We've seen some really weird movements in the markets over the past couple of months and to paraphrase Charlie Munger (Vice Chairman of Berkshire Hathaway), anybody who is confused is probably thinking correctly about the situation. From possible negative interest rates in North America, to a rebounding stock market in the face of unprecedented economic recession and job losses, to actual negative prices for Oil, there are a lot of unprecedented things happening and a lot of them are pretty confusing. Let's try and unpack them so that we can understand what's going on a little bit better.
Negative interest rates probably shouldn't exist in a perfectly rational world. Fortunately or unfortunately we don't live in perfectly rational world. Why would anyone lend money in exchange for receiving less money back? It doesn't make sense. Nevertheless, negative interest rates have been around in Japan and Europe for over a decade now. How is this possible? Well there are a few reasons why someone would invest in a negative yielding bond.
The first reason is that the price of bonds is inversely related to interest rates. So as interest rates go up, the price of bonds goes down, and as interest rates go down, the price of bonds goes up. In times of crisis the central bank will lower its reference interest rate in an attempt to stimulate the economy. This reference rate will only apply to short term loans, but usually its impact will reverberate throughout the economy and have an impact on all interest rates. When lower rates come into effect, the prices of bonds go up. If interest rates are already negative, and they go even more negative, the price of bonds will still rise. So you could invest in a negative interest rate bond if you are speculating that rates will go even lower because the economy is just that bad. Central banks are able to set rates as negative as they want, so there is no legal limit on how negative the rates can be. So theoretically no matter how negative rates are, they could always go lower and you would be able to profit on the bonds you hold.
The second reason why someone might buy a negative yielding bond is that they might be required to by law. Some investors, like insurance companies or banks are required to hold a certain amount of capital in reserve in order to protect their own financial stability. The government imposes these capital requirements on them because as we all know from past financial crises, it is a big problem for everyone when Banks and Insurance companies cannot pay their obligations. Oftentimes, at least a portion of these capital reserves are required to be held in government treasury bonds. So even those bonds are yielding a negative interest rate the company would be forced to buy and hold them.
In other cases, an investor's own investment policies may require a certain amount of their portfolio to be held in government bonds. This would include investors like pension plans and endowment funds. These institutional investors often require large parts of their portfolio to be held in government bonds and there is no discretion to deviate even if the bonds are yielding a negative interest rate. While these policies may be counterproductive in a world with negative interest rates, they still exist.
The third reason why someone would buy a negative yielding bond is a special case which only applies to central banks. As I said above, central banks are in charge of setting short term interest rates in the economy. However, since 2008, central banks have also used quantitative easing to influence the rates of longer term government bonds. By purchasing bonds with longer dated maturities, like say 5 or 10 years, the central bank can influence the interest rates of loans with those maturities in an attempt to stimulate the economy. What we see in Europe and Japan is that the central banks are by far the biggest purchasers of negative yielding bonds. So those bonds are not really being traded throughout the market, but really they are just being held on the balance sheet of the central bank.
So yes negative interest rates are possible and may even make sense in certain situations. We don't currently have negative interest rates yet in North America but we could see them in the near future if the economy continues to get worse.
Since March 23rd stock markets have been rallying while the economic and unemployment numbers have gotten worse and worse during that time. How can this be possible? Shouldn't the stock market reflect the strength or weakness of the economy? Won't all those businesses be impacted by the bad economic numbers? There's a couple of things to remember here.
The first thing to remember is timing. The stock market is what we call a leading indicator as the prices usually reflect what people think will happen in the future. So if the present economic numbers are terrible, but it looks like the future is bright, the stock market is more likely to reflect the future expectations than the current numbers. In addition, many of the economic data points that are released are actually past numbers of what was going on in the economy a month ago or even 3 months ago. If there's one thing we've learned during this crisis is that a lot can happen in 3 months!
So while the stock market could be looking 3 months or longer into the future, the economic numbers could be looking 3 months into the past, and therefore there could be huge discrepancies in the numbers. That's one reason why the numbers have been moving in opposite directions over the past month.
