Last week, we dug into the unprecedented number of initial jobless claims coming out of the United States, which topped 22 million in a period of four weeks. It’s just days later, and we already have our next market abnormality: this time, traders were baffled by West Texas Intermediate (WTI) crude — the U.S. benchmark oil price — which somehow flipped negative for the first time in history. How is that possible? And how does it tie into the COVID-19 oil price crash in general?
Setting the Geopolitical Stage
Oil is a geopolitical game, and big price swings always come with a geopolitical undercurrent. This particular story picked up steam in February as OPEC+ producers tried to negotiate a production cut, amid concerns that COVID-19 could impact demand. Russia walked out on these meetings, and Saudi Arabia responded by undercutting oil prices by $6-8 per barrel. The world went into lockdown, energy demand dissipated, and oil producers continued to pump at will. Then on April 9th, nearly a full month after COVID-19 was declared a pandemic, Russia and Saudi Arabia finally settled their differences. However, this truce came too late — prices had already fell about 60% from February highs.
How Prices Went Subzero
Up until recently, this was a fairly run-of-the-mill oil price crash — but then prices suddenly sunk below zero, with May futures for WTI oil closing at -$37.63 on April 20th. For the first time in history, producers were willing to pay traders to take oil off their hands. This oddity is partially a function of the particularities of futures contracts:
Buyers Wanted (At Any Cost!) Futures contracts normally rollover to the next month without much happening, but in this case traders saw the May contract as a “hot potato”. No one wanted to be stuck taking delivery of oil when the world is awash in it and the country is in lockdown. A Time and a Place Oil futures contracts specify a time and place for delivery. For WTI oil, that specific place is Cushing, Oklahoma. With most storage capacity booked already, taking physical delivery wasn’t even an option for many players.
In other words, sellers outnumbered buyers by a crazy margin — and because oil is a physical commodity, someone has to ultimately take the contract. At time of publishing, the May contract and spot prices have “rebounded” to about $10. The June contract is slightly higher, at $13. – International Energy Agency (IEA), Oil Market Report for April
Overcoming the Supply Glut
What do you do when oil is practically free? You store as much of it as you can, and hope that at some point you can sell it for more. Unfortunately, everyone has the exact same idea, and as a result there is a historic glut that is filling up the world’s storage capacity both on land and at sea:
In March, it was estimated that 76% of the world’s available oil storage capacity was already full. A record-setting 160 million barrels of oil is being stored on tankers at sea, according to Reuters. The cost of renting an oil supertanker has gone through the roof. It’s jumped from $20,000 per day to $200,000-$300,000 per day, according to Rystad Energy.
It remains to be seen how fast the transportation industry will recover in a post-COVID-19 world, but for now the outlook for all oil producers is grim. The continued fallout will not only affect industry, but also the countries that rely on oil exports to balance their budgets. on Last year, stock and bond returns tumbled after the Federal Reserve hiked interest rates at the fastest speed in 40 years. It was the first time in decades that both asset classes posted negative annual investment returns in tandem. Over four decades, this has happened 2.4% of the time across any 12-month rolling period. To look at how various stock and bond asset allocations have performed over history—and their broader correlations—the above graphic charts their best, worst, and average returns, using data from Vanguard.
How Has Asset Allocation Impacted Returns?
Based on data between 1926 and 2019, the table below looks at the spectrum of market returns of different asset allocations:
We can see that a portfolio made entirely of stocks returned 10.3% on average, the highest across all asset allocations. Of course, this came with wider return variance, hitting an annual low of -43% and a high of 54%.
A traditional 60/40 portfolio—which has lost its luster in recent years as low interest rates have led to lower bond returns—saw an average historical return of 8.8%. As interest rates have climbed in recent years, this may widen its appeal once again as bond returns may rise.
Meanwhile, a 100% bond portfolio averaged 5.3% in annual returns over the period. Bonds typically serve as a hedge against portfolio losses thanks to their typically negative historical correlation to stocks.
A Closer Look at Historical Correlations
To understand how 2022 was an outlier in terms of asset correlations we can look at the graphic below:
The last time stocks and bonds moved together in a negative direction was in 1969. At the time, inflation was accelerating and the Fed was hiking interest rates to cool rising costs. In fact, historically, when inflation surges, stocks and bonds have often moved in similar directions. Underscoring this divergence is real interest rate volatility. When real interest rates are a driving force in the market, as we have seen in the last year, it hurts both stock and bond returns. This is because higher interest rates can reduce the future cash flows of these investments. Adding another layer is the level of risk appetite among investors. When the economic outlook is uncertain and interest rate volatility is high, investors are more likely to take risk off their portfolios and demand higher returns for taking on higher risk. This can push down equity and bond prices. On the other hand, if the economic outlook is positive, investors may be willing to take on more risk, in turn potentially boosting equity prices.
Current Investment Returns in Context
Today, financial markets are seeing sharp swings as the ripple effects of higher interest rates are sinking in. For investors, historical data provides insight on long-term asset allocation trends. Over the last century, cycles of high interest rates have come and gone. Both equity and bond investment returns have been resilient for investors who stay the course.
