It seems 2020 is a year of making records: record debt, fastest selloff in markets in history, most rapid vicious recovery, largest unemployment move in three weeks, unprecedented U.S. central bank measures and now the largest front month WTI contract selloff into expiration on record. The beautiful thing about markets is that one never ceases to be amazed no matter how many years they have under their belts, there is always a black swan event somewhere across some asset class some time. Even though 2020 was more like a black bat event, but let's not focus on semantics, shall we?
All commodity markets have a futures curve built from a series of their forward prices. Every month, they expire and every month, their fate is determined by the physical inventory balance that is evident at the time of expiry. There are many different contracts of oil and varying grades, but one of the most well-known and benchmarked crude is the famous WTI blend that trades in Cushing, Oklahoma. What that means is that at time of expiry, depending on the storage dynamics and inventory balances in Cushing, the price of that WTI is determined.
This is not like an equity valuation, where one can do some floor/ceiling analysis to arrive at a "fair" value. It just depends on whether you have too much or too little, that price is determined by the matching demand vs. supply balance at time of expiration. The May WTI contract that yesterday was expiring started the day around $18/bbl and closed the day down -$37.63 -- negative oil pricing. That has never happened in the history of oil price trading where the front month is trading at such huge negative values, implying that somebody out there is literally paying you to take oil off their hands, not even for free. Why was that?
Given coronavirus impacted demand shock to the system as globally countries came to a screeching halt, all that oil demand via travel, hotel, industries and driving all just vanished. It is said that about 25-30 million barrels per day of oil demand was lost. Imagine a market producing ~ 100 mbpd of oil, and suddenly your demand is only about 70 mbpd, what happens to all that oil? It has to go somewhere -- back into storage or under the ground or in pipes or on vessels. Physical traders scramble to find whatever storage to put that oil so that they can use or deliver it the next month and cash out like kings, provided they got access to storage.
In a short period of time, there is NO storage, and so producers were happy to just give it away as it is much costlier than to hold it or shut in their wells. But eventually, if these prices and demand continue, they will have to shut in production; it is a matter of when, not if. Hence at expiry yesterday, when there are no buyers, oil can go all the way down until anyone is willing to actually buy that oil. Perhaps a Billy Ray Valentine and Louis Winthorpe team was standing at the edge of the oil trading floor waiting for the price to completely collapse, only to raise their hands and start bidding at negative $37/bbl, because they managed to get storage a month earlier and held onto it. Yesterday, there were shrieks of 'Sell, Mortimer, Sell' across oil trading floors.
What does that mean for oil prices going forward? Oil price is a tale of two parts of the oil curve, the spot (near few months) and the forward (back end of the oil market). The spot, as mentioned above, is dictated by near-term physical market dislocations, whereas the back is determined by actual real secular demand/supply balance of oil.
The front can be extremely scary when we see moves of down 90% in one day, but it does not mean that oil is actually trading there. For instance, the June WTI contract is now the near month and is trading at $20.5/bbl. It does not mean the retail who bought yesterday is now up $50+/bbl. The screen price just reflects the new contract as May has now gone. What is more interesting is the back-end prices of WTI, say the December 2020 and 2021 prices trading close to $31.5/bbl and $36/bbl, respectively. Prices further out are the "real" price of oil, as that is what companies base their balance sheets off of and plan budgets, or even hedge in some cases.
The forward prices of WTI are down around 40% since highs in February, whereas May, as you know, went down to 0 -- and negative 300% if one can calculate that way. Does that mean the equity needs to fall that much? Equity valuations are based off a complex set of forward prices, costs and hedge ratios. So, in short, the answer is No. But yes, they can continue to underperform the broader market, as the front-month prices fall as they average and take in a lower oil price on a quarter-on-quarter basis. At the end of the day, their top line is driven by the actual price of the product they are selling.
The only way for oil price to stabilize is if demand matches supply. April and May are seeing extreme demand weakness so the June contract could very well share the same fate as the May contract, depending on how much oil is stored and consumed and how much is shut in. Sub $35/bbl WTI prices will continue to see U.S. shale well shut-ins, it is a fact. With OPEC+ cuts of about 9.7 mbpd, we can see another 3-4 mbpd of U.S. shale out of the market -- and production around 9 mbpd down from 13 mbpd at start of year. But this still leaves an oversupply.
It is a dynamically evolving delicate balance between what demand is and what supply can be. But the only way this balance is achieved is if U.S. oil production falls, and for now it is holding up at around 12 mbpd despite how aggressively the Baker Hughes rig count is falling. It just takes time to show up in the real numbers.
OPEC and other oil members are getting very nervous seeing front month go to negative and are talking of even more cuts. What this means is we may be faced with a time in the future, perhaps 2H 2020 or 2021, when oil price will be in short supply, that prices could squeeze harder. But there are so many moving parts before we get there, as all depends on global economic recovery, whether the world goes back to normal without a vaccine and what the supply picture is. It is far from certain, but investors need to focus on the long-term prices of oil as well as the front to make their investment decisions, rather than be tempted to buy into an oil ETF in the front.
Be careful what you wish for OPEC, at a time of slowing, stagnating growth and conventional projects falling off a cliff. If they cut too much, prices would need to rise to a level where demand is choked off once it returns back to normal. But we could seal the deal for future stagnation for good. Only time shall tell.