Beware the Bounce Back

All major asset classes, with the exception of commodities, bounced back in April.

The S&P 500 ended the month up 12.8%, recovering nearly 60% of its previous decline, but is still down 9.8% year-to-date. April continued to see significant volatility: Out of 21 trading days, the S&P 500 moved more than 2% on 10 days, with seven positive days and three negative.

Fixed income markets also recovered. US government bonds were up 0.6% in April and are up nearly 9% year-to-date. US Investment grade bonds were up 1.8% in April and are up 5.0% year-to-date. The Fed has committed to a number of extraordinary measures, such as unlimited government bond purchases and a willingness to purchase investment grade corporate bonds and high yield bonds (that were previously investment grade prior to March 22nd). These actions have served to stabilize fixed income markets and kept Treasury yields low despite the massive stimulus.

Gold was the sole commodity that was up for the month, belatedly delivering on its promise of a safe haven. Gold increased 7.0% in the month and is up 11.1% year-to-date.

After experiencing their worst month ever in March, oil prices surprised everyone by briefly trading negatively in April! Let’s take a closer look at the extraordinary developments that played out in the oil markets in April. 

Free Oil 

On Monday, April 20th, the price of West Texas Intermediate (WTI) May futures fell to -$40.32 a barrel (the biggest intraday drop ever) and closed at -$37.63, a drop of $55.90. This means that the seller would pay the buyer nearly $38 per barrel to take the future off of its hands! This price move is unprecedented.

WTI is one of the key benchmarks for oil prices. The other key benchmark is Brent, which hit its lowest level since 2002 on April 20th, dropping 24% to $19.40 a barrel.

What happened?

The shutdown of the global economy has resulted in a dizzying drop in oil demand. The International Energy Agency forecasted that demand for oil in April would fall by 29 million barrels per day, or 29% from levels a year ago. That’s a massive drop in demand in a breathtakingly short period of time.

In mid-April, Saudi Arabia, Russia, the US and other oil producers announced cuts of 9.7 million barrels per day (bpd), nearly 10% of total global oil production, starting at the beginning of May. Unfortunately, that cut is merely a drop in the bucket and doesn’t come close to addressing the supply imbalance.

Historically, during periods of oversupply or limited demand, oil has been put in storage in anticipation of realizing higher prices in the near future. The problem is there’s nowhere to put it – oil storage facilities are nearly full! And that includes oil tankers.

Cushing, Oklahoma is one of the major oil storage hubs and has a working storage capacity of 76 million barrels. Stocks have nearly doubled since the end of February and stood around 55 million in mid-April, with the remaining capacity contracted out and likely full as of the beginning of May.

Oil tankers are often used for short-term storage but their rates, which normally average $100,000 per day, have recently shot up to $350,000 per day. And even at those prices, there’s not much spare floating storage capacity left.

Given this supply backdrop, what happened in the futures market makes more sense. Futures are used by both speculators and industry participants as a way to speculate on pricing and hedge risk. The thing about a future is that unless it’s rolled over or unwound, the holder of the future takes delivery of the underlying commodity at expiry. The May monthly futures contract was scheduled to expire on April 21, which is why investors were willing to pay others to take the WTI oil future off their hands – there was nowhere to put the oil!

WTI pricing partially recovered as the May futures rolled off and focus shifted to the June contract. ETF oil funds, which are heavy purchasers of oil futures, have also unwound some of their June contract positions to try avoid a repeat of what happened with the May contracts. But the oversupply issue remains and the price for June contracts have also dropped significantly. As of the end of April, the June contract for WTI was $19.78, down almost 68% year-to-date.  The June contract for Brent was $26.44, down nearly 60% year-to-date.

Unless we see a remarkable recovery in the global economy, demand for oil is unlikely to recover in the short-term. Given that storage capacity is almost full, the only solution will be to curtail production. Shutting in wells is expensive and may damage oil reservoirs but at this point, there is little choice. Which means that oil companies are facing a difficult road ahead in what has already been a challenging year.

The energy index is the worst performing sector year-to-date, losing over 40%. Investors who were piling into oil ETFs a few weeks ago in the hopes that oil prices had hit bottom have now discovered that $0 was not the lowest price oil could go.

Energy investors can expect to see oil companies redouble their efforts to preserve cash. This will mean reduced or suspended dividends, slashed capital expenditure budgets and sharply reduced guidance. Those companies which are carrying high debt loads (and many are) will face further challenges. All of which means that oil companies are a very risky bet these days.

Too much, too soon?

The solid bounce back in markets in April raises the question of whether this is too much, too soon?

The economic data is not encouraging. The US economy declined at an annualized rate of 4.8% in the first quarter of this year. Robert Kaplan, President of the Federal Reserve Bank of Dallas, has said that he expects the US economy could contract by as much as 30% in the second quarter before recovering later in the year. He expects the US economy to decline 4.5%-5% for the year as a whole. At this point, these numbers are moving targets and could easily be revised down.

More than 30 million people have filed unemployment claims in the past six weeks. As of April 18th, 12.4% of the US workforce were drawing unemployment benefits, the highest since the early 1970’s.

Earnings estimates for 2020 are expected to drop by over 15% – a number that also will be subject to multiple revisions in the weeks and months to come.

Market optimism in April seems to be have been driven by the dramatic moves by the Fed to prop up fixed income markets combined with a second round of stimulus measures passed by Congress on April 23rd. Add to that signs that infection rates have plateaued in some of the worst-hit states and early indications that the drug remdesivir may be an effective potential treatment for the virus and markets were primed to rally. These are all positive developments, however, there are still many unknowns that exist.

The hardest hit states have only just begun to see declines in infection and death rates. Others are still climbing. Remdesivir has shown promise but its true efficacy is still as yet unknown. And we are still months away (in the very best-case scenario) from developing a vaccine.  It is entirely possible that preliminary efforts by states to reopen will backfire. And even though states may reopen, their residents may not be interested or ready to resume anything resembling their old ways of doing things until the above issues are effectively addressed.

All of which is to say that investors would be wise to be wary of over optimism. We still face numerous challenges, both to our health and the economy. While we would all dearly like to see a return to normalcy as soon as possible, we still have a way to go.


© 2019 by AmericaFirst Quantitative Funds.



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