Mayhem in the Oil Market

Oil prices swung wildly this week, capturing the attention of both Wall Street and Main Street.
The price of the May West Texas Intermediate (WTI) crude oil futures contract fell to -$37.63 on Monday. You read that right, negative $37.63. It was the first time in history that oil prices fell into negative territory.

In a rapid turn of events, the May crude prices quickly rebounded before the contract expired on Tuesday (the date when contract holders were forced to either sell or accept an oil barrel delivery), but not before other contracts were rattled. The WTI June contract dropped as low as $11.57, while the July contract fell to $18.69.*

You may not be an investor in oil futures (or any oil-related product in general), but all investors should care about what’s happening in oil market right now. Here’s why.

* For reference, the price of oil is often referred to as the price of the contract in the closest month. In the case of Monday and Tuesday it was May, but now that the May contract has expired, oil prices are based off the June contract.

Why did it happen?

Ultra-low oil prices can be explained by a few major factors. Oil production globally soared due to a breakdown in a key OPEC alliance between Russia and other countries in early March. While OPEC members have since agreed to cut production in May, if not sooner, the planned cuts haven’t been enough to satisfy market participants. On the other side, demand for oil has dropped recently because of coronavirus-related shutdowns. Think about it: you’ve probably driven your car less lately, so you’ve needed fewer trips to the gas station. And when was the last time you got on a plane?
There’s a lot of oil out there right now, but fewer people around to buy it. The oversupply of oil needs to be stored, but the places where oil is typically kept (storage facilities, refiners, oil tankers, pipelines) are filling up rapidly. Thus, producers may need to pay others to store the oil.

A Slippery Slope

Oil’s plunge to negative prices is a fascinating, yet concerning, trend because it affects other industries and the economy as a whole.

On the surface, negative or historically low oil prices sound like a great deal for consumers with empty gas tanks in their cars. Lower gas prices do result in more money in consumers’ wallets, which can boost consumer confidence and consumer spending.

Despite this economic boost, there are a slew of other long-term consequences to consider for all financial markets.

Lower oil prices could have significant repercussions for U.S. energy companies. S&P 500 energy company profits are expected to drop as much as 151% year over year in 2020 (according to S&P Capital IQ estimates). Energy earnings are closely tied to oil prices, so those projections could fall further with the latest developments. Eventually, we could see debt downgrades and defaults, which could be an issue for credit markets. While energy companies are a small slice of the S&P 500 at 2.8% of market cap, their debt comprises about 7% of investment-grade debt holdings and 11% of high-yield holdings (according to Bloomberg Barclays index data).

Several energy companies have already announced plans to cut capital expenditures this year given the expectation for lower profits and debt obligations. Lower investment spending could have a negative impact on GDP growth, similar to what occurred between 2014 and 2016 when oil prices fell 76%.

Oil-based Investments

It’s also tough to say how rock-bottom oil prices will affect other instruments tracking oil, like the U.S.-based energy exchange-traded products (ETPs). Tuesday’s price action showed oil prices can go negative, but what about funds based on oil prices that trade like stocks? Some oil ETPs have already materially changed their operations to accommodate the possibility that oil will fall negative again. The United States Oil Fund (ticker: USO), a popular exchange-traded vehicle tracking oil, has re-shuffled its investing process multiple times to adjust for the commodity’s plunge.
As always, we urge you to do your homework if you’re thinking about investing in these types of products. They’re more complicated than they look at first glance, and there are other ways to gain exposure to the energy market if desired.

Another Obstacle

When assets like oil swing wildly, we pay attention. Record low oil is a clear sign that the sharp slowdown in demand from the coronavirus is impacting the economy. While it is easy to bet that oil prices will rebound from these levels, we believe demand will need to return for prices to reach more sustainable levels. We may only see that once the economy re-opens.

The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.
 

Lindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She frequently shares her knowledge as a guest on national news outlets such as CNBC, CNN, Fox Business News, and Bloomberg News. She also serves on the board of Better Investing, a non-profit organization focused on investment education.