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Market Update: Oil, Economic Recovery, and Valuations

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As Covid-19 suffering mounts, it is our task to write again of markets.

Oil
This week, many wonder about oil.  Last Friday, the May 2020 futures contract for West Texas Intermediate Crude Oil (WTI) closed at $18.27/bbl.  Monday it fell $55.90 to close at negative 37.63/bbl!  Oil had not previously traded at negative prices.  Perhaps you heard.  People ask what is going on? Are markets broken?  Does this portend some other collapse bearing down upon us?

First, the price recovered to close at $8.91 as the contract settled on Tuesday.  Then the new “front” contact (June) closed at $16.50 on Wednesday, and at $17.53 Thursday.  Monday was a blip of extreme imbalance between sellers and buyers in a very illiquid futures contract during one of its last few days of trading.  Commodities futures contracts are obligations to deliver a specified amount of a certain grade of a commodity at a specified location on a certain date, in this case 1,000 US Barrels (42K gal.) of “light sweet” crude delivered on a date in May to a single location in Cushing, Oklahoma.  Cushing, OK has a large but finite amount of storage capacity and most of it was already contracted for or occupied.  Someone owning or “long” such a contract on expiration is obligated to “take” or to receive that physical commodity delivery.  With no way to do so, most “longs” were caught in a negative “squeeze” and forced to close that obligation by selling at previously unheard-of negative prices.  In other words, this market craziness was a technical, localized, temporary matter.  Like the stock market’s “flash crash” of a few years ago, it came and went with little broader implication.

However, the unprecedented global collapse in demand for oil coupled with, initially, a perverse increase in supply has, as was inevitable, resulted in a large decline in the price of oil – in the real price of actual oil.  Moreover, usually, lower fuel prices are met with some increase in demand (“elasticity” in the parlance of economists) but this time, lower prices have been unable to stimulate more demand, for obvious reasons.  The cash or “spot” price of US oil had been trading at extremely low prices for a time as futures prices were first higher, then converging, and then greatly (but temporarily) overshooting.  Here are yesterday’s cash (spot) and futures prices for WTI for several selected dates in the future (European oil, or “Brent” is generally a little higher in each case):

 "spot" $14.33 
June, 2020    $17.53
Jan, 2021 $30.36
June, 2021 $32.83
June, 2022 $35.94
Jun, 2023 $40.60
Jun, 2025 $42.89
Jun, 2028 $49.52

Oil prices are very depressed today, but futures anticipate a recovery to $30/bbl by the end of the year and to $40 and nearly $50 in future years.  Many energy producers use futures to hedge, or presell, some of their future production to insulate them from short-term price swings.  Recent technical gyrations aside, oil prices are quite depressed, but markets expect that to be a temporary condition.  As is said, the best cure for low commodity prices is low prices, meaning low prices force producers to cut supply.  That’s already occurring and will continue until supply and demand are in balance.

Economic Recovery
Something we have heard many say is: “The economy is going to take a l-o-n-g time to recover!”  This pronouncement is always delivered with grave seriousness that bespeaks wisdom and authority.  But they don’t know.  They have not experienced this, so they’re guessing.  Jay Powell, Chairman of the Federal Reserve also ventured his own guess that he believes recovery will be “rapid”.  Who’s right?  We don’t know, and we think a little humility about the unknowable is healthy.  However, in the long run, it is not a good idea to bet against the resilience of the American Spirit.

The short run is more challenging, but we note two positive and similar developments within the last week that could imply faster reopening and faster regaining of confidence than otherwise.  A Stanford antibody study of 3,330 in Santa Clara County, CA found that as of April 1, when the county had under a thousand identified cases of COVID-19, the number actually infected was likely 50-80 times greater than recognized, and the mortality rate was much lower than previously thought.  A few days later came preliminary results from a New York study of 3,000 indicating that about 14% of the state has already had the disease (as much as 21% in NYC).  Neither of these studies is definitive for a number of reasons.  Nonetheless, these are encouraging, albeit preliminary results, hinting that broader antibody studies may confirm much higher infection rates than previously realized, and, therefore, much lower mortality rates than originally understood.  Such information could go a long way toward leading us to the Great Reopening. 

Valuations
As of yesterday, the S&P 500 index of large US stocks closed down 13.4% this year to date, off 17% from its February peak, and up 28% from its March low.  Stocks had been much lower but now are only modestly lower on the year.  At the same time, from as recently as early March, earnings estimates for the S&P 500 have fallen by nearly 20% for 2020 and by over 11% for 2021.  If we as investors are sufficiently long-term in our view that we can ignore 2020 earnings, we find that aggregate stock prices have fallen 13.4% at the same time earnings estimates for next year have fallen by 11%.  In other words, we have seen lots of volatility, and for a time much lower prices and better valuations, but as of now, while prices are a little lower this year, valuations are not much better at all.  This gives us pause currently about stocks generally but significant disparity in performance between companies has created some interesting opportunities.  Treasury yields are down over 1.25% over the same period as are short-term rates, but that offers little comparative comfort amid such heightened volatility and much greater than normal uncertainty.  If the disease rolls over and the economy reopens sooner than later, earnings estimates will begin to recover more quickly, and valuations could improve enough for us to get more comfortable.  Otherwise, stocks may have gotten somewhat ahead of themselves.