Does it get any crazier than this?
From the Wall Street Journal…
‘U.S. oil futures plunged below zero for the first time Monday, a chaotic demonstration that there was no place left to store all the crude that the world’s stalled economy would otherwise be using.
‘The price of a barrel of West Texas Intermediate crude to be delivered in May, which closed at $18.27 a barrel on Friday, ended Monday at negative $37.63. That effectively means that sellers must pay buyers to take barrels off their hands.’
How did this happen?
Shouldn’t price balance supply and demand?
It looks like it’s trying to do so now, if a little belatedly.
The negative price for the May futures contract reflects its imminent expiry. No one wants to take delivery of oil now. If you want to sell oil, it’s going to cost you.
But the active futures contract (meaning it’s the most traded contract right now) is for June delivery, and here the situation looks a little more normal. Based on this contract, US oil trades at US$21 a barrel. The November futures contract trades at US$32 a barrel.
This reflects the expectation that demand will pick up as the world slowly recovers from the lockdown.
But back to the question of how it got to this?
The culprit is easy money.
According to Fortune magazine, the energy sector has US$86 billion in debt maturing over the next four years. Ouch.
According to the Financial Times:
‘…the business model for many exploration and production companies was broken before oil prices fell. Fuelled by cheap credit, US shale producers borrowed heavily to invest in drilling, causing the US energy bond market to triple in size over the past decade. The focus has been on producing quantity to conquer market share and the flood of oil has yielded low returns for equity investors, as frackers reinvested windfalls and raised top executive pay. US fracking pioneer Chesapeake Energy, for example, hasn’t generated a single year of positive free cash flow in the past decade. As debts rose along with oil supplies, a shakeout was inevitable.’
Energy companies are the largest issuers of junk bonds. They account for 11% of the high-yield market.
The simple fact is that easy money led to an oversupply of oil in the US. That’s why there is now such a massive difference between the US oil price (West Texas Intermediate), which is currently US$16.10 and the international oil price, represented by Brent crude, currently trading at US$25.57.
With this in mind, what does the idiotic Fed do?
Well, last week it said it was going to buy junk bonds, including junk bond ETFs…
Complete and utter madness…
So if there is any doubt about how the oil market got where it is, look no further than central bank distortion of price signals.
In a capitalist economy, price signals are everything.
The Fed, and central banks all over the world, are in the process of destroying price signals everywhere.
Where it all ends up is anyone’s guess. One thing I’m not betting on longer term though is deflation. Sure, we’re in a deflationary phase at the moment. That’s going to happen when you shut the global economy down.
But the only thing central bankers can control is the amount of cash they pump into the system. I’m guessing they won’t show a great deal of restraint. That means asset price inflation will return. It might take a year or so, but this is not the Great Depression Mk II.
Vern Gowdie would disagree with me on that point. He’s made a very strong case for deflation.
But for me, it’s a simple case of supply and demand. The more cash created by central banks (they create cash when monetising debts), the less value that cash eventually has.
Oil is probably a good long-term bet
When share prices fall, it increases the relative value of cash. As I said, in the short term, the value of cash relative to shares will probably continue to increase. But longer term, that’s unlikely.
Cash relative to oil is very expensive right now. That means oil is probably a good long-term bet. But it certainly has some short-term issues it needs to work through. The ‘success’ of the oil price depends on the demise of plenty of oil/energy producers. So if you’re going to dabble, make sure you buy the producers with low debt levels and a low cost of production.
Another way to play rock bottom (actually, negative) oil prices is to look at the gold miners. Gold in Aussie dollar terms is near record highs. Energy is a major cost input for miners. With that cost having more or less halved in the past few months, it provides an additional boost to already highly profitable gold miners.
If you want some ideas, I encourage you to check out the work of my colleague (and gold nut) Shae Russell. She has a global network of gold nuts to call on, as well as deep knowledge of the Aussie gold mining sector.
Click here to read more…
PS: In a brand-new report titled ‘Iron Ore Bear Market 2020–21: Three Better Resource Investments’, financial analyst, Lachlann Tierney, reveals why we could see Aussie iron ore producers like BHP and Rio Tinto’s earnings drop in 2020–21. Plus, three alternative resource stocks with terrific short-term prospects. Click here to download your copy.