Oil ain’t worth a dime anymore

The Global Financial Crisis gave us negative interest rates, and COVID has given us negative oil prices.
April 2020

We don’t see very far in the future, we are very focused on one idea at a time, one problem at a time, and all these are incompatible with rationality as economic theory assumes it.

Daniel Kahneman

There’s a first to everything, and to paraphrase Yogi Berra, “oil ain’t worth a dime anymore.” The Global Financial Crisis gave us negative interest rates, and COVID has given us negative oil prices (Chart 1). A week after the historical OPEC+ deal that saw oil production cuts of about 10MM barrels per day, Western Texas Intermediate (WTI) oil prices traded to a mind-blowing low of -$40.32 per barrel on April 20 as global storage capacity is filling up rapidly (Source: Bloomberg), most notably in Cushing, Oklahoma, the world’s largest oil-trading hub. The full-stop of the economy means oil demand has collapsed and, unlike base metals such as aluminum or copper, oil cannot easily be stored on a fenced land lot, and therefore requires an aggressive repricing lower of oil prices for markets to rebalance.

Chart 1: WTI prices dive deep into negative territory

Chart 1: WTI Prices Dive Deep into Negative Territory

Source: Bloomberg, BMO GAM as of April 23, 2020.

Long-term impact of COVID on oil demand

Stock prices have rallied as western countries are taking baby steps towards re-opening their economies, but oil prices must see commuters back in their cars and airplanes in the sky before rebounding to above $30 per barrel. However, we doubt oil demand will recover as fast as the broad economy this summer. COVID may not only linger in the population for several more months, thereby extending social distancing, but some demand patterns might be forever changed. Even before COVID, working from home was increasingly popular (Source: Business Insider) and businesses and workers might appreciate the benefits after the intense technology adoption. Lastly, road trips and intercontinental vacations are unlikely next summer even if gasoline prices remain well below $1 per liter.

Oil has gone nuts

Watching S&P 500 daily swings of double digit percentage points was brutal, but for oil the volatility has been even wilder (Chart 2). If the inventory overhang persists and prices remain well below $30 per barrel, we expect oil volatility to remain at extreme levels.

Chart 2: Oil volatility makes S&P 500 volatility feel like a walk in the park

Chart 2: Oil Volatility Makes S&P 500 Volatility Feel Like a Walk in the Park

Source: Bloomberg, BMO GAM as of April 23, 2020.

WTI’s forward curve signals more pain lies ahead

The term-structure of the forward curve of WTI futures contracts also reached unprecedented levels as inventory concerns grew. In normal times, investors can expect a premium for owning future deliveries of commodities because of scarcity and supply uncertainty, especially for hard-to-store commodities such as oil. This premium is observed by a negatively sloped term-structure of forward prices, a phenomenon known as backwardation. Meanwhile, when a commodity is in excess supply, the forward curve is positively sloped, i.e. in contango. When the curve is in contango, the premium for owning future deliveries is negative as forward prices are expected to fall toward spot prices.

Comparing the price differential between the first- and twelfth-month contracts, the forward curve mirrors the severe supply-demand imbalance with the steepest curve ever witnessed (Chart 3).

Chart 3: Term-structure (1st vs 12th month) of oil prices reveals unprecedented excess supply concerns

Chart 3: Term-Structure (1st vs 12th month) of Oil Prices Reveals Unprecedented Excess Supply Concerns

Source: Bloomberg, BMO GAM as of April 23, 2020.

Energy stocks: Why didn’t they collapse along with oil prices in April?

The year-to-date performance of energy stocks has been atrocious (BMO Canadian Equal Weight Oil and Gas Index ETF, ticker: ZEO, -44%)*, but their positive April performance when oil traded in negative territory looks odd at first glance. However, looking beyond the near-term negativity of oil prices, the price of oil to be delivered in June 2021 has held up much better this year than front month WTI prices (Chart 4), which helps explain why energy companies have also held up this month.

Chart 4: Oil for delivery in summer 2021 holding up better

Chart 4: Oil for delivery in Summer 2021 Holding up Better

Source: Bloomberg, BMO GAM as of April 23, 2020.

Oil outlook: Healing will be slower than COVID

The first six months of steep contango suggest that the strain on the storage market is at extremes and that oil production must decline or prices will continue to be pressured lower across the forward curve. Elevated oil inventories also mean that as inventories unwind into the market, subsequent futures months (e.g., July and August contracts) are likely to be pressured lower as the demand recovery is unlikely to match the upcoming supply for most of 2020.

Portfolio update: Lingering oil pain reinforces some of our key calls

Unlike most sectors of the economy that are getting bailout money, the energy sector has received very little direct help thus far because the economic viability of oil extraction is in doubt. Given our view that oil prices could remain weak longer than the COVID-induced demand destruction continues, there are four key implications for our portfolios.

  1. We continue to prefer Canadian Low-Vol stocks as they largely reduce the direct exposure to the highly volatile energy complex.
  2. Bond duration remains attractive as the deflationary backdrop and central-bank buying persists at least into the summer.
  3. We remain underweight of Canadian stocks versus EM and U.S. stocks as the Canadian economy is the most negatively exposed to weak energy prices, unlike most EM economies.
  4. Because energy prices are the most important driver of the value of the loonie, we remain cautious and prefer to leave our foreign currency exposures unhedged as further risk-off moves would likely be dampened by a weakening loonie.


* Quoted performance as at April 22, 2020. The performance for (ZEO) for the period ended March 31, 2020 is as follows: -48.61% (1 Year);  -26.44% (3 year); -17.87% (5 year); and -10.21% since inception (on October 20, 2009).

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