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Plunge in Oil Sparks a Bout of Market Volatility

By: Craig Fehr, CFA April 21, 2020

  • Negative oil? The strange sight of negative oil prices after Monday's (April 20) late-day plunge in crude futures contracts has sparked a wider, cautious response in the equity market. A negative price for a barrel of oil may not make intuitive sense but is largely explained by the dynamics of the futures market.

    Oil prices are usually referenced by the futures contracts for delivery of oil in the coming month. As these contracts near expiration, the prevailing price of crude oil typically "rolls forward" to the next month's contract with minimal change in price. The price of oil to be delivered for the May contract is what turned negative. That contract expires today (April 21), requiring delivery of that oil.

    With oil oversupplied and very little storage anywhere, those futures contracts sold off sharply, with sellers willing to essentially get out of those obligations at extreme losses. With the May contract expiring, the June contract will become the prevailing price of oil, which is currently trading around $10 per barrel – low, but not negative.
  • A symptom of the shutdown – Equity markets have come under a bit of pressure this week as the oil price decline highlights two larger issues:
    1. The historic lack of demand for oil due to the severe decline in domestic and global economies 
    2. The ongoing challenges persistently low oil prices will pose for the energy sector in terms of employment, investment and corporate profits
  • We're seeing signs of progress in containing the virus, which is a necessary step toward restarting the economy, but the return to economic growth will be gradual, not instant. The energy sector is an important industry for employment and capital investment, so low oil prices will be disruptive to both as the industry continues to adapt to this environment. At the same time, the energy sector is less than a 5% weight in the S&P 500, lessening the impact of oil prices on the overall performance of the stock market. 
  • Potholes in the path higher – The "shock and awe" of negative oil prices in recent days will add to a list of unprecedented economic readings reflecting the dramatic economic shutdown – including a severe decline in Q2 GDP and a record-setting spike in unemployment. We think the economy will start to exhibit progress as we advance, but not without periodic setbacks along the way.

    Stocks have rallied sharply in recent weeks as markets have shifted their sights from the rise in new virus cases to the eventual reopening of the economy. We don't think volatility is gone for good, and this oil situation is an example of the conditions that are likely to prompt periodic disappointments. But we do think investors can remain confident in the broader outlook as we anticipate a market recovery to gain traction as we progress through this year.

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