Berna Barshay on oil markets; Charlie Munger: 'The Phone Is Not Ringing Off the Hook'; My latest coronavirus e-mail
1) Here's my colleague Berna Barshay on the chaos in the oil market:
After more than 25 years since my first day on the trading floor, it's not often that I see something that I've never seen before – and never thought I'd see!
But yesterday was one of those days, when the price for the May WTI crude oil future sank to zero... and then kept going lower. The contract – which closed at $18.27 on Friday – continued to crash throughout the trading session, shocking traders at each new level it hit. Surely it would stop at $10? At $5? At zero? But it in fact closed the session at negative $37.63... Yes, negative $37.63 per barrel. In other words, the seller of the contract would pay you $37.63 to take a barrel of oil off his hands during the month of May.
How is this possible? The answer lies in two stories of supply-demand imbalance...
First, there was the supply-demand imbalance for oil created by the global stay-at-home orders due to the COVID-19 pandemic. Suddenly, millions of people aren't driving to work, to their kid's soccer games, or to a weekend getaway. Flights were canceled as non-essential travel ground to a halt. And it wasn't just here in the U.S., but across all of Europe at the same time.
But wells that pump out oil don't work like your water faucet... It isn't so easy to just shut them off – and it can be even harder to restart them. As I wrote last week, oil production is set to be reduced by around 9 million barrels per day starting in June. But as producers prepare to take supply offline, the wells keep pumping out more oil... even as demand has dried up because of hundreds of millions of people sheltering in place.
Supply-demand imbalance No. 2 is storage. All that oil needs somewhere to go. It can sit at refineries, in pipelines, and on oil tankers at sea... but the receptacles that can hold oil are rapidly filling, thus causing the price of oil storage to skyrocket. The oversupply of oil combined with the dwindling supply of storage space led to the absolutely astounding and totally unprecedented negative prices that we saw for the May oil futures.
At the same time, the June WTI crude futures closed yesterday at $20.43. The difference between the May futures price and the June futures price implied that the market would pay you nearly $60 per barrel to store oil for a month – plus, you got the oil for free!
The trading relationship where the further-out month future trades at a premium to the close-in month (or spot price) is called "contango." It's common in the commodity markets, as the further-out months usually reflect storage costs and thus typically trade higher, except in times of short-term shortages (usually supply shocks).
But what happened yesterday could only be defined as "super contango," as it was something that we have never seen before and are unlikely to see again.
So why did this happen? Was there any news? Most likely the unprecedented negative oil futures price was the result of the May contract expiration today. Since commodity futures settle in the physical transfer of the underlying commodity (as opposed to a financial true-up), it seems a meaningful number of oil speculators got caught long the May WTI crude futures into their expiration, and didn't have the capacity to receive and store oil.
Compounding the issue of forced sales by May futures holders, the situation was probably exacerbated by speculation in the United States Oil Fund (USO) – the exchange-traded fund ("ETF") that tracks oil as a commodity. USO doesn't hold physical oil, but instead holds the futures. With the May futures set to expire today, that's one large holder who was forced to get out, thus driving the price down.
Now that we understand what happened, why it was so crazy, and the underlying factors behind such an historic dislocation, the next natural question to ask is: Who benefits?
Given the implied high price being paid for the ability to store oil for a month, the obvious beneficiaries of the greater oil supply-demand imbalance are the companies that can store it – the refineries, the pipelines, and the tanker companies. Thinking about the losers in this situation (besides the forced sellers of May WTI futures), top of mind has to be high-cost producers of oil, as they should be the first to be shut down in a demand-driven collapse in prices.
The high-cost producers in North American oil are the shale producers operating in the Green River Formation in the West and in the Devonian-Mississippian black shales of the East. These producers – who also tend to operate with high debt levels – should be the first to shut down.
But given the complexity of the fracking techniques used to remove oil from shale, these wells are extremely expensive to both turn on and turn off. If they are turned off, it's unlikely they will ever get turned on again, which could lead to the bankruptcy of many small shale producers.
Also at risk are the oil sands of Western Canada, but with lower start-up/wind-down costs, it's conceivable that these fields are mothballed until a point when spot prices justify them being pulled back into service.
Even if May futures turn positive today before expiration, much damage has been done by the low absolute prices in the spot and near-term futures for oil, as well as by the soaring cost to store it.
The flip side of the distress at highly leveraged exploration and production (E&P) producers could be exciting merger and acquisition (M&A) opportunities for the better capitalized players in the space – which could include major global oil companies that still have the liquidity to do deals, even when suffering the fallout of lower oil prices themselves.
Other participants in this buyer's market for production assets could include private equity, or the Oracle of Omaha, Berkshire Hathaway's (BRK-B) Warren Buffett. Stay tuned!
