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Oil: Troubles are Just Beginning, But Won't Last Forever

Wall Street tumbled for a second straight day on Tuesday as a collapse in U.S. oil prices and glum forecasts by companies worsened fears of a deep economic downturn.

All 11 S&P 500 sector indexes fell 1.6% or more, with energy sliding for the seventh time in eight sessions a day after the WTI contract crashed below zero as oil traders ran out of storage for May deliveries.

With the collapse spilling into June futures contracts, equity investors became wary of the extent of the economic damage from sweeping lockdown measures that have halted business activity and sparked millions of layoffs.

The May Crude Oil Contract took a destructive hit April 20 as the contract traded into negative territory. Crude Oil plunged to all-time lows surpassing levels not seen since 1983. A variety of factors contributed to the heavy selling pressure and the lack of demand remains a major concern. The Light Sweet Crude Oil May 2020, (CLK20) contract traded well below the $0 price point, dropping as low as -$40.32 per barrel and finally closing at a dismal -$37.63 yesterday.

What does this mean for the trader? As prices dropped below $0 the long holder of a CLK20 contract would be required to pay in order to close their position and relinquish their obligation to buy 1,000 barrels of oil per contract. This means at the contracts daily low from yesterday, long holders were willing to pay $40,320 in order to avoid taking delivery of 1,000 barrels of oil.

What caused this severe move? Lack of demand caused by COVID-19 remains the driving force of the turmoil in the crude oil contract. Production has well outpaced the demand and caused significant excess supply.

Stockpiles at the Cushing Oklahoma delivery point have risen by 48% since the end of February, currently at 55 million barrels according to the Energy Information Administration report released last week. Cushing is quickly reaching their carrying capacity of 76 million barrels.

Crude oil production was down slightly week over week by -0.8% to 12.3 million barrels per day seen in data released on April 10. However, U.S. production reached an all-time high during February at 13.1 million bpd, contributing to this oversupply.

Data released last week from Baker Hughes showed that as of April 17 the United States has 438 active oil rigs, down by 66 rigs since their last report. This should be favorable for the bull camp but even with production decreases demand cannot meet these supply levels.

Last week, US Oil Fund ETF (USO) initiated its monthly roll from the front month expiring contract to the upcoming June expiration month. USO held nearly 25% of all outstanding CLK20 contracts and through their routine roll the fund was forced to close positions at levels that continued to drop dramatically. This fury of selling pressure created a snowball effect of an already vulnerable crude oil contract.

Trading on the US Oil Fund ETF was halted this morning in response the significant downside move.

COVID-19-related business closures and stay-at-home orders around the globe have sharply reduced demand for oil, and U.S. oil producers can’t cap their oil wells quickly enough to reduce supply to match lower demand. Oil storage facilities around the country are nearing full capacity, so producers are having pay to get rid of their oil.

While there were complications surrounding the expiration of the May crude oil futures contract, the cash market was the main source of the volatility. Oil scheduled to be delivered in June also fell, sliding 16% to about $21 a barrel.

The U.S. Energy Information Administration (EIA) has forecast global oil demand to fall by more than 23 million barrels per day in the second quarter of 2020, or about 23%. But implied demand in the U.S. has dropped even faster, with refineries cutting back liquid fuel production by more than 40%, according to the April 10th EIA report.

In the U.S. oil market, major oil companies plan big production cuts, net oil imports continue to fall sharply, and new drilling is coming to a halt. However, it will take some time to implement production cuts, and U.S. oil storage capacity is quickly being filled by the excess supply. U.S. storage tanks will be full in less than two months if the pace of inventory increase continues, according to the EIA.

Saudi Arabia recently made a deal with 23 oil-producing countries to cut production by nearly 10 million barrels per day. However, even that will still be well short of what will be needed to balance the global oil market.

What should investors do?

The price of oil will continue to experience heightened volatility until supply and demand can be balanced. While oil companies are dealing with significant short-term inventory issue, energy company stocks are heavily influenced by the future price of oil—that is, one to two years out. Those prices are still positive, which helps explain why energy company stock prices did not fall by as much as one might have expected today.

Still, with oil prices well below profitable levels, the impact of COVID-19 on energy companies is expected to be enormous, particularly for smaller exploration & production and oil services companies. In a recent Kansas City Federal Reserve Bank survey, nearly 40% of oil companies said they would be insolvent within a year if oil prices were to stay at or below $30 per barrel.1 Larger oil companies—while still likely to see sharp financial losses—are in relatively better shape. The biggest companies have greater ability to make cost cuts, as well as access to credit lines, which can limit insolvency risk.

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