Tag: Energy

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Why did oil prices go negative?
Reading Time: 3 minutes

Why did oil prices turn negative? How is that even possible? Typically, instead of paying someone to take a product away from you, you would just stop making that product and wait for another day so you can make a profit. Well, it is very difficult to just stop oil production and wait. It’s very costly to shut-in production and then restart.

What led to this issue? Supply is greater than demand right now. Given the impacts of COVID-19 means the largest consumers of oil have halted (jets and cars). At the same time, we’ve been building supply in Cushing, OK which is America’s key storage and delivery point.

Negative prices may seem attractive when you’re getting paid to take product, but aren’t so great when you realize if you were to take delivery (i.e. receive physical oil) you’d have to pay high prices to store it, which could eliminate all your profits.

Why didn’t the energy ETF sell-off more? If you look at Exxon or Shell or any of the majors on April 20th, their stocks were down maybe 3-4%. In fact, if you looked at Brent futures, the benchmark for Europe, it was selling for $25 / barrel. WTI contract for June delivery was $20 / barrel. Huh?

It all has to do with the futures market. Matt Levine also has a great post on this.  In essence, if you want exposure to oil, but didn’t want to actually take barrels of oil, you could buy a futures contract that gives you paper exposure to the commodity until it expires at which point you can either roll the contract (maintain paper exposure) or take physical delivery. If you go to the CME website, you’ll see you can buy oil in 1,000 barrel increments and it is settled “physically” – not financially – so you’d actually have to find a place to store it if you didn’t roll the contract.

When the June oil futures contract price is higher than May, that means the market is in contango. The June cost being higher than May partially reflects “the cost of carry” or storage costs for you to pay someone to hold the oil for you until the contract is settled. In this case, oil went into super contango because the cost of carry went to extreme levels.

This is also why energy companies didn’t sell off more. The “real” price of oil wasn’t actually negative. It was a panic to not settle physically. In fact, if energy companies hedge, they were likely the ones selling futures contracts before this point…

So this caused oil to turn negative?  Yes. As traders looked at their May contracts, they realized they couldn’t take physical delivery without paying huge prices. Also, panic probably settled in.

Was this predictable? Yes, actually. Here is a link to an article published on Bloomberg about 1 month before oil actually turned negative essentially predicting it could happen.

Could it happen again? Yes. And it might given investors decided to buy $USO, the oil ETF, to gain exposure. $1.5BN flooded into the ETF.  The problem is that investors bought this fund, which had to create shares and buying underlying, front-end futures contracts. So what did they buy? They forced it to buy June expiry contracts. So now they have exposure to the June contract in a vehicle that cannot take physical delivery and has no choice but to roll contracts. That may very well lead to this issue happening again in a month.

Oil prices outside of futures contracts remain very low. Could we see the majors like Exxon cutting more dividends?

Another incredible black swan event for 2020!

Security Analysis

Will Exxon Need to Cut its Dividend? $XOM
Reading Time: 2 minutes

Saudi Arabia and Russia are in a price war — increasing the supply of crude oil at a time when we are seeing an unprecedented collapse in demand due to the coronavirus (COVID-19). Exxon has gotten crushed this year, down 45% YTD with a 9% dividend yield. They’ve consistently paid, and grown, the dividend over the past 37 years. Exxon’s dividend offers a juicy proposition for a company that is rated investment grade and at a time when the 10 yr treasury yield is <70bps.

But let’s do some quick math to see if the dividend is covered, first by looking at 2019 figures. As shown below, Exxon did $1.5BN in FCF.

This is not good. The Exxon dividend cost $14.6BN in 2019.

One thing we could do is look at what bare-bones capex is. In other words, what did the company spend in 2015/2016 when the oil outlook was also bleak? Cutting capex down to those levels would help preserve cash:

So now we have ~$10.5BN of FCF, but that still doesn’t cover the Exxon dividend. The other problem is that cutting capex is not what the company wants / intends to do. As stated in their March 5, 2020 investor day, they will actually be spending more than 2019:

On April 8, Exxon said it would cut this figure by 30%

Even so, cutting capex back doesn’t help. And the bigger problem is that oil was roughly 100%-200% higher in 2019 than it is right now.

What other ways could the Exxon dividend be maintained?

  • They could sell assets, but what price would they get in a time like this?
  • They could issue a bond to help cover it – but do you want an increase its debt load? Is jeopardizing the company for the dividend worth it?

I think its a matter of when, not if. Besides, I personally don’t think the oil industry is dead – there must be good long-term investment opportunities out there for them now that so many players are distressed.