Barrelling along

Guy Foster, our Head of Research, considers the recent dramatic drop in oil prices and cautions investors to brace themselves as the recovery is likely to be a bumpy ride.

Earlier this week the oil price turned negative for the first time ever in the US. The price of West Texas Intermediate (WTI), the US ‘benchmark’ crude, hit a price of minus $40.32 a barrel (1) in an historic day in the markets.

The problem has been triggered by a 30% drop in demand caused by the coronavirus lockdowns (2), but was initially intensified by oil producers competing for market share, with prices finally being driven negative as oil-holding facilities near capacity. If nobody wants your oil, then storing it or disposing of it is expensive and difficult.

But the US is not the only oil producer to have been affected. The Brent crude oil price, the international oil benchmark, then plunged to a 20-year low at under $16 a barrel (3) as over-supply fears bit.

Globally, the demand for oil, and oil-related products, has fallen dramatically from both households and industry. Factories have either shut, or sharply reduced production. There are far fewer flights with travel generally curtailed on both road and rail unless deemed necessary. The need for oil right now has markedly diminished.
Although negative oil prices are pretty much unprecedented, very weak oil prices are not. They get resolved by the forces of supply and demand. Over the long term the world will be transitioning to lower oil demand but that is not the force which is at work now. Instead lower oil prices slow that transition down because oil becomes a much more competitive source of energy. At the same time, it is also less profitable at low prices so producers inevitably devote less resource to investing in future production. Without a base level of investment oil production, capacity shrinks each year by a little over 5%. That is why people observe that the best cure for a low oil price is: a low oil price. It will mean more oil demand and less oil supply over the coming months and years, which means prices will rise.

Markets are selective about what they react to

There is scant economic data showing the severity of this economic slowdown because that data only tends to be released monthly. Hence, we are just beginning to see releases now. The most notable has been the pace of job losses in the US. These have been much faster than in any previous recession for which we have data. For instance, US initial jobless claims now indicate that over 22 million people have lost their jobs in the US in the last four weeks. That is likely to add about 13% to the US unemployment rate when it gets reported next month. We believe US unemployment forecasts still look too low.

The fact that markets typically strengthened on the days of these releases goes to show that they were expected, but could be wrongly interpreted as implying that markets are invulnerable to bad news. Instead markets are looking beyond measures of the severity of the current downturn and towards indications of when it will lift and how quickly. Nobody can predict these with precision. They include developments in the race for a vaccine or therapies (or lack thereof) and news about future waves of infections.

We can be confident that in the long run the incredible body of resource being devoted to the world’s most important problem will bear fruit, but the timing is something we can be less sure of. It is therefore reasonable to assume that, as has typically been the case in previous difficult times for markets, the path to recovery will feature some setbacks as well as many advances.

Last week saw the first set of US industrial production numbers for March that had been hit by the lockdowns.
Although shocking, at least these were not the worst numbers on record. That is because this data series goes back to the Spanish flu period, industrial production slowed faster back then, as well as during The Great Depression and World War II. However, all those major interruptions lacked the strength of the policy response we are seeing now and with time, we should start to see the benefit of those interventions.

Bumpy times ahead, but normality will return

Over the coming weeks and months, the bad news will lessen. We will eventually see more evidence of lockdowns being lifted and economic life resuming. Progress on the search for a COVID-19 vaccine, proven anti-body tests, and effective therapeutics, will further lift investor confidence.

An unmitigated positive has been government and central banks’ policy response to the crisis. There has truly never been anything like the scale of this intervention, which sees actions to inject cash into markets as well as reinforcing the solvency of companies and households.

Specifically, interest rate cuts, quantitative easing and monetary operations have supported the functioning of markets. These interventions will remain a positive, but the impact on markets will lessen over time as policymakers run out of new things to announce.

Our view on markets over twelve months is upbeat, but over the near term we expect markets to remain bumpy with both positive and some negative moves. Normality will return with time, but it will not be instantaneous. It is likely to be a gradual development until a vaccine is available or herd immunity reached.

Now more than ever, it is important to remain level-headed in these extraordinary times and focused on the long-term fundamentals of sustainable companies and markets.

1 FT.com, 20 April 2020
2 Guardian.com, 10 April 2020
3 FT.com, 22 April 2020

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