The second thing to remember is that the stock market is not the whole economy and doesn't necessarily reflect what is going on in the whole economy. Small businesses are by and large not publicly traded and therefore the health of small businesses would not be reflected in the stock market directly. What skews the stock market numbers even more is that they are heavily influenced by a few very large companies which dwarf the size of the smaller or even medium sized publicly traded companies. Amazon, Apple, Facebook, Microsoft, Netflix and Google have all seen their share prices hold up pretty well during this crisis and a number of them are even higher than they were before the pandemic.
This doesn't mean that the stock market as a whole is doing well. It just means that the stocks of a few very large companies have done well. We will see if the share price rebounds of these huge technology companies are sustainable if the economic conditions continue to deteriorate. Over time, the stock market will reflect the earning power of the companies which make up the stock market. Certainly if the economy continues to be bad, that will impact their earning power. However over the short term, the economic numbers and the stock market prices can move in vastly opposite directions, and there is nothing unusual about that.
The price of oil is a lot more complicated than people think. Oil is not a standardized product that is the same in all cases. Different reservoirs will have different chemical characteristics to their oil and that will impact their price. In Canada our oil is heavier, especially oil that's extracted from tar sands. As such it trades at a discount to other lighter oils due to its characteristics. In addition, geography is a big factor as the ease and availability of transportation for the oil can impact the price.
Landlocked American oil which is represented by the West Texas Intermediate (WTI) price usually trades at a discount to the international standard which is Brent Crude. That's because Brent Crude has easy access to the ocean and therefore can be transported around the world with relative ease, whereas North American oil requires expensive pipelines to be built in order to transport the oil from the drill site to the refineries and the ultimate end users of the oil.
Oil is also only valuable once it has been transported and refined into a useful product. The crude oil itself isn't really useful for anything. If you are not a refiner, then the actual commodity is worthless to you unless you can find someone to buy it from you. The best you can do is to find storage for your oil and wait for somebody to buy the oil off of you. Storage and transportation of your oil costs money, so effectively owning oil is a liability to you and not an asset if there is no one to buy your oil and you're not a refiner yourself.
What further complicates this is that forward contracts which are used to show the price of WTI oil are financial instruments which may or may not reflect the value of the underlying commodity. What happened this week is that the May contract for WTI oil was due to expire on April 21st. Many of the speculators who owned the contract had no intention of ever taking delivery of the oil which is represented in the contract. That's because they are banks or hedge funds or other commodity traders who are not actually a refiner or purchaser of oil. As such there was a rush to get out of the contract before expiry because bankers don't want to have to take delivery of the actual commodity.
Normally this wouldn't be a problem as there will always be someone available to take the oil. The problem right now is that there is such a glut of oil due to the drop in demand caused by COVID 19 that storage capacity for WTI oil is simply running out. So you combine the lack of storage with the rush to get out of the May contract before expiry and you get the violent price gyrations that we saw earlier this week. This led to the price of oil dropping to -$37 at one point.
So I know what many of you are thinking. If the price of oil is so low, or even negative, why don't oil companies simply stop pumping the oil out of the ground and lower the supply in order to improve the price? You are partially correct as oil companies are certainly cutting back on their drilling drastically and they are also slowing the production of existing wells to the extent they can. This will gradually lower production levels and reduce supply. But it takes time to reduce production and unfortunately for many North American wells, it is simply not possible to completely stop oil production without doing damage to your reservoir or incurring large shut in costs.
This means that it can actually be more economically beneficial to continue to pump oil even at very low or negative prices as long as you can avoid having to completely shut down your well. Again, this usually isn't a problem as long as there is storage available. But when the max capacity of the storage is reached, there is no viable way for the driller to just cut production off completely. Does the -$37 reflect the price of oil producers are actually getting paid? Almost certainly not as the price only remained negative for about 24 hours before bouncing back to positive levels and settling at about $17 a barrel to end the week.
This drastically negative price was more a glitch in the contract given the circumstances. The June dated contract has not turned negative yet, and longer dated contracts are priced significantly higher, suggesting that financial markets believe that the storage capacity issue will recede later in the year. Nevertheless, the storage issue is still acute and it is possible we could see negative oil prices again in the near future. While this is unprecedented it is not impossible.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.
This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
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