2) Speaking of Berkshire, kudos to the Wall Street Journal’s Jason Zweig for scoring an interview with investing legend and Berkshire Vice Chairman Charlie Munger (disclosure: I'm a certified Munger groupie, and was a contributor to the definitive book about him, Poor Charlie's Almanack: The Wit and Wisdom of Charles T. Munger): Charlie Munger: 'The Phone Is Not Ringing Off the Hook.' Excerpt:
Overall, Mr. Munger made it clear that he regards this as a time for caution rather than action.
In 2008-09, the years of the last financial crisis, Berkshire spent tens of billions of dollars investing in (among others) General Electric Co. and Goldman Sachs Group Inc. and buying Burlington Northern Santa Fe Corp. outright.
Will Berkshire step up now to buy businesses on the same scale?
"Well, I would say basically we're like the captain of a ship when the worst typhoon that's ever happened comes," Mr. Munger told me. "We just want to get through the typhoon, and we'd rather come out of it with a whole lot of liquidity. We're not playing, 'Oh goody, goody, everything's going to hell, let's plunge 100% of the reserves .'"
He added, "Warren wants to keep Berkshire safe for people who have 90% of their net worth invested in it. We're always going to be on the safe side. That doesn't mean we couldn't do something pretty aggressive or seize some opportunity. But basically we will be fairly conservative. And we'll emerge on the other side very strong."
Surely hordes of corporate executives must be calling Berkshire begging for capital?
"No, they aren't," said Mr. Munger. "The typical reaction is that people are frozen."
Overall, while I respect his (and, I assume, Buffett's) frankness and conservatism, I'm a little disappointed not to hear more bullishness. I understand why the phone wasn't ringing and why they might not have wanted to buy more airline stocks, but why not more of the banks (as I was doing) plus adding Alphabet (GOOGL) and Amazon (AMZN), two companies for which they've long expressed admiration?
At the very least, I hope they bought meaningful amounts of their own stock during the nearly two full weeks when Berkshire A-shares traded below $275,000. I find it hard to imagine a scenario in which shareholders wouldn't be happy in a few years if the company had bought back shares in size below that price...
3) This is one possible reason for Buffett and Munger's conservatism: Restaurants vs. Insurers Shapes Up as Main Event in D.C. Lobbying Fight. Excerpt:
The government's efforts to help businesses recover from the coronavirus pandemic are triggering waves of lobbying skirmishes, and one of the biggest fights shaping up pits restaurants against the insurance industry.
Restaurants and their allies are lobbying President Trump and Congress to press insurance companies to cover "business interruption" claims stemming from the coronavirus, even where restaurants have policies that exclude losses from pandemics.
While insurers do offer coverage, those policies are significantly more expensive than standard business-interruption policies, and few restaurants carry them, industry representatives said. But restaurants and some U.S. lawmakers say the business-shutdown orders in states and cities should constitute business interruptions under their existing policies.
Insurers are pushing back hard with the help of some Republican senators and conservative groups, saying retroactive changes to coverage policies and threats of lawsuits from restaurants could undermine the nation's insurance system.
"Exploiting this crisis with litigation profiteering will stop America's recovery before it even starts," said David Sampson, president and chief executive of the American Property Casualty Insurance Association.
That abrogating insurance contacts is even being discussed is outrageous. If the government wants to help restaurants, that's fine... but it shouldn't be done by stealing from insurance companies!
4) Here's a link to part two of my response to Porter Stansberry (you can read part one here), which I sent to my coronavirus e-mail list last night (to join the 4,200 people on it, simply send a blank e-mail to: cv-subscribe@mailer.kasecapital.com). Excerpt:
So, the actual number of people who get the flu is 5% to 20% of Americans each year, 67% to 82% higher than 3% to 11%. Taking the midpoint, that's 75% more. This drops the 0.131% to a 0.075% true (infection) fatality rate, meaning the true COVID-19 fatality rate is 6.7 times higher, as this chart shows:
Now do you see why people are freaking out about the coronavirus, and not the flu???
Conclusion
In conclusion, we don't have to guess at what happens if we do what Porter and others recommend. We have been told the answer again and again, ever since the first outbreak in Wuhan: left unchecked, the coronavirus quickly leads to an exponentially growing bloodbath that overwhelms even the best health care systems.
Reasonable people can disagree about the details of what measures should be taken. I totally reject the recommendation that we lock down our entire country for 30 days – or even one day! For example, Wyoming's degree of lockdown and distancing should be a small fraction of NYC's in my opinion. And I don't think we should do a full Wuhan-style lockdown even in NYC.
But to do what Porter recommends – end the shutdown orders, even in hotspots like NYC ("these shutdown orders did virtually nothing to stop the spread of the disease or to reduce its lethality in the population") and strive for herd immunity as quickly as possible ("allow everyone who can manage the virus to get exposed. As quickly as possible. After all, the sooner the herd immunity we need develops naturally, the safer we will all be") – is an almost certain invitation to disaster.
So, yes, it's worth the high price we're paying to avoid this utter calamity. (While, again, noting that there's plenty of room for disagreement on the details.)
Best regards,
Whitney