We have been getting some questions from our clients around the recent news on oil prices and wanted to answer those questions and clear up some confusion that is out in there in mainstream media.
To review: Oil prices have dropped sharply over the last few months.
The major catalyst for this has been the COVID-19 pandemic. With most of the world’s major economies shut down, the demand for oil has dried up. This vast reduction in demand has caused oil prices to crash. In addition, oil-producing countries outside the US have decided to keep production up and put pressure on US producers, who have a higher cost of production.
This combination of reduced demand and increased supply has caused oil prices around the world to collapse, even sending some prices into negative territory.
How can oil prices can go negative? It is important to remember that only “paper oil” has gone negative. The actual cost for a barrel of oil is not negative. What has gone negative are very short-term futures contracts, which are contracts to take delivery of a good, such as oil, at an agreed upon price, and future time.
As a result of both reduced demand and increased supply, storage facilities across the world have almost reached maximum capacity. With nowhere left to store the oil when it is delivered, sellers are having to pay buyers to take these oil contracts off their hands. This is to help offset the increased cost associated with storing the oil.
As you know, at Telarray, we practice wide diversification in our portfolio design, and while we expect these developments in the oil markets to have some impact, we anticipate the direct effect of these events to your portfolio will be minimal.
However, there are two major lessons we can learn from these events as investors.
The first lesson is to diversify your portfolio to avoid concentrating your risk in one area of the market. When bad things happen to the general market, as we have seen recently, they tend to be relatively short-lived. On the other hand, really bad things can and do happen in an individual sector, industry, or company often. By spreading your risk, you limit the effect that these bad events have on your ability to meet your financial goals.
The second lesson we can learn is that it is important to understand what you own, why you own it, and what are the risk involved with the investment. Many investors piled into some exchange traded products on the news that oil had dropped to zero to take advantage of the situation, thinking there was very little risk.
These investors learned quickly and painfully that they were taking on risk they did not fully understand and saw their investments fall sharply as the price of these contracts went negative.
We hope this communication helps you understand what has been going on in the oil markets and how it may affect your financial plans. If you have any further questions, we urge you to reach out to your Telarray Advisor.