble than constraint it. Fiscal policies help postpone problem instead of solving it.
Without letting enough companies or assets fail, the world cannot function normally. In the past financial crises, people mistakenly think that the US came out of their debt problem. They just exported the damage to other countries through the Dollar & Treasury Bonds. The emerging markets and, to a certain extend, Europe paid the bills. That is why the US was the only best performing stock market in the past decade. It was due to complex reasons.
What is different this time is that the US has zero interest rate and the money velocity is extremely low now. Printing money is much less effective. This does not mean that they don’t have other methods. For example, the Fed is playing the grey area by purchasing junk ETF etc. But how this will turn out is everyone’s guess.
But one thing is for sure, all these are short term measures at the expense of long term impact. So someone still has to pay the bill eventually. That is the time of recession. Wealth does not disappear, it is transferred from one party to the other. When a debt is written off as a company goes under, the wealth of the creditor is transferred to the pre-paid consumption of the company. And a recession does just that.