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Why Did Oil Prices Collapse, and When Could They Recover?

 

April 22, 2020

 

EVEN IN A WORLD THAT HAS GROWN ACCUSTOMED to the possibility of negative interest rates, the idea of negative oil prices—paying people to buy oil—seems almost unfathomable. Yet that’s what happened on Monday, when West Texas Intermediate (WTI) oil prices dropped to nearly minus $40 per barrel before climbing back into positive territory by Tuesday morning. Still, the precipitous decline was enough to spark volatility, impacting not just the shares of energy producers but the broader market overall.

 

While lower energy prices are usually good news for consumers, the current state of oil prices is a reflection of the massive disruption to people’s lives caused by the coronavirus, says Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. “The massive oil supply glut is driven by the sharpest-ever contraction in demand. There’s nowhere to store oil right now, and nobody wants to take delivery.” 

 

“The massive oil supply glut is driven by the sharpest-ever contraction in demand. There’s nowhere to store oil right now, and nobody wants to take delivery.” —Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank

What’s likely ahead for energy and the economy?
Economically speaking, this has been called a crisis of mobility, says Hyzy. “We’re not traveling to work, to hotels, to restaurants or on business trips.” Recovery for the oil industry and the broader economy hinges on when governments and individuals decide that it’s safe to start moving again, he adds. Hyzy outlines three possible scenarios below:

 

  1. The health crisis eases to the extent that stay-at-home restrictions can be lifted for many Americans in May. If so, consumer confidence and oil demand could return to pre-coronavirus levels by 2021.

  2. Even as the health crisis eases, people’s behavior may fundamentally change. “It could be that we’ve all gotten used to less travel, and demand is reset at a lower level,” Hyzy says. Recovery, then, could be lower and slower.

  3. A third scenario—and the riskiest, in Hyzy’s view—is that when people begin to move freely again the virus returns with a vengeance, resulting in a series of “rolling lockdowns.” The unpredictability of that scenario, and the damage to consumers, could stall hopes of a recovery for an extended time, he says.

 

To ease the current historic glut, oil producers are likely to shut down supply for May and June, Hyzy believes. In the months to come, oil prices will have to climb back to about $50 per barrel to at least cover the cost of production, he says. That could happen either through renewed demand or, if recovery stalls, through industry consolidation, as many smaller producers are forced out of the market.

 

What can investors consider?
We anticipate an extended period of recurring volatility as declining oil prices and other economic impacts of the coronavirus resolve themselves, says Hyzy. With so much uncertainty regarding both the health crisis and the economy, he suggests maintaining a portfolio diversified both across and within multiple asset classes. He also recommends focusing on high-quality investments, particularly in large U.S. companies that pay dividends, and on rebalancing to make sure portfolios stay invested towards long-term goals.

 


Information is as of 04/22/2020

 

Opinions are those of the author(s) and are subject to change.

 

Investing involves risk, including the possible loss of principal. Past performance is no guarantee of future results.

 

The Chief Investment Office, which provides investment strategies, due diligence, portfolio construction guidance and wealth management solutions for Global Wealth & Investment Management ("GWIM") clients, is part of the Investment Solutions Group (“ISG”) of GWIM, a division of Bank of America Corporation (“BofA Corp.”).

 

Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

 

Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration.

 

Dividend payments are not guaranteed, and are paid only when declared by an issuer’s board of directors. The amount of a dividend payment, if any, can vary over time.

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