Who Is Most Endangered by Negative Oil?

Negative Oil

In a year filled with random and unexpected events, hopefully not likely to be repeated anytime soon, the price of oil going negative may stand out as a particularly unusual one. People are familiar with the idea of investments suffering losses and posting negative returns, but for an investment to be negative, to literally be worth less than zero is unique in our history.

All this, we may say, has been precipitated by an oil war being fought between Russia and Saudi Arabia, made worse by a pandemic that has slashed global demand by 30% and the cumulative effect of a global shift in oil production over the last decade that turned America into the world’s largest producer of oil. We may also assume that the worst hit in this mess are the oil producers themselves.

Oil Producers

Certainly in Canada it is easy to assume that it is Canadian producers most at risk from the collapse in oil prices, already suffering trying to get their oil to market more efficiently and cheaply than by train. But while the collapse in oil prices is indeed a headwind for producers, they are not the most at risk at being hurt by the volatility in oil’s spot price.

No, the one most at risk is you, the average investor.

It is important to remember that “financial services” are exactly that, retail products in the financial space. Products that you invest in may reflect a real need by investors, but they also reflect demand. As such it shouldn’t be surprising to discover that products exist that are not needed but are wanted. If someone thinks they can make money providing a vehicle of investment it will likely find its way to the market, for good or ill.

Exchange Traded Funds, the popular low-cost model of investing that has become very common, is where all kinds of investments like this appear. Reportedly there are something like 500 different ETFs in Canada alone. All this variety is good for the consumer, but maybe not for the citizen merely trying to save for their retirement.

Let’s turn our attention back to oil and to fate of investors that, having sensed that the price of oil was so low, they considered investing in the commodity was a “no lose” scenario. In the week before the price of West Texas Intermediate (WTI) went negative, investors put $1.6 billion into the United States Oil Fund LP (USO ETF). USO was one of a handful of investments that allows investors to try and invest in the actual commodity of oil and skip investing in an oil producing company.

Oil Price

What many of those investors likely didn’t realize is that to get close to the price of oil you have to buy oil contracts that expire very soon. USO did this by holding contracts that mature within the month and then roll those contracts to new contracts for the following month, and so on. This keeps USO’s price and performance close to the spot price (the price the oil is trading for at that moment). But it also means that USO must sell those contracts it holds onto other buyers every month or it risks having to take physical delivery of the oil it holds the contracts for.

The problem should become self-evident. As the May month end contract was approaching, and with oil prices low and storage at a minimum, oil buyers didn’t want USO’s contracts, and USO couldn’t physically receive the shipment of the oil. It had to get rid of the contracts at any price, and that’s just what they did, paying buyers to take the oil contracts off their hands.

ETFs, Mutual Funds and a host of other investments make it seem as though investing has few barriers, with ease of access making experts of us all. But that isn’t the case. The unique qualities of a product, the mechanics of how some investments work and ignorance about the history of a market sector can spell danger for novice investors that assume markets are simple. In Canada there are only a few investments that deal directly in the commodity of oil; the Auspice Canadian Crude Oil ETF (due to be closed May 22 of this year), the Horizon BetaPro Crude Oil Daily Bear and Daily Bull ETFs (HOD and HOU respectively, both of which may have to liquidate. Horizon ETFs have advised investors NOT TO BUY THEIR OWN ETFS!) and lastly the Horizon’s Crude Oil ETF, which uses a single winter contract to reduce risk but will radically alter the performance compared to the spot price.

Many investments are not what they seem, maintaining a superficial exterior of simplicity that masks the realities of a sector or structure that can be a great deal riskier than an investor expects. In 2018 investors that had purchased ETFs that traded the inverse of the VIX (a “fear gage” that tracks investors sentiment about the market) suffered huge losses when the Dow Jones had its (then) largest one day drop ever, wiping out 80% of the value of some of these investments. Then, like now, investors had a poor understanding of what they owned and were easily blindsided by events they considered unlikely.

As I’m writing this I see reports out that suggest the price of oil could once again go negative. Whether they do or not is irrelevant. It is enough to know that they can and that investors will have little defence against a poorly constructed product that has the ability to go to zero. Before last week the USO ETF owned 25% of the outstanding volume of May’s WTI contracts. That was a concentration of risk that its investors just didn’t realize or understand. Today its clear just how dangerous that investment was. Investors owe it to themselves to get some real advice on what they invest in, and make sure those investments fit into their risk profile and investment goals.

Information in this commentary is for informational purposes only and not meant to be personalized investment advice. The content has been prepared by Adrian Walker from sources believed to be accurate. The opinions expressed are of the author and do not necessarily represent those of ACPI.

If I Tell You This is Just a Correction, Will You Feel Better?

