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Institutional Perspectives

Here, we assess the potential implications for key asset classes of the dramatic plunge in the price of May 2020 West Texas Intermediate crude oil.

Recent convulsions in the energy market have grabbed headlines, but had minimal impact on more forward looking equity and credit markets. On April 20, the day before the final day of trading for the May futures contract for West Texas Intermediate (WTI) crude oil, May futures collapsed to a negative price, reaching levels below -$30.00 per barrel (see chart) before rebounding somewhat in the next session.


Figure 1. Demand, Storage Woes Help Send Prices on a Key Crude-Oil Contract into Negative Territory
Price per barrel for West Texas Intermediate crude oil (May 2020 contract), January 2, 2020-April 20, 2020

Source: Bloomberg. Data as of 4/20/2020. 
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

The move exposed yet another among many of the unique economic and market challenges associated with the disruptions related to the pandemic crisis. While forward contract prices, which represent longer-term supply/demand needs, dropped only slightly, energy market participants trading the current-month contracts had to grapple with storage issues as physical oil supply overwhelmed existing storage capacity. Exchange participants were forced to liquidate long positions to avoid heavy fines and the possibility of being banned from trading on major commodities exchanges.

The impact of this oil market stress was relatively small in other markets. The U.S. high yield market, which we believe is a useful indicator of corporate stress in the energy sector, underperformed modestly, with energy names lagging slightly.1 However, we think the impact was negligible compared with the magnitude of the move in the oil market, for two primary reasons.

  1. The prospects of oil companies are widely viewed as tied to the longer term outlook for oil prices, not the price of today. Exploration and Production (E&P) companies, for example, will lock in the price of oil in the future, and then produce the oil to fill that need. Short-term price gyrations don’t typically affect profitability.
  2. Many companies in the oil industry, particularly in the E&P and Oil Field Services categories, are already priced for significant stress or default.  We believe incremental stress in oil prices would have little impact on the valuations of companies that are already priced for default.

A Final Word
Markets have a way of correcting imbalances over time. The present “contango” of the oil markets – that is the price difference between oil today and what oil may be in the future – is historically extreme. Over time, this differential should reach equilibrium, in our view, but there are short-term logistical hurdles to get physical oil to every place there is available storage. The extremity of the storage situation may result in earlier-than-anticipated production cuts until the imbalance is cleared. While this situation is likely to result in continued short term volatility, cutting supply earlier than expected may be a positive for forward oil prices.

The severity of the May contract move tells us simply that certain market participants (presumably those involved in a speculative capacity) were caught off guard with an unexpected shortage of storage. Where longer term oil prices go from here is anybody’s guess, but we can gain only limited information from these storage-related issues. In our view, forward looking markets – such as the equity and high yield markets – will be driven more by expectations of global oil supply and prospects for economic recovery.

 

1Based on the performance of the Bloomberg Barclays U.S.  High Yield Index and related subcomponent indexes.

 

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