It’s been a tough few years for the zero lower bound (ZLB). Most investors thought that it would hold in all but the most unusual of circumstances. 1 1 Close It was as solid as the floor beneath their feet. As long as it wasn’t a EURCHF. Some economic history buff might point to a breach during the Great Depression, but that would have been more a point of conversation than something applicable to current markets. The first challenge to this ZLB complacency came in fixed income, when Swap Spreads went negative during the financial crisis. Then Sweden’s interest rates went negative, and soon bond yields across much of Europe were below zero. Last week, the negativity crossed the barrier from financial instruments into commodities in dramatic fashion. 2 2 Close At times, producers of difficult-to-store commodities have been forced to pay to offload their inventories. A few isolated events in natural gas didn’t prepare anyone for what happened in oil last week. Also, I know negativity doesn’t exactly mean that. NYMEX Crude Oil didn’t just break the ZLB, it went more than 40 dollars through it. It caught experienced traders off guard and created a sudden interest in oil futures among folks who would normally find speculating in markets infinitely less compelling than speculating about what happened in Tiger King. 3 3 Close I haven’t seen Tiger King. It seems like everyone else has, and they keep telling me they think someone killed her husband.
Conditions have been ripe for unusual moves in energy markets. Oil demand has collapsed. 4 4 Close The IEA’s April 2020 Oil Market Report projects second quarter demand to decline by 23.1 million barrels per day compared to the year earlier period. Available storage space is filling up and may soon be at capacity in some areas. 5 5 Close Reuters: “No vacancy: Main U.S. oil storage in Cushing is all booked,” 4/21/2020. The NYMEX crude contract has a limited number of delivery areas which makes it vulnerable to technical issues on expiration. 6 6 Close This is different from the Brent Crude contract, which can be delivered to any qualifying ship and has a convenient cash settlement option in which no delivery is made. Problems can occur in NYMEX crude when there is nowhere to store the oil. Any hapless investor caught taking delivery of oil may have to pay to get rid of it. Many reports describe this as what happened over the past couple of weeks, but the reality is a bit more complex. 7 7 Close Just when you thought things couldn’t get weirder.
The May NYMEX contract was set to expire on April 21 with first delivery ten days later. 8 8 Close That sounds like the introductory voice-over to the worst detective movie ever made. In the few days prior to expiration the open interest remained very high, much higher than it was going into the previous two months’ expiration days. 9 9 Close Per Bloomberg, open interest in the near-expiry contract stood at over 108,000 contracts two trading days prior to expiry, as compared to 65,000 and 49,000 at the same point in the prior two months. For those of you who don’t follow futures markets, it means that an unusually high number of contract holders appeared to be planning to take delivery of oil. 10 10 Close It also means that a lot of people were planning to make delivery. Some commentators had speculated that an ETF was holding that contract, but that does not appear to be true. Later reports indicate that an unusually high number of retail investors were holding the contract. Retail investors tend to get out of the positions well before expiration. 11 11 Close The crude oil contract can be tricky because the MAY contract expires in APRIL, so it can seem like you have more time to get out of it. Usually clearing houses force people to roll well before expiration. The high number of potential deliveries put pipeline companies in a difficult position. They didn’t want to be flooded with oil, so they reduced their bids to as low as negative 40 dollars per barrel the day before expiry. 12 12 Close For example, Plains All American Pipeline’s April 17th Crude Oil Price Bulletin showed bids for WTI Crude around $14/barrel, but that bid dropped all the way to -$41 on April 20th. https://www.plainsallamerican.com/customer-center/crude-oil-bulletins. They were essentially telling any futures owners planning to take delivery that they could not count on the pipelines as a buyer. The message got through, and positions were liquidated. Futures prices went negative, and open interest fell sharply. The delivery points were not overwhelmed. When the futures settled the next day, they had rebounded all the way back to positive 10 dollars per barrel.
So the brouhaha was really about the threat of a storage shortage. While a worst-case scenario was avoided, the experience is a warning as to how chaotic things could become if one does materialize. It is not unrealistic to imagine that the storage space will be overwhelmed at some point. There is still much more production than can possibly be used while much of the world remains in lockdown.
