Don’t Run and Shoot, Jed!
Market Commentary

Don’t Run and Shoot, Jed!


“The energy markets, like everything in life right now, are not behaving normally.”

If Jed Clamplett, the iconic patriarch from the Beverly Hillbillies and formerly poor mountaineer, missed with his rifle shot today, his family would have ended up in hock instead of the Hills. Come and listen to this story.

Oil prices (as indicated by the near month expiration oil contract) fell below $0 yesterday and investor and media attention has understandably been intense. Before discussing how this can happen, it is important to know a few things about the energy markets and the “prices” the media report.

Headline oil prices in the U.S. almost always represent the contract prices realized at the Cushing, Oklahoma transport hub for West Texas Intermediate (WTI) crude oil. There are more than 20 additional hubs in North America that quote their own prices. All of them posted negative prices for May contracts yesterday. Further, the price of crude is technically the price of a contract that guarantees its holder the physical delivery of one barrel of oil. The contracts have future expiration dates (i.e. “futures”) around the 21st day of each month. Currently there are active contracts for crude delivery in November 2030 for instance. The prices reported in the media are almost always the nearest month’s expiry, the best approximation for the market’s view on “current” oil prices.

So, what happened yesterday? As we are unfortunately and acutely aware, these are not ordinary times. The COVID-19-induced shutdown of many parts of the global economy has clearly had an impact on oil demand. We estimate demand has fallen by nearly a third globally due to the ongoing pandemic. For example, about 75% of a barrel of oil is used for gasoline, heating, diesel, and jet fuels. I don’t know about you, but I filled up three weeks ago and still have three-quarters of a tank left. I have not been on an airplane in a while either.

The oil market has also faced an oversupply issue for the last few years. The Shale Revolution in the U.S. has rapidly made us the world’s largest producer of oil. And the Organization of Petroleum Exporting Countries (OPEC) has been even more unsuccessful at policing oil production amongst its membership than usual. The demand and supply issues have resulted in a lot of oil going into storage. Lots of it. Our domestic infrastructure can only hold so much – about a billion and a half barrels including the Strategic Petroleum Reserve. And we’re essentially full. Oil market participants have even brought in tanker ships to hold more of it offshore (~160 million barrels currently).

That brings us to negative prices. As discussed, when oil contracts expire, holders are required to take physical delivery of the barrel. Currently not ideal for a refiner that must find more room on its shelves for storage. A disaster for an exchange-traded fund (ETF) that attempts to reflect crude prices but CANNOT take physical delivery. Historically, ETFs have simply sold the near-term expiration contracts to actual users of oil and “rolled” to the next month’s contract. This was certainly not the case yesterday. Those willing to take physical delivery essentially became landlords throughout the day, requiring those who could not or did not want to take delivery to pay them for storage. Unprecedented to say the least.

Where do we go from here? In the near-term, the two things that can solve the current issues are: 1) demand recovery when economies eventually reopen; and 2) supply curtailments. Low and negative oil prices will certainly help to speed up the latter, but it will take time to work through the current storage glut. At the time of this writing, the June 2020 contract (the new nearest expiration) is down more than 30% to $14.76 as market participants figure out how long the process is likely to take. Until we have persistent demand normalization however, it is unlikely we can cut our way out of the problem.

Our portfolios have modest energy exposures focused on larger, relatively more stable participants with balance sheets capable of weathering this storm. These companies give us less exposure to a potential energy recovery but remain going concerns during these periods of volatility. In other words, for now we have chosen sectors other than energy to provide reward in up markets but have maintained exposure to the segment in case short-term trading proves us wrong from time to time. We have redoubled our efforts in evaluating which companies generate sufficient cash flow and have manageable debt loads to survive this downturn and continue returning cash to shareholders.

The energy markets, like everything in life right now, are not behaving normally. As always, please do not hesitate to reach out if you have any questions or concerns.