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Pay me to buy oil?

24 April 2020

5 minute read

We take a look at the dramatic plunge in oil prices. Can they stay negative? When might they feasibly be expected to recover? Is this all part of a long endgame for oil? Here, we try to answer some of these questions.

Who's it for? All investors

The value of investments can fall as well as rise. You may get back less than you invest.

What you’ll learn:

  • What has happened to the oil price?
  • What are the effects of the oil price slump?
  • What is happening outside of the oil market?

A few years ago we were wondering whether we were starting to run out of oil and what we would do about it when that happened. Fast forward to today and the price for the May futures contract (a legal agreement to buy or sell a particular commodity asset, or security, at a predetermined price at a specified time in the future) for West Texas Intermediate (WTI), one of the grades of global crude oil in the US, has sunk to minus $40 a barrel. Owners of the contract were paying other market participants to take the contract and the accompanying physical delivery of oil barrels. How did we get to this situation for such an important global industry?

What happened?

In one day, the price for the May WTI futures contract fell over 300% into negative territory. This is the first time in history that the so called ‘front month’ or nearest contract fell into negative territory. There are several factors behind this.

First, prices are set as a function of a rough balance between supply and demand. However, neither are easy to measure accurately. Nonetheless, it is easy to see a huge chunk of global oil demand has disappeared with the attempts to contain the coronavirus. Domestic and international travel volumes have plunged and it is still unknown when they will return to normal levels. Even dramatically curtailed supply, as per the recent historic agreement between some of the world’s major producers, will prove insufficient to balance markets. One of the primary worries amongst oil market participants right now is where to store all the excess supply? Storing all the excess oil requires costly storage facilities, of which capacity is quickly running out…

Second, there are also technical factors that require a little unpacking. Oil futures contracts relate to specific delivery periods, usually specific months. The current front month contract has this week shifted from May to June and it was this shift that created at least some of the jaw dropping problems we saw in related markets. These problems were particularly acute in the aforementioned WTI grade. This is because in WTI, unlike some other areas, contracts are settled through physical delivery. So if I own the June contract for WTI, I will receive physical barrels of oil on my doorstep at the end of the month when the contract expires.

The oil market plays host to many participants who are simply not able to take physical delivery (they can’t store physical barrels of oil). Such investors will always need to find willing buyers who actually have the storage capacity to take physical delivery for their contracts ahead of the expiry date. In a world that is running out of room to store all the excess production, such participants were strikingly rare this week as the contracts switched over. This meant that traders who aren’t able to take physical delivery are willing to pay others for these contracts to be taken off their hands, hence the negative prices.

What about the effects?

The oil industry and its affiliates are going to be under considerable financial stress with prices at these levels. There are large swathes of production that simply do not make financial sense. Futures markets do suggest improving prices over the next couple of years as demand comes back on line. However, even if prices recover as the futures curve (a view of future expected prices) suggests, many operators will still not be able to make money at the levels currently suggested by the market, even two years out. Some argue that if there were to be no intervention from authorities around the world, this has the potential to significantly harm a major slice of the world’s economy.

Looking back at similar cases of oil price volatility, such as in 2014/15, provide a useful illustration for the immediate and longer term effects. In terms of a medium to longer term outlook, lower oil prices are equivalent to a tax cut for consumers, especially for the major economies that are also net oil importers. This rise in disposable income should translate to more spending as the economy restarts, and therefore a net positive for growth in the longer term, should low prices persist.

Outside of the oil patch...

Whilst the rest of the world is digesting the first wave of infections, other parts of the world have slowly started to emerge from lockdown. Experts are keeping a close eye on Asia’s return to normality, and will use their experience to decipher the best way to move forward. Our ability to weather future outbreaks without having to resort to a full-scale lockdown will, in part, be decided by how well we learn the lessons from Asia’s experience. Thus, the growing database on the virus and its behaviour, along with developments in treatments and better public understanding of the necessary social protocols will all be integral to how we manage potential future outbreaks of this kind.

Investment conclusion

It’s not sustainable for oil futures to stay firmly in negative territory forever. But this doesn’t mean that a rebound is necessarily imminent. Those who put a definite time stamp on this should be viewed with caution as there are a number of factors at play. It is important to note that short-term oil futures are notoriously volatile and near unpredictable. We would be wary of investing in oil (in its various forms) at present as prices can go even lower.

We should be prepared for a long and uncertain road ahead. At the moment, we feel that investors are still a little too bleak on the prospects for global growth and inflation, even if we acknowledge that those prospects are dire in the short run and only set to regain some of their lustre towards the back end of the year. Again, we remind long-term investors not to get caught up in any of this. Do you believe that humankind will continue to invent and adopt new technology as we have done successfully for several hundred years? If yes, the answer remains a diversified fund or portfolio. Within that mix of assets, we will still be owning some exposure to the oil market but that slice is small and is mixed in with other commodity exposures.

Where you might invest

The Barclays Ready-made Investments are just one example of a range of diversified funds which allow you to select the level of risk you are most comfortable with. These multi-asset funds invest across a range of asset classes and regions, offering a globally diversified one-stop solution for investors. Ready-made Investments are not the only funds that we offer and they won’t be appropriate for everyone.

Smart Investor offers a wide range of funds, and our Barclays Funds List may help you to narrow down the wide range available to invest in. These funds are selected by Barclays investment specialists and, based on our research, they’re the funds that have built solid reputations and established sound investment processes.

Funds are designed for the long term so you should only consider them if you can stay invested for at least five years.

These are our current opinions but the future, as ever, is uncertain and outcomes may differ.

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The value of investments can fall as well as rise. You may get back less than you invest. Tax rules can change and their effects on you will depend on your individual circumstances. Smart Investor doesn’t offer personal financial advice. If you’re not sure about investing, seek independent advice.

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