“The Long Squeeze”
Welcome to another blog update of the Weekly Overview Series.
In this week…
- Coronavirus cases now at their peak or slowly falling in most of western countries. However, daily death tolls still accelerating in Canada, Brazil or Turkey.
- US Weekly Jobless Claims in line with expectations. 4.427 million Americans filed for unemployment benefits, bringing the total reported over the last 5 weeks to 26 million or 16% of the labour force. Following from that, Trump signs an executive order to suspend legal immigration into the country to “protect American workers”. Given the big proportion of foreign employees in the technology industry and the potential impact restricting immigration could have in the U.S, tech stocks dipped.
- Brexit talks resume as time runs out for a deal to agree on the future relationship between the European Union and the UK in trade, aviation or security. Chief negotiators, Frost and Barnier, say the UK will not ask for a postponement and will veto any EU request for one. Key areas of disagreement are:
- Competition policy: the EU wants the UK to commit to a level playing field: a set of standards and rules to avoid tariffs.
- Criminal Justice and Law enforcement.
- Netflix added a record 15.8 million subscribers last quarter, taking advantage of the captive market lockdowns have given the company. After the initial 12% surge in the stock market, the stock dips as Netflix expects this surge to come at the expense of future growth. Always remember expected cash flows are what moves markets.
- Gilead drug remdesivir fails to improve patient condition according to draft documents accidentally released by the World Health Organization. Until now, the evidence was based on studies that were not randomised and did not have a control arm. Although the WHO considered that the study was “underpowered to enable statistically meaningful conclusions”, it also said that trends indicated a potential benefit in early stages of the disease.
After the summary, it is the time to go straight to the top event of the week.
It is the black gold, although since the lockdown maybe that name should be changed. I am referring to oil.
The problems in the oil industry came the moment China announced a lockdown in the most affected areas by COVID-19. The biggest importer of oil in the world was halting its production. The demand for oil fell by 20%.
Afterwards, Russia and Saudi Arabia started a price war, conceived by the latter as a punishment to Russia for its unwillingness to reach an agreement on a supply cut.
The additional drop in demand after the global spread of the virus and the application of lockdowns and social distance practices, caused oil prices to gap down and trade at around $20. According to the IEA, in April, demand is estimated to be 29 million barrels per day (mb/d) lower than a year ago. For 2Q2020, 23.1mb/d below year-ago levels.
American Petroleum Institute (API) Weekly Crude Inventories reported crude stockpiling consistently over 10 Million barrels from the end of March due to this imbalanced supply and demand.
United States API Crude Oil Stock Change
Cushing is America’s key storage hub and delivery point of the WTI futures contract. In mid-April, Cushing was at 70% of its full capacity. During the expiration date for the WTI May futures contract (20th April), traders and speculators that did not want the barrels to be physically delivered as they did not have storage available, were forced to sell to get out of their long positions to the point where traders were willing to pay 40$ to sell their contracts.
Cushing is expected to be full at the time June contract expires, with similar consequences as those from this week. To protect its positions, the United States Oil Fund, the biggest oil ETF in the world, delayed their WTI contracts average expiration date, an attempt to hedge against negative oil prices. It did that by increasing its weight in August and September contracts and reducing their June exposure, hoping that the storage capacity is back to normal by then.
How this situation affects the oil industry and the financial system?
JPMorgan said on Thursday that oil collapse is not a systemic risk to markets. Their rationale behind the statement is that as oil has been coming down for some weeks, the weight of the associated energy sector has significantly reduced in the S&P500, breaking down the positive correlation between the index and the energy sector.
Having said that, U.S shale companies are at risk, especially independent smaller companies. Their breakeven price is around $40 a barrel and they have accumulated a lot of debt lately.
The industry is estimated to owe $200 billion to lenders backed by oil reserves. Some companies such as Whiting, that filed for Chapter 11 to restructure its debt, have already stated that they will be unable to pay. Credit worthiness ratings will be downgraded for sure, meaning higher yields and costs of financing for oil shale producers.
The financial industry, despite being in a better position to face credit default after the bank stress tests, have to be prepared to see toxic assets in their balance sheets. In this particular case, they should be partially protected by the expectation of higher oil prices for the collateral they could receive from a bankrupt shale producer.
The €2 Trillion Discussion
The European Commission prepared a draft plan that allegedly included €2 trillion euros although it is not said how the commission reached that number. The only information that is given is that the EU would integrate a €300 billion recovery fund in its seven-year 2021-2027 budget and €320 billion raised in capital markets.
In an attempt to bridge the gap between the group against joint debt issuance led by Germany and the Netherlands and the group aiming for joint debt issuance led by Italy and Spain, France suggested a temporary fund financed by joint debt issuance to stimulate the economy in the early future.
Germany and the Netherlands want that fund, in order to accept the proposition, to offer low-interest rate loans which could leave highly indebted countries with even more liabilities. France support giving handouts instead.
The ECB, meanwhile, is willing to accept some junk bonds as collateral for loans to banks, in clear reference to the Italian credit worthiness complicated situation.
As always, I leave here two useful charts to wrap up the week:
Have a good weekend!