Potential investment strategies of the oil crisis during March and April 2020
On April 20, U.S. crude oil futures for May delivery, the near-term contract, plunged to their lowest level, falling to -$52.24 a barrel. It was the first time for US oil to go negative and it also unveiled the unprecedented stress in the oil industry.
People had to cover their long positions simply because they had no way to deliver and especially store too much crude oil with such limited demand in the current market.
The oil price has been declining since February this year. Due to COVID-19, many countries in Asia started to practice quarantine and people were required to stay at home since January. Therefore, the sudden decrease in the number of trips led to a huge drop in the oil consumption and brought down the oil price. The world had to look for a cut-off of oil production to stabilize the global oil price and major oil producers such as Russia, Saudi, and the US started their negotiation. However, the oil price sank significantly to its multi-year lows on March 8 as tensions between Russia and Saudi Arabia escalated. OPEC didn’t reach a deal with its allies about oil production cuts. Thus, Saudi Arabia slashed its oil prices and even intended to ramp up production. The fear was among everyone that an all-out price war was imminent.
During March, the majority of countries around the world required people to stay at home to conquer the COVID-19. Also, most flights and cruise lines had been suspended. The world-wide actions again lowered the consumption of oil to a much greater extent. On April 12, OPEC agreed to cut the oil production by a record amount of around 10% of its current production. But a 10% oil reduction in production failed to save almost 50% drop in oil consumption. Finally, due to the shrink of oil demand, the short sellers of the nearest term futures kept pushing the futures prices down. People had to cover their long positions simply because they had no way to deliver and especially store too much crude oil with such limited demand in the current market. That’s why we could even witness the negative price of the oil.
In such a volatile market, we have several investment strategies to benefit from the decrease of oil demand and the drop of the near-term crude oil futures price:
1. An oil tanker’s strategy
Oil tanker hire rates surged 150% after the Saudis flood market with cheap crude oil since March. With such low near-term crude oil prices, investors would look for spaces to store crude oil and sell it in the future when the oil price goes back to its normal condition. Therefore, we should find a way to capture the short-term shortage and appreciation of oil storage in the market.
Stock prices of firms engaged in crude oil storage and transportation, such as DHT Holdings INC(DHT) and EURONAV(EURN), surged almost 50% during March and April. A simple long position of those stocks could help us make profits from the market.
2. Oil contango
Since the spot rate of the crude oil is cheaper than its futures price, we could potentially buy crude oil on the spot market, short sell the crude oil futures contract, and store oil on tanker until futures contract maturity. In this case, we bet on the fact the futures price will gradually decrease to the spot price and the strategy would be profitable as long as storing oil on tankers is not too expensive.
3. Oil ETFs
The USO, United States Oil fund, popular among retail investors, tracks the front-month, or nearest, West Texas Intermediate futures contract. Over March and April, the fund plunged 75%, reflecting the drop of the crude oil price. We can either short sell the ETF or enter a long potion in its put option to capture the decrease in the crude oil futures price.
4. Pairs trading in US oil production firms
As the oil production in the US is much more expensive than that in Saudi Arabia and Russia, many oil production firms have to stop or greatly reduce their production to fit current oil demand in the market. But not all the oil production firms in the US have enough cash and ability to go through this oil crisis. Recently we had more oil and gas firms’ bankruptcies such as Haynes and Boone in Houston. Therefore, another strategy we could build is a pairs trading strategy where we take a long position in dominant US oil production firms such as Chevron and Exxon and take a short position in weaker producers with smaller market cap and limited ability to walk through this production drop. We make the bet on the fact that weaker firms will eventually file bankruptcy and major firms will be able to return the normal status.
Sources:
1.“Oil plunges 24% for worst day since 1991, hits multi-year low after OPEC deal failure sparks price war”. Sun. March 2020.
2.“Oil prices turned negative. Hundreds of US oil companies could go bankrupt”. Egan. April 2020.
3.“Oil And Gas Companies Have Begun Filing For Bankruptcy. Here’s Why More Could Be On The Way.” Buckley. May 2020.