Weekly market recap – West Texas Chainsaw Massacre

Oil sell-off continues, but investors remain optimistic as US equities rally.

FacebooktwitterlinkedinmailFacebooktwitterlinkedinmail   by Tertius Bonnin, 17th April 2020

A lady from Paraguay was surprised when she woke up in a body bag at a funeral parlour having been previously declared dead. Gladys Duarte had gone to a clinic in the city of Coronel Oviedo with high blood pressure… Staff at the funeral parlour were left with a shock when the noticed the body bag moving!

No doubt oil traders have been suffering from high blood pressure as the sell-off in the commodity has continued. Asset class returns in sterling and local currency are below; US equities continued to rally last week as investors remain optimistic about the spread of the coronavirus.

Table 1: GBP total returns

Source: Bloomberg

Table 2: Local CCY total returns

Source: Bloomberg

Rather than telling you yet again about the economic fallout of the Covid-19 lockdown and how equity markets seem to be ignoring bad news, I’m going to follow up on a previous blog piece (Oil’s Obituary, 3 April 2020) with some truly remarkable developments that have occurred in the last 24 hours. In that piece, I described the current backdrop for energy markets which has taken shape since 2014. Before I go on to more recent price action, I need to set out a high-level structure of how oil is traded and why prices for “a barrel of oil” can (and have) deviated significantly across the world.

First, when we talk about the oil price, it’s important to understand that we are referring to the price of a contract in which a counterparty is committed to delivering the physical commodity to you on a specific date. While the amount of the commodity each contract promises will be standardised, different contracts will have different maturity dates e.g. one contract may deliver 1,000 barrels of oil on 31 March, another may be 30 April.

Next, where you are in the world will likely impact the kind of oil you buy. What we do we mean by this? Well, you’ve likely heard about two major types (or benchmarks) of crude oil, West Texas Intermediate (WTI) and Brent Crude, which are produced in the US and the North Sea respectively. Each has its own price, with the differential coming down to several structural and transient factors. The dominating factor is the ever-shifting balance between local and international supply and demand dynamics, while other structural features are:

  • High sulphur content (termed “sour crude”) requires an increased level of processing and can negatively impact the end-product, so low sulphur content (“sweet crude”) commands a higher price;
  • Lower density oil (“light crude”) costs less to produce as it requires a simplified refining process, while denser oil (“heavy crude”) may cause issues when being extracted, transported and refined so will trade at a discounted price;
  • The physical location of the oilfields which then has implications for transportation costs; those fields closer to ports mean transportation is easier and as such command higher prices.

In short, this unintuitively means there are multiple prices for oil depending on when you want to take delivery, which type of oil you are looking to buy, and local supply and demand dynamics.

Source: Bloomberg

With the above in mind, we can now look at recent price action. The past 24 hours have seen US oil benchmarks tip into negative territory. Yes, you read that correctly, that means people are being paid to take delivery of oil…. So, what’s caused this bizarre price action? Very simply, the supply war between Russia and Saudi Arabia which is being felt throughout energy markets combined with the collapse in demand due to the economic lockdown has caused a glut to such extent that participants in the US are physically running out of storage space for the oil. Meanwhile in Europe, the oil price – while still depressed from the global oversupply – hasn’t yet faced such extreme shortages of storage meaning the price has remained in positive territory.

Source: Bloomberg

It’s difficult to say whether these pressures will indeed ease by June, particularly given the fact that there still is no agreement to cut supply between the Russian and Saudi states. In addition, while the spread of Covid-19 around the world appears to be slowing, it’s difficult to say how quickly economic activity will pick back up when entire countries are still in lockdown.

STAT OF THE WEEK: 60% – the proportion of the UK workforce employed by small and medium-sized businesses (Federation of Small Business).

DATA CORRECT AS AT: 10/04/20

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    Tertius Bonnin

    Tertius is an Investment Analyst on our research team. He focuses on investment ideas within US, global and thematic equities, and sits on our fund selection committee.

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