The behaviour of the price of oil in the last week was, to understate the matter, jerratic. A sharply negative oil price (the first time since 1870 at least) in the May contract served to illustrate how topsy-turvy the economic world has become (I hope some airlines hedged in negative oil!). Together with the relatively recent advent of negative interest rates, negative oil prices will convince many that something is not right in the engine room of the global economy.
I mentioned in last week’s missive that assets like oil that did not fall under the spell of central bank asset purchases gave a truer indication of the economic outlook than those assets that did.
In this context, the signal sent by the price of oil, even today, should be a cause for concern. Of course, other factors conspired to push oil into negative territory – notably a shortage of storage, the convince of some hedge funds and traders as well as the side effects of financial engineering (exchange traded fund (ETF) structuring).
This upside-down oil shock is not over and the effect of low oil prices will continue to ripple through emerging and high yield debt markets, emerging market currencies and the dollar, as well as banks and the Texan economy.
In the greater scheme of things, it also brought to mind the case of Metallgesellschaft, a giant German industrial conglomerate which in 1993 ran up a USD 1.5bn (a lot of money then) loss on an oil hedging contract. Metallgesellschaft fell foul of the same effect we witnessed last week, contango, where the price of near dated contracts (i.e. May) dropped well below the level of later dated contracts (e.g. July).
The Metallgesellschaft case left a mark on the financial economic history of the early 1990’s and is widely taught in business schools as a case study in the dangers of mixing business and financial engineering.
The collapse of Metallgesellschaft came at an early point in the deployment of derivatives in markets and should have served as a salutary lesson to corporates, regulators and banks. That was not the case.
For instance, the lesson that Deutsche Bank, which had arranged the hedging trades for Metallgesellschaft, apparently drew from the blowout, was to aggressively expand its investment banking operation. Today, the share price of Deutsche bank is down 95% on the level it reached before the global financial crisis (without being too unkind to Deutsche Bank, David Enrich’s ‘Dark Towers’ is worth a look).
What the jumpy oil price and Metallgesellschaft have in common is an instruction on how the real economy and finance have become increasingly intertwined.
From an economic and investment point of view, there is plenty to consider in this regard. I am tempted to say that there is one sector that does not rely on finance – technology – but the corornavirus crisis has turned tech from an industrial gargantuan into a stock market monster (Microsoft, Apple, Amazon, Alphabet and Facebook account for 22% of the market capitalisation of the S&P 500 index). Next week’s tech earnings results may bring a reality check for stocks, and see volatility pick up.
The two other sectors to consider are banks and private equity. In the light of the Metallgesellschaft discussion what is remarkable so far in the coronavirus economic crisis, is that no bank has keeled over (I may speak too soon).
Indeed, the balance sheet restrictions that have been put in place, and general focus on risk management, appear to have paid off. In many countries, banks are now part of the rescue mechanism, and there is an opportunity for many of them to repair their reputations. In Europe the price of heavy regulation has, made banks very cheap from a valuation point of view so that there may be some upside if a round of consolidation takes hold into 2021.
Unlike banks, private equity has for some reason not come under the intense scrutiny of regulators, even as private equity (and private debt) have replaced the role of banks in parts of the global economy (i.e. shadow banks).
A crunch is coming however. In the USA, private equity companies are heavily invested in medium sized enterprises, and in any cases have taken on large amounts of debt to do so. As the economic toll of the coronavirus deepens, the financial pressure on private equity will translate into economic pressure on companies (leading to cost cuts and layoffs), and social pressure on their workforces. Sadly, this may have a deeper human, economic and political effect than the drama of negative oil prices and deserves to be watched closely by policy makers as the summer approaches.
Have a great week ahead,
Mike
The Levelling 