On Monday, April 20, investors were stunned as they watched panic selling swamp the May crude oil futures of its benchmark, West Texas intermediate, or WTI. In the end, May contracts plunged $55.90 to nearly negative $40. Retail investors with a large portion of their portfolios in oil and gas saw significant losses in the ensuing mayhem.
Huge swings in contracts bring big risks to investors, but also significant opportunities for those who are risk tolerant and have no aversion to the oil sector to pursue them.
But what should long-term investors be looking at right now? Brian Overby, senior options analyst with Ally Invest, a Fort Lauderdale, Fla.-based financial services company with $7.5 billion under management jokes that investors with a longer-term horizon should “lie down until the urge goes away” to invest in oil.
“People need to understand the inherent risk of trading oil futures,” he says.
Futures themselves are an approximation of the underlying asset and don’t always perfectly track the commodity. Also, futures are monthly rolling contracts so that the spot month—the nearest month—is constantly changing over time. Two weeks before the end of each month, the futures contract rolls into the next month and becomes the new spot futures contract. This triggers “rolling risk” between one month’s settlement price and the conversion to the next month’s spot price.
Super Tankers as Profit Centers
One area for investors to keep their eyes on in the short term is oil storage. A glut of oil on the market has led to a high demand for storage.
“The joke is that people in Texas are filling up their swimming pools with oil,” Overby says. “The storage of oil is where the best benefit has been recently. Profitability has come from the supertankers.”
Just after the crash of the crude market last week, oil traders began contracting super tankers to act as floating oil reserve vessels. This increased the number of barrels of oil held in tankers to 160 million, up 60% from the 2009 record level, according to Reuters. Each VLCC, or very large crude container, can hold more than 2 million barrels of crude oil.
Some of the largest tanker and oil shipping companies, such as Nordic American Tankers, Teekay Tankersi, and Tsakos Energy Navigation, saw their shares rise 10% to 20% as demand for storage rose..
The oil industry had already experienced a huge drop in consumption and, and subsequently, prices by the time April 20 rolled around. In early March, Saudi Arabia had started an oil price war by slashing its prices after Russia walked out of OPEC negotiations to cut production during the Covid-19 crisis. When oil dipped below zero, traders were awash with excess oil, causing them to scramble to find oil reserve tanks.
Look to Oil Refinery Stocks Instead
While the bottom of the crude market fell out last week, share prices of the largest refinery companies fared far better. Overby views a mini-crash in crude markets in 2015 to 2016 as instructive for what’s happening in some parts of the oil market today.
“I would look back to 2016 [as a] precedent,” he says. “How did Exxon do relative to the underlying market?”
In 2016 and again in 2020, the largest oil refinery companies outperformed oil futures and oil exchange-traded funds. For illustration, while the crude market on April 20 lost 306%, shares of Exxon, Phillips 66 and British Petroleum, for example, lost just 5.3%, 4.6%,and 7.6%, respectively, from the market close on Friday, April 17, to the close on Tuesday, April 21, rebounding to their prior levels by April 22.
Going Forward
There is no doubt that the oil market is trading on fear from the economic fallout of the pandemic and from the geopolitical situation among Saudi Arabia, Russia, and the United States. Like any other industry, the oil market can’t succeed in the long run by selling oil for $20 a barrel when its break-even costs are closer to $35.
Watch the employment side of companies, Overby says. Unemployment in the oil sector forecasts longer-term demand issues and pessimism about government support.
Another wildcard for oil is not knowing what level of support to expect from the U.S. government. “What is the government going to do?” Overby says. “You might be able to make the case that oil is a defense issue. If so, how much more money are they willing to throw in to stabilize the market?”
Ultimately, demand for oil is the driver of price. “Overall, the oil picture is so muddied right now,” Overby says. “I don’t see anything in the immediate future that will bring oil back to where it was. Do people go back to work, and are they driving, and are they driving Teslas.”
For broader index investors, the portfolio exposure to oil should remain fairly moderate, according to Mark Haefele, chief investment officer of global wealth management at UBS.
“The fall in oil prices in recent years has been reflected in a lower weighting of the energy sector in the main benchmark indexes,” Haefele said in a research report, Oil Spills on Risk Assets, April 22, 2020.
“Energy stocks account for just 2.7% of the S&P 500 and 5.8% of MSCI EM, down from around 10% and 14% a decade ago, respectively,” he said. For that reason, “The impact of oil prices on broader equity markets is likely to be relatively small, and likely [will be] eclipsed by developments in addressing the Covid-19 pandemic.”