Last week, the oil price wasn’t the only factor driving markets – with earnings season results confirming the impact of the economic shutdown and speculation about Coronavirus vaccines also impacting markets. However, investors seemed hopeful on the midweek surge in oil, and about the US Senate agreeing on a multi-billion-dollar relief package for small businesses, hospitals and testing. Locally, the Reserve Bank of Australia (RBA) announced a change to its bond-buying program and forecast economic growth of up to 7% next year – but also warned against the rapid easing of lockdown restrictions. After a week of volatile trading, the All Ordinaries Index fell 4.4%, the S&P 500 fell 1.3%, and the Australian Dollar (AUD) traded at 0.6392 US cents.
The most encouraging development last week was a further fall in new infections. There are now well-established downward trends in Spain and Italy, and what appears to be a peak in the UK. In the US, the downward trend in the number of new cases is less obvious, as the decline in New York and neighbouring states has been offset somewhat by an increase in new cases in other states. Australia has seen a very clear decline in the number of new cases – with fewer than 100 new cases last week.
However, what’s concerning is the number of countries experiencing a second wave of infection – for example, Singapore. While Singapore was quick to control the initial spread but, the number of new cases has since increased due to the infection spreading among migrant workers housed in high-density buildings. There are also reports of a large number of new infections in Harbin, a major city in North Eastern China, due to returnees from Russia. Those two cases highlight the widespread nature of the virus and the likelihood that in the absence of a vaccine, there will likely be episodes of new infections in future – even after the current situation is brought under control. Interestingly, RBA Governor Lowe commented last week that while easing lockdown restrictions would be helpful to the Australian economy, loosening the reigns too soon could further impact it.
The Effectiveness of Central Banks
Since the outbreak, fixed interest markets have changed dramatically. All major central banks in developed economies, including the RBA, have reduced policy rates close to zero. They have either restarted their asset purchase programs (in the case of the US), increased the size of their asset purchase programs (in the case of Europe), or started an asset purchase program for the first time in history (as seen with the Bank of Canada and the RBA). The aim of these initiatives is to reduce and maintain interest rates at a low level to allow households and corporations to continue borrowing and to refinance their debts. In the case of the US Federal Reserve (the Fed), which serves as the world’s de-facto central bank, their asset purchase program is also designed to “un-freeze” or to improve liquidity in some debt markets – in particular, corporate bond markets. But how successful have central banks been in achieving their objectives?
In the case of pushing interest rates lower, central banks have been very successful. The Australian 10-year bond yield and the US 10-year bond yield have reversed their sharp increases in early March, and are both lower and considerably less volatile.
The effectiveness of the Fed’s policy in restoring liquidity in other bond markets is more open to debate. The buy/sell spreads in many markets, mainly for sovereign bonds and investment grade corporate bonds, have declined from their peaks in mid-March, indicating a level of success. However, the Fed’s programs are also creating new anomalies. Instruments, which are not included in the central bank’s myriad list of asset purchase programs, are being “left behind” – with significant gaps between fundamental value and price. This could create an interesting opportunity for patient, long-term investors who are willing to tolerate short-term price volatility.
Negative Oil Prices?
The most volatile development last week was oil. We know there has been a significant decrease in demand for oil, but waking up one morning to news of negative oil prices was still somewhat shocking. The oil price that generated the most headlines last week was the West Texas Intermediary (WTI) April futures price. However, things are somewhat complex on this front, so some explanation is required - see figure 1.
Firstly, WTI is a grade of crude oil produced in the US which is used as a benchmark for oil pricing. Secondly, futures are a financial instrument (or contract) that can be used to speculate on the future direction or performance of an underlying asset – in this case, oil. So if an investor purchases a June futures contract on one barrel of oil for US$20 today, they pay $20 now and take their barrel on the settlement day in June. If the oil price is greater on settlement day, the investor makes a profit. But if the price is lower, they make a loss. In practice, the physical delivery of the asset is unusual, with most futures markets cash-settled.1
So why did WTI May futures reach negative US$37.63 on 20 April – just one day before settlement? The WTI futures market is an unusual market in which contracts can change hands and involve the physical delivery of oil (in Cushing, Oklahoma – see map in Figure 2). If an investor held a contract for 21 April (the settlement day), they were legally obliged to accept physical barrels of oil from sellers. The problem is, storage for oil is currently scarce – with excess oil production quickly filling up capacity. This means that the day before settlement, the buyer of a May WTI futures contract would not have been able to find storage for their oil delivery – and neither could they simply pour that oil down the drain. This made many buyers desperate to pay someone US$37.63 just to take their oil and solve this problem.
There is no doubt that oil producers are in dire straits – pushing many to the brink. The spread of the pandemic, the lockdown of various economies, and the almost complete shutdown of commercial aviation have resulted in a significant reduction in daily global demand for oil of around 20 million barrels per day. Major oil producers promised to reduce daily production by about 12.5 million barrels per day from May – but even if they adhere to this agreement, the industry could still face a supply-demand mismatch until there is a sustainable recovery in demand. This could occur in the September quarter, but it likely won’t be until 2021 before a recovery is seen to a level comparable to pre-pandemic demand.
So, does all of this mean we should get into our cars, drive to the nearest petrol station, and expect our friendly multi-national oil company to fill up the fuel tank and pay us for it? Looking ahead, our readers won’t be paid to fill their tanks with fuel. However, anyone with sufficient determination may still be able to get to Cushing, Oklahoma by 19 May when the June WTI futures settle. Given the low WTI spot price and the lack of storage, the same scenario may play out – meaning an oil futures trader may very fill up your fuel tank and pay you.
Article written by George Lin - Senior Investment Manager - Colonial First State
1Most futures contracts are “cash settled”, meaning the seller and buyer exchange cash at settlement to close out the contract. For example, if the spot price at the settlement date is lower than the purchase price of the futures which took place two months ago, the holder of the futures will pay the difference to the seller.