At the outset of 2020, economists predicted global growth to rise by 3.3%. However, with the advent of the coronavirus pandemic and widespread shelter-at-home orders, that figure is being revised downwards.
Some top investors, such as Bridgewater’s Ray Dalio, are comparing conditions to the Great Depression: “This is not a recession; this is a breakdown. You’re seeing the same thing that happened in the 1930s.”
One of the most dramatic impacts of the coronavirus has been the oil crash of April 20, when crude plummeted to less than -$38/barrel.
Oil is an important commodity relied by many industries. Fluctuations in its price have a wide-ranging impact on the economy.
In this article, we will take a look at the impact of the coronavirus pandemic on oil prices, and consider where things are headed.
First, some basics.
Key Determinants of Oil Prices
Like every other commodity being traded, supply and demand determines the price of oil on the markets.
The Demand for Oil
The demand for oil is vast and ranges from uses in transportation (such as freight transportation, consumer automobiles, and passenger jets) to products like computers, plastics, and fertilizer.
An increase in demand has knock-on effects, such as boosting the need for components like oil country tubular goods ( OCTGs ) — welded steel tubes and pipe fittings used in oil rigs.
The Supply of Oil
The supply of oil, however, is highly variable.Typical factors that affect the supply of a commodity (including labor and other costs of production). Geopolitical factors — such as trade wars and production levels — can also affect prices.
The Middle East is one of the world’s largest producers of oil, and a significant amount of the world’s reserves are held there.
Nevertheless, the Middle East is also one of the most turbulent regions in the world, and political action greatly influences the amount of supply produced. This factor is so important that some economists consider there to be three factors that affect the price of oil: supply, demand, and geopolitics.
The Current State of Crude Oil Prices
Today’s crude oil prices are primarily driven by two events:
1. The price war between Russia and Saudi Arabia
2. The coronavirus pandemic
The Russia-Saudi Arabia Oil Price War
In the first quarter of 2020, two major producers of oil, Russia and Saudi Arabia, engaged in a price war that resulted in a significant decline in the price of oil. Russia had initially refused to join members of OPEC+ in cutting output. In retaliation, Saudi Arabia boosted production and slashed prices. Brent Crude and West Texas Intermediate prices tumbled.
Once prices hit $30 commentators were talking about how US shale producers would go bankrupt if the price didn’t rise by at least $20.
The peak of this price war, unfortunately, coincided with the spread of the coronavirus. And the subsequent agreement between the Saudi Arabia and Russia to cut production seemed to arrive too late.
We must point out that many believe the effect of the price war waged between Russia and Saudi Arabia to be small compared to the effect of the Coronavirus Pandemic. Nevertheless, the initial oversupply has not helped matters.
The Economic Impact of the Coronavirus Pandemic
Because of the coronavirus pandemic, the demand for oil has dropped significantly. Governments issued stay-at-home/shelter-at-home orders and forced businesses deemed non-essential to close. People drove less and commuting came to a standstill.
The decrease in business operations has resulted in a decline in energy usage. Shutdowns affected not only retail outlets and services-based businesses like hotels and restaurants, but also manufacturing and mining.
Furthermore, the aviation industry is facing multiple bankruptcies, and airlines are among the biggest consumers of oil.
A Glut of Oil, and a Storage Crisis
The decline in demand also created a storage crisis. Crude storage facilities filled rapidly, and as space runs out, refineries will have no choice but to cease operations.
Supertankers served as floating storage with over 176 million barrels stranded at sea.
The Oil Market Metldown
In short, as the supply of oil went up, the demand for it went down — in fact, it seems that oil consumption is down almost 25% between February and April of 2020.
● At the end of March in the U.S., prices turned negative for the first time. Wyoming Asphalt Sour was the first to bid negative .
● The lack of available storage led to futures traders becoming desperate to dump May contracts before expiration, igniting a market meltdown on April 20, 2020 when oil plummeted to -$38/barrel
● Oil volatility spiked to 400% on that day
Many American energy companies are perilously close to bankruptcy as they struggle to make interest payments on loans. They were already heavily indebted before the oil crash and demand slump.
Furthermore, the energy industry is one of the largest employers in the US economy , and a large number of those jobs are relatively high-paying. The struggles of the oil companies will trickle down, leading to cascading layoffs, which further worsens the nation’s overall economic condition. Spending power is way down, and as it declines more, there appears to be a vicious cycle of decline.
