The Bottom of the Barrel - II

​What a week it was!  Oil prices plunged, but they did not stop at zero.  At one point during the week, the price of the expiring current month Crude oil contract was negative $40 dollars.  Did anyone think this was possible?  Theoretically, this price quotation would suggest that a producer of Crude oil was paying the buyer $40 dollars to take a barrel of crude off his or her hands.  Although this transaction did not happen in the real world and negative prices were mostly a technical issue, traders were caught on the wrong side of an illiquid market and option volatility accelerated the decline.
 
Here is a fundamental difference in commodities vs. stocks.  The physical supply vs. demand plays a major part in determining the price of a commodity, and when a market is oversupplied, prices move lower to dis-incentivize production.  When consumers are stuck at home and storage is filling up in the U.S., lower oil prices are forcing producers to shut off the oil spigots.  Oil prices will not rebound until economies get back on their feet and the oversupply is reduced.
 
Stock prices in the short term also depend on the supply vs. demand of buyers and sellers, but the value of businesses over the long term are based on the cash flows they produce well into the future.   And here is where this week gets interesting.  While crude oil was plunging to depths unknown to investor kind, stocks of oil producers did not follow commodity prices.  Take a look at this interesting analysis  (LINK).  Most energy stocks were positive and did better than the overall market for the week.  This is simply because most future month Crude prices did not plunge the same way spot prices did, and stocks anticipated that bad news was coming.
 
A good rule of thumb is that by the time a news event reaches PAGE 1 status, it is very well discounted in (anticipated by) stock prices.  In layman terms, energy stocks are pricing in a bad future.  Reality can always get worse.  However, stocks are a long-duration asset.  While short term events create volatility that takes a toll on the human psyche, it does not impact the long-run valuation of the business.  This week is the beginning of a bottoming process for energy.  If you are looking for background, read The Bottom of The Barrel.  Undoubtedly, this will be a long process.  Many producers will have to restructure their businesses depending on their debt loads.  Lots of service providers will not make it to the other side.  But downcycles are opportunities for the best companies – with low cost resources and excellent balance sheets – to capitalize on the mismanagement of others.  This economic Darwinism is much needed to repair the oversupply and put the entire energy patch on good footing again. 

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