The news feed from the coronavirus is all consuming, and rightly so. A disease that was widely touted, just a couple of months ago, as ‘similar’ to influenza has infected millions and killed hundreds of thousands of people.
As a result, economies are in a tail spin. Demand for certain goods and services has fallen off a cliff. Countries that can afford to try to prop up some economic activity are rushing to do “whatever it takes”, concentrating funding on small and medium sized businesses and individuals through a variety of schemes. Other countries whose economies are still developing face greater headwinds to finance the cost of the pandemic.
What hadn’t featured in many headlines, until Monday that is, was the story of another demand and supply catastrophe: one focused on the oil industry. The story starts in mid-February, when China turned away oil tankers. The country didn’t need the oil. People were staying at home and factories were closed. Even though oil is used to heat homes, far more is used for transportation fuel and in the production of plastics and polymers, textiles, paints and dyes, to name but a few – usage that has flat-lined.
This low level of activity can be seen in China’s Q1 2020 GDP numbers, which contracted by -6.8%, its first ever negative number in 40 years.
If China had been the only country to realise that the demand for oil was about to come to a dramatic halt, the story might have ended there, despite China being the largest consumer of oil. Cue the Saudi and Russia spat. The rumblings of this saga started in 2016 when the US ramped up its oil production. Even after a year of negotiations to cut oil production, which saw OPEC become OPEC+, the Saudis were left carrying the can and shouldering even more of the cuts than they originally agreed to.
In March of this year, when further cuts were proposed, Russia decided it did not want to play ball. The Saudis responded by boosting production, and offered discounts to its biggest customers – discounts it can afford given it has one of the lowest oil production costs. But neither nation could have anticipated what would happen next. Despite an eventual agreement to substantially cut production in the 9 April deal, the fall in demand was such that the price per barrel would carry a minus symbol before it. West Texas Intermediate crude (the US benchmark oil price) fell dramatically, finishing at almost –US$38 on 20 April. Brent Crude (the benchmark used by the rest of the world) didn’t fare much better finishing off at US$26.
So what happened on 20 April?
The answer lies in the small town of Cushing, Oklahoma – a town that was largely unknown to the world before now. If you are an oil trader and can’t onward sell the oil you have agreed to buy, you have to take physical delivery of that oil. Cushing is a town that typically sees 90 million barrels of oil stored (about 13% of the US oil inventories), and 6.5 million barrels per day carried through the town via its 20+ oil pipes. But Cushing’s facilities were almost all booked up. There was no room at the inn.
Other options for oil storage had also vanished – even in March, it was estimated that 76% of the world’s oil storage facilities were full. When this happens, a popular solution is to hire an oil tanker as a temporary storage facility, but lease prices had already exploded from US$20,000 in February to US$200,000 to US$300,000 in March, as availability bottomed out. The situation came to a head on 20 April because this was the day on which unsettled oil future contracts in April expired. Traders had to pay to not take delivery of something they couldn’t store – the equivalent of a negative price. Although contracts expiring in May and June are trading in positive territory, they are still trading well below any semblance of normality. With nowhere to store the oil, the oil price turned negative as sellers paid people to physically take the oil off their hands.
The news hit financial markets hard. Oil is a large part of the global economy and its price fluctuations have big implications, which vary from country to country. The EU, for example, is an oil importer and lower oil prices therefore generally boost economic growth. On the opposite end of the scale, some oil producing countries were hit hard.
The US is the biggest gas and oil producer due to its shale oil and gas industry. While shale wells can close down production much more easily than traditional oil producers, there is a far bigger knock-on effect on capital expenditure – for every job created drilling the shale gas/oil out of the ground, there are hundreds more in the form of hydraulic manufacturers, loader operators, truck drivers and diesel mechanics. These in turn support other businesses, such as hotels, restaurants, and food and clothing shops. The list goes on.
So what does this mean for investments?
Lower oil prices mean that new shale production isn’t coming on line, and the investments in these wells suffer. Not only is money lost if the production doesn’t come online as planned, it also means secondary industries linked to this also aren’t being paid, threatening millions of jobs.
Lower oil prices also hit energy companies who are some of the biggest stocks listed on exchanges around the world. This in turn drives down the overall stock index averages and other investments get sold as people worry that this is the start of another big drop. Energy companies also make up a significant part of global bond issuance, so credit markets are impacted too.
Low oil prices are generally a good thing for consumers. Whether filling our cars, firing up gas barbecues, decorating our homes or buying household goods, the price of oil makes a difference to the day-to-day cost of living. In fact, a 2015 EU study showed that a 50% decrease in the oil price could generate up to three million additional jobs in the economic region, which was then 1.3% of the total labour force.
We live in strange times, however, as oil price falls are not yet putting more money in people’s pockets or boosting consumer sentiment. In fact, this has arguably spooked markets and left people wondering what else might be around the corner, at least in the short term.
If demand for oil continues to be suppressed over the long term, it could change the balance of power in the Middle East. Oil has played an important role in shaping history in the past. If Hitler hadn’t diverted some of his troops to capture oil producing regions in his Operation Barbarossa, his march on Moscow might not have failed. Many conflicts in the Middle East today can be directly linked to the 1917 Sykes-Picot agreement in which Britain and France redrew the borders of countries with different histories, languages and cultures as they carved up oil rights.
In the same way, oil continues to play an important role in politics today, for opposite reasons. There are rumours that the Russians and Saudis are trying to damage the US’s ability to be more self-sufficient by ensuring its shale oil production is unprofitable and therefore stops. While this may or may not be true, it is highly likely that the West’s interest in supporting the oil-rich governments in countries such as Saudi Arabia or Venezuela will disappear. It may also, over time, lead to increased investment in renewable energy as governments wake up to the idea of a world free of the oil-linked politics.
What should you do about this? Diversify and search for opportunity. Those most shielded from volatility are investors with large levels of diversification. A portfolio diversified across companies, industries and sectors, geographies, types of investment and currencies is best placed to fulfil a double mandate: to reduce volatility and find opportunity, which is exactly what we do for our clients.
Clients of Nedbank Private Wealth can get in touch with their private bankers or relationship managers directly to understand how their portfolios are responding to market events or call +44 (0)1624 645000.
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Rebecca joined Nedbank Private Wealth in May 2004 having moved to the Isle of Man from Barcelona to pursue a course in Business Studies with the Isle of Man Business School. Rebecca was appointed to the role of investment counsellor in March 2019 to focus exclusively on the company’s discretionary investment management services. She works closely with our teams of private bankers to provide support in advising our clients with integrity, and to give additional technical investment expertise where more complex portfolio requirements exist. Rebecca is a Chartered Fellow of the Chartered Institute for Securities & Investment and a Chartered Wealth Manager.