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Crude Oil: It’s 2020 and You Can’t Give It Away

It has been a rough start to the year for the price of crude oil. COVID-19 related shutdowns have decreased global demand for crude oil by an estimated 20-30 million barrels a day. Facing an unprecedented drop in demand, the logical thing to do would be to cut back production. Instead, two of the three largest producers (Russia and Saudi Arabia) engaged in a price war, flooding the market with cheap oil. As a result of both of these issues, West Texas Intermediate (WTI) crude futures lost 2/3 of their value in the first three months of this year. 

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Storage Concerns

Normally, the crude oil futures contract closest to expiration trades in close proximity to the contract expiring the following month (chart below). However, last week the current month contract completely disconnected from the rest of the futures curve. Why?

Simply put, given the extreme supply/demand imbalances described above, the world was running out of places to store crude oil. This was especially true in the town of Cushing, Oklahoma. Cushing is important because it is where physical delivery takes place for holders of WTI crude oil futures contracts. (For every futures contract held to expiration, 1,000 barrels of crude oil are delivered at the beginning of the next month.)

As the April 21st expiration date for the May contract neared, most traders moved on to the more liquid June contract. A handful of inexperienced traders held on for too long. On April 20th, the day prior to expiration, the May crude oil futures contract fell to -$37.63. With limited spare storage capacity in Cushing, taking physical delivery of oil presented a challenge. As such, traders had to pay for someone to take delivery of their crude! Now that the May contract expiration has passed, crude oil has rebounded to around $17 a barrel. As you can surmise, trading oil futures contracts isn’t for the faint of heart. 

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The New Normal?

Will we see negative crude oil prices again? The answer will depend on how quickly the global economy recovers. If we see a second wave of COVID-19 cases later this year, there is a strong likelihood negative prices will return.

Even if crude remains positive for the remainder of the year, a lot of oil producers may not survive. Following the 2014-2016 crude oil bear market, for example, 25% of U.S. producers went bankrupt. 

The chart below helps illustrate the recent damage inflicted on the energy sector. Five months ago, the energy sector was roughly the same size as Microsoft. Now Microsoft is twice its size. 

There will come a time when big integrated oil companies offer a compelling value, but there is likely more pain to come in the short run. Allegiant is monitoring changing energy dynamics, its impact on the economy and markets, and more importantly, any risks or opportunities for your investment plans. 

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