It seems that every time I sit down to write one of these newsletters at the moment, the first thing that comes to mind is that it has been a crazy week in the energy markets. None, though, have been as crazy as this week, nor is there ever likely to be a week like this again.
The sight of oil, once one of the world’s most valued and valuable commodities, changing hands at below zero was unthinkable to most people until it happened on Tuesday, let alone the short-dated futures contract falling to the point where suppliers would pay over $30 for someone to take a barrel of oil off their hands. In the circumstances, though, that wasn’t as crazy as it sounds.
The problem was not really the value of oil, it was the value of storage space.
Global oil supply has been too high relative to demand conditions for some time, so when the coronavirus shutdown decimated what demand there was, the impact was exaggerated. Many storage facilities were already full and what was left quickly filled up, too. Tankers were hired for temporary “at sea” storage, then that capacity too began to run out.
That left E&P companies with a problem.
Oil, unlike some other things, cannot be stored just anywhere, nor, if things get really desperate, can it just be disposed of. Even with the current White House’s tolerant attitude to oil companies and with an understaffed, ineffective EPA, any company that tried to dump significant quantities of crude would probably be fined, sued, and regulated out of existence within a year or two.
In that context, paying someone else to deal with the problem of where to put your crude is a perfectly rational long-term economic decision.
Price Versus Value
Oscar Wide once famously said that the trouble with the youth of his time was that they knew the price of everything, but the value of nothing. That difference between price and value is an important one for investors of all stripes to understand at all times, but it is especially relevant to energy investors at this time.
The price of oil may be a stunning negative $30, but it still has value. More importantly, reserves yet to be lifted have value. That value is not unlocked until the oil is out of the ground, and what matters is the price when that happens.
There are reasons, now more than ever, to believe that at some point, that price will be higher than even seems possible right now.
What Will Drive Prices Higher
To a market geek like me, there is a beauty to the relationships between price, supply, and demand. When one gets out of line, the others adjust automatically, based on human nature and the nature of business, to bring it back.
In this case, price has collapsed because demand has been cut to virtually zero. That will, sure as eggs are eggs, cause supply reductions. It doesn’t make sense for most U.S. producers to pump oil and sell it at +$30 per barrel, let alone -$30. It takes time to shut down a well and there are costs involved, but regardless of price, oil in the ground has value. It makes no sense to destroy that value by lifting it now.
And that is not to even mention the agreed upon “biggest ever” supply cuts from the OPEC+ group that will kick into effect soon. Add together the market driven cuts in output in North America and other free market countries and the artificially created OPEC+ ones and you have a big supply adjustment coming.
Initially, that will help a little, but there will still be oversupply and with such an enormous amount of stored excess crude to get through, prices will remain low for some time.
Eventually, coronavirus will have passed, and the global economy will restart. That may be a while coming but come it will. When it does, we will move rapidly from massive oversupply to undersupply. The futures market is already anticipating that time.
As you can see, the chart for front month WTI futures is a classic “V” shaped recovery, but prices are still extremely low. That though, is not all of the story. Even just a couple of months out, futures indicate prices almost double where they are now. To me that looks too soon for a recovery, but also nowhere near enough of one.
If, as looks likely, demand is recovering quickly at the same time as supply is dropping dramatically, the spike, like the crash, could be of epic proportions.
Buying with A Long-Term View
Obviously, when that happens, we will be looking back on now as a time of great opportunity. You have to remember that it is unlikely to happen very quickly, but that doesn’t mean that you should necessarily hold off on buying energy stocks. The market knows all too well that those days are coming. That is why, on Tuesday, as crude futures fell an unbelievable 400% to massive negative numbers, Exxon Mobil stock (XOM), for example lost 22 cents, or just a fraction over a half percent.
Other big majors held up well too, and will probably continue to do so, but smaller firms, who have less capacity to outlast the problems, saw their stock fall significantly more.
I have said a couple of times here that if you are looking to profit from this big drop it is best for now to stick to multinational integrated firms, and this week has amply demonstrated why. That is where the money betting on an eventual recovery will and should go. For now, it is about survival, and these are companies that have survived massive shocks before and will again.
There are other, much riskier trades but with huge profit potential that could be considered and that I will outline in our new service, Energy Income Trader, when it is launched, but for now, buying big oil names looks like the best long-term play.
There is hope on the horizon for energy, stay focused on it!