What Happened to Oil?
Lately, of course much of the news has been focused on coronavirus. However, coronavirus wasn’t the only significant news affecting the markets this spring. In fact, something happened that could have caused a bear market all on its own!
The spot price of crude oil went below zero—to negative $39 per barrel.
This is certainly a bizarre situation—but it doesn’t mean that you will be paid to fill up the tank. Much of this can be attributed to the spot oil market—where traders buy and sell contracts to purchase oil at a certain price. Without getting too in the weeds—essentially, there is such an oversupply in the market that traders were willing to pay to get rid of their spot oil contracts prior to the contract’s deadline of April 21. The oversupply is due to many factors. After their alliance fell apart in March, Russia and Saudi Arabia flooded the market with an oversupply of oil at a time when most people are not driving, flying or using oil for industrial purposes due to coronavirus restrictions! On April 12, President Trump came to an agreement with the OPEC+ nations to dramatically cut supply, but even this historic deal will not fully resolve the oversupply issue. There are simply not enough storage facilities for the oil that is being produced!
Effect on consumers
This has affected the investment price of oil to a huge extent, but it is also trickling down to consumer gasoline prices at the pump. As of April 27, over 125,000 gas stations sold gasoline under $2/gallon, with nearly 50,000 stations under $1.50/gallon. In over a dozen states, gasoline sold for less than a dollar per gallon last month!
Effect on traders versus investors
Investors in the most popular oil-related investment vehicles are feeling the pain too—showing why it is so important to understand what you own and why! Individual investors and retail brokers often buy United States Oil Fund (USO), thinking that it will give them direct exposure to the West Texas Intermediate (WTI) crude oil price. If that were the case, then it would make sense to buy at a low price, with the expectation that the value of the investment would grow over time. What these investors fail to understand is that USO actually tracks the price of WTI crude oil futures, not the price of oil itself—which can lead to a pricing pattern called negative roll yield that is extremely damaging to long term investors. Over the past two years a holder of USO lost a whopping 78%, and just this week, the managers of USO announced a 1-8 reverse share split. This means that every eight shares of USO will combine into one proportionally higher-priced share. It does not indicate a change in the health of the fund, but window dressing like this typically signals a stock, or exchange-traded product, in distress. Transocean (RIG) stock is another popular oil investment that burned investors even more severely—down over 90% in the past two years!
Suffice it to say: speculating in oil is incredibly risky. So many factors outside of anyone’s control are at play. Unless you have a crystal ball, it is not advisable to bet on the outcome of international oil treaties between countries, technical aspects of futures market or black swan events like this pandemic---let alone all three at once!
So many investors did not really understand what they owned, and are paying dearly for it. Particularly with RIG—it is very easy to see how someone would be drawn in by the catchy ticker, just like when investors mistakenly invested in Tweeter (TWTRQ) when Twitter announced its plans for an initial public offering in 2013.
However, the idea is not to avoid an entire sector of the market entirely—simply to understand what you own and why. Compare the USO and RIG fiascos to a quality company like Exxon (XOM).
Exxon stock was not immune to the energy sector’s struggles. The stock traded around $74 two years ago…and now trades around $45. However, it has recovered from $30 to $45 in a single month, and pays a dividend close to 8%! Buying quality is important. And if you take an index-based, diversified approach, you are insulated even further from shocks to one particular company or sector.
Be an investor, not a trader.
Bottom line, you must be an investor, not a trader. Investors know what they own and why. They hold quality companies for the long term, and ideally through an index to protect themselves with diversification! Remember, indexes have certain requirements for the stocks they include, so failing companies will be pushed out before bottoming out. Buy quality in a manner that suits your risk propensity and will allow you to meet your goals.
No analysts or economists had a global pandemic OR a historic crash in oil on their radar heading into 2020 – and that’s why we do not attempt to time the market or jump in and out of asset classes. Oil will likely have a healthy bounce once normal activity resumes and demand increases – but in any market, it’s best to maintain exposure to a wide variety of asset classes. When one area falls, another can help support the overall portfolio. With a disciplined and well diversified strategy, you can handle this.