So what can we learn from the oil crash?
Lessons From the Oil Crash
● Corporate balance sheets matter. As highly indebted companies in the American oil and gas sector struggle to make interest payments on loans, they are a reminder of the ballooning debt across all sectors. For example, Equitrans Midstream Corp. (ETRN) has a long-term debt/equity ratio of 90.2%; Tetra Technologies Inc (TTI) has a ratio of 84.6%, and Apache Corp. (APA) has a ratio of 71.8%.
● Peter Zeihan is worth a listen: Many considered the oil crash to be a complete surprise, yet Zeihan predicted negative oil prices .
● Don’t expect demand to bounce back: “Demand is not coming back anytime soon. We will have a massive glut to work off for months to come,” Zariq Zahir, commodity fund manager at Tyche Capital Advisors LLC, told Bloomberg.
● Look for opportunities in the short-term: Year-to-date (YTD) crude is down -51.8%, gasoline is down -42.9%, and S&P 500 Energy is down -40.3. But in the current quarter, as of May 18, 2020, crude is up +43.7%, gasoline is up +69.3%, and S&P 500 Energy is up +29.3%.
● Crude stored on tankers is a bellwether: It has declined from 176 million barrels to 155 million barrels per Vortexa , but it’s still more than double what it was 2 months ago, according to Bloomberg. Jay Maroo, a senior analyst at Vortexa told Bloomberg that “Crude in floating storage is likely to fall first and fastest upon any demand strength, as it’s typically the most expensive form of storage available.”
● Stay alert to potential alternate energy opportunities: Uranium prices have increased by a third in recent weeks. Traders can get exposure to uranium via YellowCake plc (OTCMKTS: YLLXF) or via Uranium Participation Corp (OTCMKTS: URPTF). But before you decide to buy or sell, check for signs of oversold conditions (RSI) or signs that momentum is slowing or reversing (MACD).
● Keep your eye on inflation hedges: traditionally traders look to gold and stock market, orange juice, and US Treasurys as inflation hedges. And these have not disappointed. Year-to-date, orange juice is up +27.1%, 20+ year US Treasurys are up 23.1%, and gold is up 15.4%.
● Be sure you’re trading with a reputable broker: Interactive Brokers’ platform experienced a glitch during the market crash, and failed to show oil prices had descended below $0. But this broker made things right by refunding any lost money to its traders.
What the Future Looks Like for Crude Oil Prices
There is a lot of uncertainty regarding what the future holds for crude oil prices.
● Though many governments are lifting the stay-at-home/shelter-at-home orders, many expect the global economy to remain sluggish. Unemployment numbers have been spiking to Great Depression levels.
● Cities that re-open may experience new surges of the coronavirus. If that leads to a secondary shutdowns, the cumulative impact of these across a country may stunt growth and send oil prices tumbling again.
● Some speculate that a second wave of the coronavirus may appear this winter, and could theoretically be more difficult for governments and hospitals to manage if it coincides with flu season.
● Americans’ savings rates hit 13%, or over $2 trillion, a level not seen since Ronald Reagan was president. This is typical of deflationary periods: consumers hold on to their cash. This can also slow the economic recovery.
● If the energy industry, which employs many and pays well, continues to be negatively affected economically, this will increase the number of people without work, further slowing the economic recovery.
But the biggest puzzle of all for oil is this one: for oil to rebound there has to be a rally in the stock market. How can there be a sustained rally in the stock market given historic levels of unemployment and bankruptcies?
The economy started off fairly strong in 2020, but the coronavirus pandemic has unleashed a global recession The drop in oil prices has a wide-reaching effect, but no one can say when prices will recover.
Remember that markets are still subject to volatility. Price movements can be triggered by announcements of large government aid packages as well as increased coronavirus death numbers, “second wave” infections, or news about possible treatments or vaccines. In the U.S., an announcement of large-scale government-funded infrastructure projects could buoy oil prices as well.
Traders who seek to benefit from oil price movements need to watch short term trends and follow changes in storage capacity as well as the lifting of lockdown orders. Investors may want to research opportunities in traditional inflation hedges.
Remember: in a financial crisis, wealth never disappears; it merely changes hands. We hope that you will position yourself well to benefit from this ongoing wealth transfer