19_6_origA correction is typically defined as a drop of roughly 10% in the markets over a very short period of time. It’s often “welcomed” by investment professionals because it creates opportunities for new investments into liked companies that were previously trading above valuations considered appealing. Corrections are talked about as being necessary, beneficial and part of a normal and healthy market cycle, which all makes it sound somewhat medical. But in medical terms it falls under the category of being told your are about to receive 5 injections in short order and they are all going to hurt.

Screen Shot 2014-10-02 at 7.22.55 AM
S&P TSX From Bloomberg – October 2, 2014

For investors the past couple of weeks in the market has felt like many such injections. The US markets have had a significant sell off, as have the global, emerging, and Canadian markets. All of it very quickly. The sudden drop has erased many of the gains in an already slow year and eaten dramatically into the TSX’s return which had been one of the best.

From Bloomberg - October 2, 2014
Dow Jones Industrial From Bloomberg – October 2, 2014

For many investors any sudden change in the direction of the markets can immediately give the sense that we are heading into another 2008. As Canadian (and American) investors are now 6 years older and closer to retirement the stakes also seem much higher. So here are some reasons why you shouldn’t be concerned about the most recent market volatility, and what you can do to make them work to your advantage.

1. Everyone is nervous.

For several months people have been calling for a correction. Investor sentiment is neutral and consumer confidence has dipped, meaning that overall atmosphere is somewhat negative for the markets. But that can be a good thing. Market crashes and bust cycles typically show up when people are exuberant and feel euphoric about markets. Bad news is swept aside and the four most dangerous words in investing “This time it’s different” become the hallmark of the new bubble. It’s rare that negativity breeds an over exuberant market.

2. The Economy isn’t running on all cylinders.

There certainly have been encouraging numbers in the United States, and even recently Canada has had some improved economic numbers, but by and large there hasn’t been a big expansion yet in the economy. Unemployment is still high, especially in Europe and the labour force has shrunk (which can skew the unemployment numbers) while corporations continue to sit on enormous piles of cash, to their detriment. A market crash usually follows an overheated economy that begins to over-produce based on faulty views about future growth potential. That isn’t where we are yet.

3.  Corporations are really healthy, and so are investors.

Canadians may still have bundles of debt, but the US is a different story. American corporations and households have been heavily deleveraging since 2008. In fact corporations in the US look to be some of the healthiest in decades, showing better earnings to debt ratios than previously thought. Crashes have as much to do with over-production as they do with out-of-control borrowing. The two go hand in hand and both factors are currently missing from the existing economic landscape.

4. Energy is cheap. Like, really cheap. 

Remember when oil was more than $100 a barrel? High energy prices, and the expectation of future high energy prices can really put the kibosh on future returns and throw cold water all over the market. As we’ve previously said, energy is the lifeblood of civilizations and a steady supply of affordable energy is what separates great economies from poor ones. (Look, we tweeted this earlier! See, twitter is useful. Follow us @Walker_Report)

https://twitter.com/Walker_Report/status/517604263493894145

West Texas Crude Oil Price over the last 3 months - from NASDAQ - October 2, 2014
West Texas Crude Oil Price over the last 3 months – from NASDAQ – October 2, 2014

The arrival and growth of American gas production combined with changing technologies and increasing efficiencies on existing energy use means that global demand is slowing, while global supply is increasing. In fact in March of last year, the head analyst for energy at Citigroup published a paper describing exactly this trend of improved efficiency with new sources as a mix for lower energy prices in the long term. Whether this proves true over the next two decades is hard to say, but what is true is that cheap energy helps economies while expensive energy hinders it. Since economies have already adjusted to the higher price over the last few years, a declining price is a tailwind for growth.

Does this mean that there aren’t any risks in the market? Absolutely not. Europe is having a terrible year as a result of persistent economic problems and Russian intransience, and many Emerging Markets are showing the strain of continued growth, either through corruption or exceeding optimism about the future. Those pose real risks, but taken in the grand scheme of things our outlook remains positive for the markets.

How can I make this all work for me?

So what can you do as an investor to make a correction benefit you? The first piece of advice is always the same. Sit tight. Dramatic changes to your investments when they are down tends to lead to permanent losses. Secondly, rebalance your account periodically as the market declines. On the whole equity funds will lose a greater proportion of their value than fixed income, leaving a balanced portfolio heavier in conservative than growth investments. Rebalancing gives you a chance to buy more units of growth funds at a lower price while adding greater potential for upside as the market recovers. Lastly, if you have money sitting on the sidelines, down markets are great opportunities to begin Dollar-Cost-Averaging. For nervous investors this is a great way to ease into the markets even as markets look unstable. You can read about it here, but I recommend watching the movie below for a nice visual explanation. Now, take your medicine.