Covid-19 – What happens when oil futures go negative?
Volatility across the different asset classes in financial markets has been remarkably stable in the last couple of weeks when we consider the amount of ‘unknowns’ and economic risks in global markets from COVID-19. However, this low volatility environment has masked a significant move lower in commodity prices, and notably oil, with Brent crude back below US $26.00 a barrel, a ~62% drop in price year to date.
Many sources of Oversupply
Furthermore, there has been an almost unbelievable fall in the US West Texas (WTI) oil price overnight, with the soon-to-mature futures contract trading to as low as -$40 per barrel (minus forty dollars). Yes, you have read that correctly. This means sellers were willing to pay buyers to take oil off their hands. So how do you rationalise a negative oil price? For sellers of oil, its expensive to shut down wells and oil pipelines. Storage facilities are filling up towards capacity, and there are costs and practical difficulties with transporting oil from inland hubs to ships on the coast which offer floating storage. WTI futures are deliverable, meaning that those who own the contract need to have a place to store the oil. Those participants betting on higher prices via the May contract have rushed to close out positions before expiry, so as not to be delivered physical oil.
This lack of physical storage capacity and technical factors related to the May futures contract expiry are all at play.
Central Banks and the deflationary impact
Whilst central banks globally have committed to lower interest rate settings for at least the next 12 months. A lower oil price will make it near impossible to begin to normalise interest rate settings in a post COVID world. This is merely another factor for long dated bond yields. US 10 year Treasuries yields (a global benchmark to measure long dated interest rates) are now trading at 0.60% indicating the likelihood of a deep recession in a deflationary environment.
Our first quarter consumer price inflation (CPI) number actually printed at 2.5% yesterday but that is ancient history now as we’re in the midst of the most significant and synchronised global economic contraction in a generation. The point been however, the lower cost at the pump (offset some by the weaker dollar) will be another contributor to the weak inflation pulse that’s likely to persist for quite some time. This, alongside the significant contraction in employment that’s already underway, means the RBNZ has its work cut out.
Oil prices haven’t fallen this much since 1988, when an eight-year war between key producers Iran and Iraq was in its final stages. This time around, no one can predict the lasting impact of a global pandemic.
Needless to say, growth and ultimately inflationary outcomes seem less likely to filter through from commodity markets in an environment of oversupply and a declining demand side trajectory.