A Black Swan In Oil

May 11, 2020

“Unprecedented” is a word that only begins to describe what’s transpired in the oil markets this year. Not only were long-standing records for oil broken in 2020, they were absolutely shattered, just like prices for the energy commodity.

Perhaps no other asset has been as affected by the economic devastation caused by the coronavirus as oil—not stocks, not bonds, not currencies.

Sure, all those other asset classes have felt the pain of the once-in-a-lifetime sudden stop in the economy. But they’ve been backstopped by seemingly infinite firepower from fiscal and monetary authorities, and have been able—to some extent—to look past the economic valley created by the virus.

Not so for oil. Because of physical constraints, oil prices have been at the mercy of the immediate economic realities in the real world. That’s stymied oil traders—many of which use ETFs—from capitalizing on the commodity’s decline. In some cases, unsuspecting traders have been completely wiped out by what’s essentially the blackest of black swans in the oil market.

The Beginning
While stocks rallied for a good month and a half before topping out, oil prices peaked right at the start of 2020. West Texas Intermediate (WTI) crude oil, the most popular U.S. benchmark for oil, hit $63.27 on Jan. 6.

Shortly after that, things turned sour. Reports of a novel coronavirus in China began to circulate early in January; by the end of the month, the country was in lockdown. Despite this, other countries were hopeful that the virus could be contained to the world’s most populous country, and U.S. stocks hit record highs in February.

The oil market didn’t have the luxury of ignoring the virus. The world’s second-largest economy, China, was also the world’s second-largest consumer of oil. In its February Oil Market Report, the International Energy Agency (IEA) estimated that oil demand would fall by 435,000 barrels per day year over year in the first quarter, largely due to the lockdown in China. Oil prices fell to $51.56 by the end of January, and $44.76 by the end of February.

Spot Oil vs S&P 500

Alliance Breaks Down
By late February, the severity of the coronavirus crisis was becoming increasingly clear. Even U.S. stocks, which were oblivious to the growing number of virus cases around the world, began to crash later in the month.

By early March, it was apparent that the virus had spread well beyond China’s borders. Lockdowns in Italy, Spain and France were followed by shelter-in-place orders in California and New York later in the month.

On March 6, a Friday, oil prices settled the week at $41.28, down 10% on the session, and the lowest closing level since 2016. Talks between the Organization of Petroleum Exporting Countries (OPEC) and Russia had broken down, ending with no agreement to cut production. Saudi Arabia had hoped to convince its allies to trim production by 1.5 million barrels per day on top of existing curbs, but Russia balked at the idea.

The alliance known as OPEC+, which consisted of OPEC, Russia and a number of smaller producers, had already trimmed output by 2.1 million barrels per day over the last several months, with little to show for it. Russia figured there was no point throwing good oil after bad.
Saudi Arabia was furious. The country threatened that if Russia didn’t join in the new cuts, the whole OPEC+ alliance would effectively be dissolved, and countries would be free to produce as much oil as they wished.

With no sign of a deal, the Kingdom followed through on its threat that weekend, dramatically cutting prices for its crude. The country would boost its oil exports to a record high, flooding the market with oil just as demand was collapsing.

Demand Collapse
That following Monday, March 9, oil prices plunged to $31.13, a loss of 24.6%, and at the time, the second-largest daily decline ever.
But while the supply surge was forefront on traders’ minds, little did they know the extent of the demand collapse that was coming. As the coronavirus spread, governments around the world began shutting their economies one by one. Borders were shut, travel ceased and people hunkered down at home.

An onslaught of negative headlines piled up day after day. By the third week of March, it became apparent just how far oil demand would fall. In its latest Oil Market Report, the IEA threw its previous estimates out the window. Demand would collapse by 29 million barrels per day in April, falling to levels last seen in 1995, the agency said. For the year as a whole, demand would be down by 9.3 million barrels per day year over year.

On March 18, oil prices fell 24.4% to $20.37, the first time at that level since 2002.

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