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.

What a Race Car Driver Taught Me about Oil Prices

karun_carouselTesla is all over the news. Most recently I have seen several postings about the new P85D Tesla’s Insane Mode, a setting in the car that delivers the maximum amount of power to the car (a big thanks to my client who sent me the link).

Tesla, and it’s CEO Elon Musk (who is a real life bond villain) has made quite a splash, building a high quality and competitive electric car with a solid range. A real first. And while his current offerings in the market remain decidedly high end, his ambitions include creating a more affordable middle class version as well.

But the economics of electric vehicles remain challenging at best. There are more options than ever, from Chevrolet, to Ford to Toyota. But these cars all tip the scales at the upper end of the car market, and are not sensible economically on a three year lease.

This is the Tesla Model X. It's due to hit the road in 2016, and is gorgeous. Notice the "Falcon Wing." Notice it! Did you notice it?  Awesome, right?
This is the Tesla Model X. It’s due to hit the road in 2016, and is gorgeous. Notice the “Falcon Wing.” Notice it! Did you notice it?
Awesome, right?

But the problem for electric cars may be best explained by the new Formula E series that is currently in it’s inaugural season. Using a newly designed electric race car I was surprised to learn that there are limits on the power that drivers can use in races, (while fans can vote to give some drivers an addition 50 bhp to boost speed each race via twitter). Why is this? Ostensibly it is to help preserve the life of the battery, already the heaviest part of the car and not powerful enough to get a car through a single race without a second car. In other words, the economics of the battery is still the biggest challenge facing all auto producers.

By some good fortune my brother in law is a driver in Formula E for team Mahindra. Mahindra & Mahindra isn’t as well known in Canada, but is a large conglomerate and a significant auto producer that sells in many countries. This past year they have launched India’s first electric passenger vehicle, the Reva e2o, which they had loaned to Karun and afforded me the opportunity to test drive while visiting my extended family in India. It’s a good car, and I could see that Karun had enjoyed driving it. But he pointed out the first challenge to electric cars in India was that the Indian government is only just introducing an electric car subsidy (having previously canceled one in 2012). In fact it is government subsidies that have helped foster the boom in electric cars.

From NASDAQ, February 4, 2015
From NASDAQ, February 4, 2015

What this all leads to is the inevitable challenge poised by the sudden drop in the price of oil. Electric cars sit at the top of the market in terms of cost, and many aren’t even viable until after you both:

  1. Don’t have to buy gas anymore when oil is over $100 a barrel.
  2. Are given money by the government to help afford the car.

So if high gas prices underly the business case for electric cars, then a sudden cut in the price of oil does significant damage to that business case. It makes traditional petrol cars more cost effective, more competitive and more profitable compared to their e counterparts.

This tells us two things about oil and electric cars. The first is that while oil prices may stay depressed compared to previous market highs, the demand for oil is unlikely to decline and will likely recover as cheap oil spurs economic growth. The second issue is whether the rise of companies like Tesla is overstated. As exciting as they may appear, the market valuation of TESLA is the real insane mode, and certainly not in line with a traditional auto maker. The reality at least is that the end of oil, and the growth of electric cars is going to be dependent on considerable innovations in battery technology and will not be viable in the long term with cheaper oil and government subsidies. But who knows, next year’s Formula E series will allow teams to design their own cars and we may begin seeing some interesting innovations start in battery development.

Will We All Be Victims of Cheap Oil?

OILEarlier this year we wrote that Russia’s economy was fundamentally weaker than Europe’s and that their decision to start a trade war in retaliation for economic sanctions over the Ukraine would hurt Russia far more than Europe. As it happened Russia has suffered that fate and had a helping more. The collapsing price of oil was a mortal wound to the soft underbelly of the Russian economy, leading to a spectacular collapse in the value of the Ruble and an estimated 4.5% contraction in their economy for 2015.

The Ruble’s earlier decline this year had already made the entire Russian stock market less valuable than Apple Computers, but as the price of Brent oil continued to slide below $60 (for the first time since 2008) investors began to loose confidence that Russia could do much to prop up the currency, prompting an even greater sell-off. That led to an unprecedented hike in the Russian key interest rate by its central bank, moving it from 10.5% to 17% yesterday. Moves like that are designed to reassure investors, but typically they only serve to ensure a full market panic. The Ruble, which had started the year at about 30 RUB per dollar briefly dropped to 80 before recovering at around 68 to the dollar by the end of trading yesterday.

The Russian Ruble over the last year. The spike at the end represents the last few weeks.
The Russian Ruble over the last year. The spike at the end represents the last few weeks.

Cheap oil seems to be recasting the economic story for many countries and millions of people. The Financial Times observes that oil importing emerging markets stand to be big winners in this. Dropping the cost of manufacturing and putting more money in the pockets of the growing middle class should continue to help those markets. The same can be said of the American consumer, who will be benefiting from the sudden drop in gas and energy prices.

The Financial Times always has the best infographics.
The Financial Times always has the best infographics.

Losers on the other hand seem easy to spot and piling up everywhere. Venezuela is in serious trouble, so is Iran and the aforementioned Russia. Saudi Arabia should be okay for a while, as it has significant foreign currency reserves, but as the price drops other member states of OPEC will likely howl for a change in tactic. But along with the obvious oil producing nations, both the United States and Canada will likely also be victims, just not uniformly.

Carbon Tracker Initiative
Carbon Tracker Initiative

Manufacturers may be breathing a sigh of relief in Ontario, but Canadian oil producers are sweating it big. Tar sand oil requires lots of refining and considerable cost to extract. Alberta oil sands development constitute some of the most expensive projects around for energy development and a significant drop in the price of energy, especially if it is protracted, could stall or erase some future investments. This is especially true of the Keystone Pipeline which many now fear isn’t economically viable, in addition to being environmentally contentious.

This chart was produced by Scotiabank
This chart was produced by Scotiabank

Saudi Arabia has continued to allow the price of oil to fall with the intention of hurting the shale producers in the United States. This price war will certainly claim some producers in the US, but it will difficult to know at which point that market will be effectively throttled. Certainly new projects will likely slow down but the continued improving efficiency of the fracking technology may make those producers more resilient to cheap energy.

But there is one more potential victim of the falling price of oil. That could be all of us. I, like many in the financial field, believe that cheap energy will enormously benefit the economy. But our biggest mistakes come from the casual confidence of things we assume to be true but prove not to be. A drop in energy should help the economy, but it doesn’t have to. If people choose not to spend their new energy windfall and save it instead, deflationary pressure will continue to grow. As I’ve previously said, deflation is a real threat that is often overlooked. But even perceived positive forms of deflation, like a significant reduction in the price of oil, can have nasty side effects. The loss to the global economy in terms of the price of oil is only beneficial if that money is spent elsewhere and not saved! For now confidence is that markets will ultimately find the dropping price of oil helpful to global growth, regardless of the early losers in the global price war for oil.