Can we go back to pre-crisis oil prices?

Jul 1st, 2020 | By | Category: Commodities

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Crude oil prices have been on a rollercoaster ride in 2020, sinking to record lows, briefly plunging deep into negative territory in the case of West Texas Intermediate (WTI), and, most recently, staging an impressive rebound.

Can we go back to pre-crisis oil prices?

Oil prices are up more than 100% since the end of April.

Yet, despite gains of more than 100% since the end of April, the price of oil, which currently trades around $40 per barrel, is notably below the $60 – $70 range seen at the start of the year.

The path forward remains uncertain as question marks linger over the speed of the global economic recovery, the potential for a resurgence in Covid-19 infections, and the integrity of the current pact between oil producers.

Investors are understandably wondering whether oil prices can return to pre-crisis levels?

To help navigate this complex environment, WisdomTree, a leading issuer of commodity ETPs in Europe, recently shared its perspectives with an audience of investors in a webcast co-hosted with ETF Strategy (see Can we go back to pre-crisis oil prices?).

On the call was Nitesh Shah, Director of Research, who explored the macroeconomic factors that are affecting oil markets this year; Pierre Debru, also Director of Research, who discussed how investors can position themselves with different oil ETPs depending on their outlook; and Michael Delew, Associate Director of Capital Markets, who talked through some of the nuances of trading oil ETPs.

WisdomTree offers a comprehensive suite of oil ETPs, providing investors with a robust toolkit to implement their strategies. The suite consists of ETPs for both WTI and Brent varieties and target contract maturities stretching out as far as three years. The firm also provides a full range of leveraged and inverse oil products.

Most of these ETPs are listed on London Stock Exchange in US dollars and pound sterling, while several also enjoy listings on Deutsche Börse Xetra and Borsa Italiana in euros.

Shah kicked off the conversation by examining the forces that led oil prices to historic lows this year. He noted that the world experienced an unprecedented supply glut driven by sparring oil-producing nations, most notably Saudi Arabia and Russia, as well as the pandemic’s impact on global oil demand.

Volatility in oil markets rose sharply, peaking at unprecedented levels in March and April. The price crash also drove the oil futures curve into a state of ‘super contango’ where the price of contracts with later delivery was significantly higher than those with nearer delivery, leading to exceptionally high rolling costs for investors.

In April, the WTI futures contract for May delivery remarkably swan-dived far below zero. Shah noted this was a unique event, however, caused by acute storage issues at Cushing, Oklahoma, and exacerbated by low contract liquidity and potentially a high proportion of inexperienced futures traders.

In response to oil’s price decline, US producers quickly began turning off the spigot with rig counts dropping to levels last seen before the shale boom. Shah notes, however, that the least efficient rigs were the first to be made idle and, consequently, US oil production has tapered off less than might be expected.

The turmoil couldn’t last forever and, as parts of the world started to emerge from lockdown at the end of April and an OPEC+ agreement to cut production by 9.7 million barrels per day came into effect in early May, oil prices started trending upwards again. Volatility has fallen off from its peak, while the shape of the futures curve has flattened significantly (see charts below).

In further signs of the oil market normalizing, Cushing began reporting an increase in storage capacity, charter rates for oil supertankers have fallen, and the discount between WTI and Brent benchmark has narrowed, indicating oil’s ability to move internationally had improved.

Source: WisdomTree.

Source: WisdomTree.

Looking ahead, Shah was aware of the headwinds and uncertainty facing the world economy and conceded that oil’s future gains could certainly be affected if the recovery stumbles. Noting how China has experienced a V-shaped recovery in refinery activity, however, Shah pointed out that, from a demand perspective, oil’s rally could easily continue its momentum in line with global growth.

Turning to supply factors, Shah was optimistic that OPEC, along with its non-member allies, can maintain their current agreement, noting that despite political conflicts, these countries tend to find common ground in unifying petroleum policies. Shah also pointed out that Saudi Arabia, the world’s largest oil exporter, and arguably OPEC’s most prominent member, is incentivized to push for higher oil prices as the country’s fiscal breakeven is around $70 per barrel. Furthermore, OPEC will soon begin pressuring non-complying countries into reversing their oversupply in later months, although this may be difficult to implement in practice as oil production in countries like Iraq is controlled by competing regional factions.

According to Shah, Russia poses the greatest threat to the current OPEC+ harmony as the country wishes to destabilize the US shale oil industry which really begins to thrive when oil prices rise above $50 per barrel.

To discuss the ways in which an investor might implement an investment an oil, Shah passed the baton to Debru who highlighted three factors that drive a positive return in crude futures markets: when to enter and exit a trade, what benchmark to use (WTI or Brent), and whereabouts on the futures curve to invest? According to Debru, this third choice is often overlooked by investors.

Debru noted that during recovery, investors hope to benefit from increases in oil’s spot price; however, no investable spot price exists practically. Instead, investors will typically seek exposure to front-month futures contracts. Potential returns are diminished though by high rolling costs associated with investing in front-month contracts when markets are in contango, as well as the tendency of the futures curve to flatten during recovery.

Front-month contracts also suffer from higher volatility and increased drawdowns during periods where oil prices continue to fall.

Debru was not implying, however, that investors should never hold front-month futures contracts. Rather, the decision of where to position on the futures curve should depend on an investor’s expectation as to the duration of the recovery. Debru pointed out that, historically, longer-term futures (contracts with maturities greater than three months) tend to outperform front-month contracts during protracted recoveries.

In terms of WTI, longer-dated contracts have historically outperformed when the recovery takes more than a year. For Brent, longer-dated contracts tend to outperform when the recovery extends beyond two years.

Source: WisdomTree.

In this regard, investors who predict a quick V-shaped recovery may wish to consider the $2.3 billion WisdomTree WTI Crude Oil (CRUD LN) and the $500 million WisdomTree Brent Crude Oil (BRNT LN), both of which provide exposure to front-month contracts and come with management expense ratios (MERs) of 0.49%.

Investors who predict a more gradual recovery should look at the WisdomTree WTI Crude Oil Longer Dated (FCRU LN) and WisdomTree Brent Crude Oil Longer Dated (FBRT LN) which offer exposure to contracts for delivery in three months. They also have MERs of 0.49%.

Finally, Delew offered his insights from a capital markets perspective into trading oil ETPs effectively. He noted that investors should take heed of liquidity in the underlying futures contracts.

Most oil ETPs track NYMEX WTI or ICE Europe Brent futures contracts, both of which are highly liquid; however, the spike in futures volatility during April and May did impact ETP trading. Trading was halted in some ETPs, while bid/ask spreads also widened, highlighting how ETPs are not immune to stress in their underlying markets.

Delew pointed out that the most actively traded futures contracts are those for delivery in the nearest three months, after which liquidity drops off sharply. Investors can lessen the negative consequences of poor liquidity and trading inefficiencies by keeping their exposure within this band.

Source: WisdomTree.

Delew also recommended that institutional investors should deal directly with the ETP’s authorized participant (AP) in order to keep costs down. Most APs adhere to a cut-off time between 2 pm and 3 pm, after which it will no longer create or redeem shares for that day. Institutional investors looking to execute large orders after this time may find that spreads have widened as APs account for holding that inventory until the following day.

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