Market Update April 24, 2020 – Uncharted Territory for Oil

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Market Update April 24, 2020 – Uncharted Territory for Oil

The S&P 500 was down 1.3% for the week, snapping a two-week winning streak. President Trump signed a $484 billion stimulus package that will add to funds for small-business lending and direct money to hospitals and efforts to ramp up U.S. testing capacity in the fight against COVID-19. The bill will bring total federal spending on coronavirus to more than $2.7 trillion. With Thursday’s latest weekly figure of 4.4 million, U.S. unemployment claims over a five-week period grew to a total of 26 million. A broader picture of the nation’s troubled labor market will emerge on May 8, when the government reports monthly jobless claims.

On Monday, for the first time in history, the price of WTI oil closed in negative territory at -$37/barrel. With the extreme volatility we have been experiencing in the oil markets, it may be useful to revisit how the oil market functions.

Oil trades on the futures market via contracts that have a monthly expiry, so contracts trade for every month of the year. Most futures contracts are financially settled, meaning the position is closed out prior to contract expiration and you take your profit or loss. However, if held to expiration, contracts must be physically settled. If you are long a WTI (West Texas Intermediate) contract at expiration you are obligated to take delivery of 1,000 barrels (42,000 gallons) of WTI at the delivery point in Cushing, OK; and if you are short, you are obligated to make delivery at the same location.

Demand for crude has declined dramatically because of the drop in economic activity due to sequestration orders stemming from the Covid-19 pandemic. Despite the fact that many producers have already reduced production volumes, inventories are building rapidly because production still exceeds demand.

The function of commodity prices is to incentivize or disincentivize supply and demand. In an environment where supply is greater than demand and storage capacity is rapidly diminishing, prices need to decline rapidly to a level that forces producers to shut in production.

On Monday, the May 2020 WTI contract settled around -$37. If someone didn’t own storage or have firm storage contracts, they could not go into expiration long because they had no way to physically take delivery of the oil, and were forced to exit the position at any price available, and that drove the price to a negative value for the first time in history. This effectively implies that a producer must pay someone to take the oil away. Because this is obviously uneconomic, unhedged producers will be forced to shut in production or go bankrupt. Eventually, enough production will be shut in to avoid tank tops, and the market will balance.

Most market participants have already rolled their positions to the June contract, and that is considered “front month” now. June WTI closed at $21 on Monday. We expect continued pressure on the front of the curve until the market believes worldwide storage capacity will not be exceeded.

Chart of the Week: Has the U.S. Economy Found its Bottom?

According to the UBS Evidence Lab’s weekly update, real-time data is indicating that the U.S. economy may be finding its bottom.

“In the financial markets, hindsight is forever 20/20, but foresight is legally blind. And thus, for most investors, market timing is a practical and emotional impossibility.”  – Benjamin Graham, The Intelligent Investor

Despite so much uncertainty in the headlines, what is virtually certain is that volatility is likely to continue for some time, tempting some loss-averse investors to try to get out of the market to avoid losses during market pullbacks. However, It is nearly impossible even for the most sophisticated investors to predict the optimal time to return to the market after sitting on the sidelines. History has demonstrated that market pullbacks tend to be relatively short periods most often followed by favorable returns. Missing those favorable return periods can spell disaster for meeting an investor’s long-term goals. We believe the wisest course of action is to remain invested in a strategy designed to minimize downside volatility while maintaining exposure to high-quality, high conviction stocks.

Waycross Partners, LLC (“Waycross”) is an independent, privately owned investment management firm registered with its principle place of business in Louisville, Kentucky. Waycross offers investment strategies to our clients, which are made up of institutional and high net worth individuals. This material is for informational purposes only and is neither an offer nor solicitation to invest. Please read all offering memorandum, ADVs, and other risk disclosures before investing. Any projections, market outlooks or estimates in this document are forward looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance . Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Waycross Partners. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only Waycross Partners’ current opinions, which are subject to change and which Waycross Partners does not undertake to update.

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