"I Did Not See That Coming": The Oil Crash and What Happens Next
April 27, 2020
By Tom Limoges
Asst. VP - Investments
Over the years, there have been events that I definitely did not expect to happen. Whether in my personal life or on the global stage, these instances were unpredictable, extremely rare, and usually tied to some catastrophic event. One of these events happened last week with oil prices moving below zero for the first time in history. In times like this, it helps us to understand the factors that created this unexpected event. Why did this happen, and what does the future hold for the commodity and the companies that produce it?
Negative Oil Prices?
The decline in oil prices last week occurred because of a combination of a few factors. First, demand for the commodity declined as fewer people are traveling. The transportation sector accounts for the largest consumption of oil per day – nearly three times the next largest sector. Second, oil production has not fallen enough to offset the lower demand. The result has been rapidly filling storage capacity on the ground and tankers at sea.
Contracts to purchase oil trade on a commodity exchange and prices (most quoted in the news) are reflective in current contracts. As oil contracts for May delivery (most current) reached expiration, there were no buyers and few places to deliver product. Contract holders paid to close out positions — an unprecedented event. Future contract prices remained stable (in comparison), the May futures expired, and the immediate chaos passed.
What About Oil Stocks?
In contrast, oil and gas exploration and production companies measured by Standard and Poor’s rose over 10% last week.
SPDR S&P Oil & Gas Exploration & Production ETF
Why do stock prices rise on negative oil prices? It is important to keep in mind that the stock market is always forward looking. Many of these companies have been preparing for lower oil prices by reducing dividends and cutting spending over the last few months. Because of these measures taking place as well as falling oil prices, volatility in oil stocks spiked near the end of the first quarter.
What Happens Next?
Looking forward, demand will catch up to supply. This will be mostly due to lower oil output as a result of decreased spending and caps on production. On the other end of the string, demand will improve as restrictions on travel are lifted and the overall fear of the unknown subsides. While it may take time to regain demand levels of the previous year, increased demand and lower production will support higher oil prices.
Companies within the energy sector will remain volatile, but they could have the potential for continued price recovery when oil prices rebound. Do NOT wait for oil prices to rebound to own energy stocks as part of your well-diversified portfolio. Once oil prices recover, the renewed optimism will be realized much sooner in stock prices.
This drop in oil prices below zero is something few would have predicted. It is a historically unprecedented occurrence tied to the COVID-19 pandemic. In times of unprecedented uncertainty, we can take small comfort in understanding the factors that have contributed to this event. Changes in consumer behavior affect supply and demand. As these behaviors continue to recover in the future, so will the state of oil prices. If you have any questions regarding your portfolio or our strategy, please reach out to your advisor today.