Doug King, CEO and CIO of RCMA Capital’s long-running Merchant Commodity Fund, has described Covid-19 as an “out-and-out demand shock” to oil markets that cannot be solved or cured by governments and central banks.
The recent crash in commodities markets hints at longer-term lower prices as the sector grapples with lower industrial demand for energy and a looming consumer-led recession, the veteran oil and commodities specialist added.
The Merchant Commodity Fund – which trades commodity derivative markets by combining a fundamental supply-and-demand analysis with real-world cash price information – has surged during recent oil volatility. It gained 31 per cent in March, driven by a directional short crude position along with certain other bearish relative value bets, such as selling gasoline and buying crude.
Last week’s unprecedented collapse of the May 2020 West Texas Intermediate price into negative territory a day before its contract expiry was “shocking”, but not entirely unforeseen, King told Hedgeweek.
Fundamental analysis suggests the price fall stemmed from crude supply exceeding storage space at the key physical delivery point. He said the collapse in WTI and other US crudes makes it more competitive against Brent or other European Atlantic Basin crudes.
“WTI is a physically delivered contract, while ICE Brent is cash settled, so there is a forced convergence with the real-world pricing of WTI crude oil if you take this contract into expiry,” he explained. “Since the US lifted restrictions on oil exports back in 2017 US crude oil prices, including WTI, have reconnected to global prices. So moves in the front end of WTI do have an impact on the ICE Brent, a proxy for global oil prices.”
He added: “We will learn more in the coming days and weeks as to what really happened and who was on the other side of the negative value trades.”
King said the Merchant Commodity Fund has been tracking the spread of the virus from Asia since mid-January.
“It has dominated our trading decisions given that our focus is not just on oil, but on coal and natural gas as well as global steel and iron ore,” King said.
“Without pretending to be epidemiologists, we drew some early conclusions that the spread of the virus would deliver one of the largest commodity demand shocks ever experienced. Unlike supply shocks, demand shocks don’t come around as often. Even the crisis of 2008-09 was a still primarily financial crisis that delivered a demand vacuum.”
Noting that some 4 billion people have been in lockdown since mid-April, King said the hit to power demand during the pandemic has been “immense”.
The longer-term demand outlook ultimately hinges on how governments can co-ordinate a plan to exit the lockdown. But he warned this must be weighed against the impact of a consumer-led recession along with the challenges of a potential second wave of coronavirus infections.
“We solve the problem of excess crude supply by pushing prices below the cost of production. Also, as crude tanks are full, we reach operational limits for pipelines so crude oil production must be forcibly shut-in. This will obviously impact associated gas production in its own right,” he said.
“However, these supply losses must be offset against the loss of demand. Industrial production has slowed very sharply in the US. Even oil refiners are shutting down due to operational limits. While the residential consumer is locked at home furiously baking away, it is the loss of the industrial power and gas consumer that matters more.”
He added: “Given the immense supply and demand mismatch and with storage at a maximum, the market must push the outright price of crude oil lower to ensure production is shut in. It is not good enough to touch these very low levels but the market must hold at these lower levels for long enough to force oil E&P corporate management to take these decisions. As this happens the risk of a dislocation at the front end of the curve rises.”
