We've seen a number of unprecedented moves in the financial markets over the past two months.
We watched stocks plummet to bear market depths in half the time it took in 1929, which had stood for the past 90 years as the fastest drop into bear market territory in history. We saw the Treasury bond market, which is normally among the most liquid and orderly markets around, seize up and barely function, sending panic rippling out through every quarter of the financial markets.
We saw the Fed jump in with an emergency 1% rate cut. We've seen (and continue to see) unprecedented government and Federal Reserve action to support the economy and financial markets, including the Fed stepping across the government bond line and intervening directly in public markets for the first time with its support of investment-grade — and then high-yield (junk) — bonds.
And most recently we've seen an epic stock market rally off the lows that erased more than half the bear market's drop.
But what we saw Monday probably topped all of that in terms of its sheer "What in the world?" factor.
Below the bottom the barrel
On Monday, the West Texas Intermediate (WTI) oil futures contract for May started the day at an already collapsed level of around $20. It fell to $10. Stunningly, it proceeded to fall all the way toward zero. And then, in a move that has never happened before — and I doubt anyone ever imagined — it fell all the way to –$37.63 a barrel.
We need to back up a step here and unpack what this even means. At the end of Monday, traders were willing to pay someone $37 to take a barrel of oil off their hands.
The key to understanding this seemingly insane turn of events is grasping that commodities futures involve physical delivery of a product. With the market flooded with oil supply and the world using very little of it, storage capacity has filled up rapidly. Which is how you get traders with no ability to take physical delivery of the oil and nowhere to store it panic selling to the point where they're willing to pay someone to take it off their hands. Remarkable.
Futures and oil can get technical and complicated quickly. We're going to sidestep all of that under SMI's "what you need to know, not all there is to know" guiding principle. There are plenty of articles out there for those who are interested in a deeper dive. (Here's a brief Twitter thread that unpacks it a little.)
The –$37 oil price on the May contract was largely driven by the technical issue of taking delivery while the contract was set to expire the next day. I suspect there were probably some trading firms and hedge funds that were caught leveraged the wrong way in this "never happened before" event, because there always are, and those levered positions probably drove them to take extreme actions they never dreamed of. (In fact, we're starting to see the blow-up stories emerging already: Interactive Brokers and a pair of Singapore oil traders — both articles are behind the Financial Times paywall.)
But the more important information is likely gleaned from the next month's (June) contract price, and those of future months, because this is what is going to tell us what the market expects the future of oil to look like. While May was collapsing to –$37, the June price fell to $21 on Monday and settled at $10.26 on Tuesday. As the chart below shows, the market expects oil to recover very slowly. U.S. oil prices don't rise to $30/barrel until you get a full year out on the curve, and are still priced in the low-$30s nearly two years out.
Three things to ponder
I am definitely not a commodities expert, so I don't want to overstep and draw faulty conclusions here. But here are three things I think we can take away from this episode.
First, the bear market isn't over. The huge bounce higher in stocks over the past three weeks had made it seem like maybe we were going to leap past this unpleasantness quickly. And who knows, maybe we still will. But this week has been a reminder of the extraordinary volatility still lurking within the system — particularly in areas of the market that haven't been directly hammered down by Fed action.
Even in the stock market, volatility remains very high. The chart below is of the VIX, the common measuring stick of volatility in the stock market. Note that while the VIX has come down dramatically, from a high around 80 to its current level in the low-40s, that current level is still more than double what it has normally traded at in recent years.
Second, there are often downstream effects from events like these. Many people, including us, have been afraid of the junk bond market for quite a while. That's because we've seen the amount of junk credit explode over the past decade, while the terms of that credit have gotten worse and worse. Simply put, there's never been more super-risky credit in the market than there is today. And one of the prime sources of that low-end junk credit has been the U.S. shale oil industry.
In addition to the demand shock produced by the global shutdowns — planes aren't flying and cars aren't being driven — there's been a supply glut. Russia and Saudi Arabia have been pumping like crazy in what sure seems like a coordinated effort to put U.S. shale out of business. Unfortunately, the highly levered position of our shale companies isn't helping them weather these extremely low prices. There are going to be bankruptcies here. This is a big part of what the Fed was trying to head off with their unprecedented decision to involve itself in buying high-yield/junk debt. Ultimately, I think that was a horrible decision, but you can at least see through this prism why they did it, as they're trying to keep companies like these shale producers from going under (and dragging the whole junk bond market into utter chaos).
It's not just the junk bond market that will feel the impact if these companies start blowing up. I have to imagine that many of these shale companies have direct loans from banks and other more traditional sources. If they're unable to pay, the impact of that ripple effect through the banking system (and other sources of lending, like hedge funds, etc.) is a big unknown.
Last, it's another market indication of a slower expected economic recovery. The stock market has, until this week, seemingly been clinging to the hope that the worst is behind us and things are going back to normal quickly. How else to explain the Nasdaq index trading at mid-January levels at the beginning of the week? One of my favorite financial people, Howard Marks, said recently about the market being down just -15% or so from its prior highs, "The world is more than 15% screwed up." Exactly.
Meanwhile, the bond market is certainly not pricing in a quick economic recovery, with yields still trending toward zero. And now we're getting this clear signal from the oil market that it's not expecting a dramatic rebound either.
There's always a risk in reading too much into "signals" like these. So don't take any of this as a strong statement that the market is going to do this or that. I'm viewing it as a cautionary reminder that bear markets are unpredictable, volatile, and that this one might not be over as quickly as the recent stock-market run was allowing us to hope might be the case.