News of negative oil prices has been prominent in the news worldwide this week – something that was not even thought possible by most investors just a few weeks ago. It is not the first time we’ve seen unusual movements in financial assets. After all, negative bond yields were once seen as irrational and are now common. Nevertheless, a negative oil price certainly catches attention.
How did negative oil prices happen? We have to understand there is a technicality in the oil market which makes it quite different to other financial assets, such as stocks and shares. The key factor is that oil, like other commodities, will ultimately be physically delivered and needs to be transported and stored. Oil is typically exchanged among participants using futures contracts. These are standardised agreements, which are traded on an exchange, for delivery of an asset at a specific date in the future. Whereas for financial assets there is generally no physical delivery, just cash exchanged at the contract expiration, in the case of oil or other commodity contracts, problems of storage and transport really matter.
What has traded with a negative value recently isn’t the entire oil market but one specific type of contract linked to American oil, West Texas Intermediate (WTI) – specifically the one with short maturity. Here, short maturity implies delivery this month or next.
Why has the price of WTI gone below zero?
There are two reasons for this unprecedented collapse in the oil market. First, lockdowns to slow the spread of coronavirus have reduced demand for oil in the short term. Transport usually consumes more than 60% of oil produced – that’s mainly a combination of road transport (about 50%) and aviation (about 8%), see chart below.
Second, the production of oil has remained at a high level due to growth in US shale oil production and the recent rift among the OPEC members and their allies. All these factors together created lower demand, high supply and limited storage capacity in the US. As a result, sellers have been forced to accept a very low price for their oil, in some cases paying buyers to take it off their hands.
Source: Oil 2017 OECD/IEA Report, 2017
Commodity ETFs: why Nutmeg does not hold them
Here, we should highlight the impact of a certain type of exchange-traded fund (ETF), namely commodity ETFs. These are ETFs that invest in physical commodities, such as oil, often by trading in futures contracts. As you may know, we build Nutmeg portfolios using ETFs, and regularly review the commodity ETF landscape; however, we have never approved a commodity ETF for use in Nutmeg portfolios with the exception of a gold ETF based on a different mechanism.
The complexity of commodity ETF structures, which may be based on derivatives, and the cost associated with buying and selling futures of a recent maturity did not seem to us to be a viable and attractive investment option. While it would be presumptuous to say that we saw negative oil prices as a major risk for these ETFs, our due diligence process was, rightly in this case, never comfortable with the balance of potential risk and reward they offered.
How will negative oil prices affect other assets?
The next question is what impact the collapse in oil prices will have on other asset classes and on the macroeconomic picture. Here we can say that the impact of oil on equities and bonds is not totally straightforward. For those asset classes, the price of oil matters but is only one factor among many.
For equities, it’s important to note that energy-related stocks account for a much smaller proportion of stock indices than ten years ago. Nutmeg’s overall energy sector allocation is around 3-4% of our equity investments among our different portfolios. The main contributor is our allocation to the FTSE 100 index, which has 11.3% in energy (it used to be more than 20% just after the global financial crisis)1.
So, energy stocks are a smaller part of equity indices than in the past, and they account for a fairly small portion of Nutmeg’s equity allocation. It’s also worth noticing that while energy stocks tend to suffer when the price of oil goes down, many other components of the index benefit from cheap oil.
In the bond market, the price of oil is likely to have an impact on certain types of bonds, particularly emerging market debt, US high yield debt and inflation-related bonds (oil is a major component of the inflation calculus). For all those, a negative oil price is expected to have a negative impact that will be more or less pronounced depending on the asset class. Emerging market countries that are oil exporters will be especially hard hit.
On the positive side, socially responsible investments tend to benefit from low oil prices. We think the relatively low oil prices that we have already seen this year have had a strong impact on the excess return generated by socially responsible portfolios.
Let’s not forget that cheap oil can be a boon
The recent price of oil will have a meaningful impact on different asset classes but this impact will vary dramatically. In the medium term, cheap oil should support oil-importing economies and consumers, perhaps even helping to support a global rebound when coronavirus lockdowns are relaxed. Cheap oil lowers transport costs and input costs in industry, thereby increasing profit margins and boosting profitability. We would expect this positive effect to be seen in most developed countries as well as those emerging economies that are not dependent on oil exports.
Sources
- In the US, the allocation to energy was 4.5% at the beginning of this year versus more than 12% after the global financial crisis.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.
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Pacome Breton
Pacome is an investment manager and head of risk at Nutmeg with more than ten years' experience in investment and risk management. He previously worked for a US family office and a large European asset manager and started his career at Société Générale in Tokyo. He holds an MSc in quant finance from Bocconi University in Milan and is a certified financial risk manager and chartered alternative investment analyst.Other posts by Pacome Breton