Suppliers were aware of the oversupply and had started to react, even prior to prices going negative. A few weeks ago, the oil producing countries came to an agreement to reduce supply. 13 13 Close CNBC: “OPEC and allies agree to historic 10 million barrel per day production cut,” 4/10/2020 So far, the measures appear inadequate, but it is too early to be sure. Stopping the flow of oil is not as simple as turning off your TV when you get tired of watching Tiger King for the tenth time. Shutting down a well or a pipeline is a complicated process. Once it is shut down it can be expensive to restart, and production may never return to its prior levels. Many operators prefer to let the production slowly run off instead of abruptly stopping. As a result, the full effects of the cuts won’t be felt for several months.
In markets, low prices create the conditions for higher prices later. This longer-term mean reversion doesn’t always play out, but the same factors that have led to the current dislocation may also lead to its reversal. The lack of storage space prevents inventories from continuing to increase indefinitely and will force some discipline on producers. 14 14 Close It is like an upside down zero lower bound. As always, clever folks will figure out ways to store more oil, but it will become marginally more expensive and will require much higher prices later to make it worth it. The price is so low today that very few projects are profitable even on a marginal cost basis. While some countries will subsidize them, it won’t be enough to prevent many oil-related companies from permanently shuttering.
Reduced production is the first step toward a recovery in oil prices. As coronavirus restrictions are eased, people will start driving again and demand can come back into balance with supply. As producers have struggled to bring production down, they may find it equally challenging to bring it back up. Inventories can begin to come down. Next year we may find the oil market in deficit, just as it is in surplus today. When you look at the futures curve and marvel at how steep it is, at how much higher the prices look next year, just remember that at one point $40 per barrel seemed like liquidation levels. Even though now it seems like an upper bound.
What We Are Watching
U.S. Treasury Refunding Announcement (Wednesday)
With a substantially larger budget deficit to finance, the U.S. Treasury’s quarterly refunding announcement is expected to reveal larger issuance plans across maturities. Market focus will be placed on the maturity composition of the increase in supply, including the size of the new 20-year benchmark that has already been announced. So far, the Treasury has largely focused on issuance of short-term Bills to fund emergency stimulus programs, but over time these are likely to be replaced with longer-dated debt. While the Treasury has sounded amenable to exploring ultra-long-dated issuance (i.e. over 30 years) given the low level of long-term yields, their assessment of demand across the curve will determine their decision. An announcement with heavier weight on long-dated issuance could steepen the Treasury curve.
Central Bank of Brazil (Wednesday)
The central bank of Brazil will announce its policy rate amid a sudden flare-up of political risks in the country, adding to an already vulnerable economic situation. The recent resignation of the Justice Minister and risks around excessive fiscal expenditure as Brazil tackles the COVID-19 economic slowdown have weighed strongly on market sentiment in recent weeks. While the depreciation of the real would normally push central bank policy in a hawkish direction, the low level of inflation and the negative shock to aggregate demand may feature more prominently in this week’s decision, allowing the central bank to maintain its easing mode. Expectations are tilted toward additional cuts, so an on-hold outcome could lead to appreciation of the Brazilian real and declines in domestic equities.
U.S. Employment Report (Friday)
This week, the Bureau of Labor Statistics (BLS) will publish U.S. employment data showing the largest net loss of jobs on record and a historic spike in unemployment. 15 15 Close The consensus forecast among economists polled by Bloomberg is for 21 million lost jobs and an unemployment rate of 16%. The data will capture changes in the labor market between mid-March and mid-April, a period in which large portions of the U.S. and global economy were directed to shut down in order to contain the coronavirus outbreak. The rebound in equity and credit markets in recent weeks suggests that market participants are already focusing more on the eventual economic recovery than on the depth of the current downturn. Nonetheless, data casting light on the precise magnitude of labor market damage may provide useful information about the potential for rapid recovery moving forward. In particular, job losses in industries not directly impacted by shutdown orders deserve careful attention. Weakness in these sectors may speak to meaningful second order impacts as households and businesses spend more cautiously, a development that might point towards a less vigorous rebound in GDP as the economy reopens.