Written by: Samira Fatehyar
Introduction
The past two weeks has seen a lot of change. Headline after headline about oil prices, a meat shortage and the Federal Reserve’s meeting has many people wondering what it all means. History was made when we observed WTI Crude future contract prices falling below zero as sellers were willing to pay buyers to get millions of barrels of oil off their hands. On top of that, the supply chain for meat products is experiencing disruptions. The Fed also announced on April 29th, that they will not be changing interest rates. So what should you make of all of this?
I wanted to talk about unemployment for this blog post, but I’d rather wait until the official numbers come out from the Bureau of Labor Statistics (BLS). I suspect it will be fairly high as there is now a record number of people (30.3 million) who filed for unemployment from the start of the pandemic until now (May 4th).
Oil
Russia Vs. Saudi Arabia
In order to understand what has lead to the decrease in oil prices, we need to back up and discuss what happened between Russia and Saudi Arabia not too long ago. In March of this year, Saudi Arabia had announced to the Organization of the Petroleum Exporting Countries (OPEC) and its allies, that they would all need to start cutting production due to the decrease in demand caused by the Covid-19 pandemic. Russia, who is not part of OPEC but is usually seen as an ally, refused to cut its oil production. When this happened, Saudi Arabia decided that it would increase production, this lead to both countries producing more oil than they knew what to do with. A simple supply and demand graph would illustrate that when supply increases and demand decreases, a drastic price reduction is inevitable. Graph 1, below, shows the year to date graph of WTI Crude Oil Future Contract Prices.
Before I explain more about the graph, I realize that I should probably explain what WTI Crude Oil is as opposed to Brent Crude Oil. WTI, or West Texas Intermediate, is crude oil produced in the US, mostly Texas, and is the main oil benchmark used for the North American continent. Brent Crude oil is produced and refined in Europe and is typically priced higher than WTI crude oil.
Another point that might need to be explained is the concept of future contracts. Future contracts are usually used for commodities; these contracts can be for a month out to a year out. A buyer will come in and think that a commodity, like oil, is trading at a low price and buy it. When it comes time to sell the contract they will want to sell it for a higher price. That is the incentive behind it. Once the contract expires, the one holding the contract will have to take delivery on what ever commodity and volume the contract stated. Currently we are not seeing people making money in the oil futures market since the trend has been downward sloping, meaning people are buying at a high price and selling it at a lower price, and as we saw, even at negative prices.
WTI Crude Oil Prices
Now looking at Graph 1, we see that WTI crude oil prices are now down 67.63% since the beginning of the year. At its lowest point, when it was trading well into the negative prices, it was down over 150% from the beginning of the year. So basically what the negative prices are telling us is that people were trying what ever they could to get the future contracts out of their hands, so much so that they were willing to pay people around $30 a barrel to take it from them. This was something we had never seen in history before and something I hope people will remember for a long time.
Graph 1
Year to Date graph of WTI Crude Oil Future Contract Prices.
https://markets.businessinsider.com/commodities/oil-price?type=wti
Since the negative storm happened on April 20th, WTI has somewhat recovered and is no longer in negative territory. Many people have asked me if the June contracts will go negative as well and if oil demand is picking up. The main problem I think we are seeing is that two oil producing powerhouses produced way too much oil that we are now seeing limitation of physical storage. Demand will start picking up as the world starts to reopen, but I don’t necessarily see this happening as fast as people want it to happen. The whole world is still in a fragile position against this virus until a proven and trusted vaccine can come out. Many oil analysts say that there might even be negative prices for the June contracts. I’m not an oil expert in the slightest, but after what we saw happen to the May future contracts, it is proof that anything is possible.
Meat Shortage
Farmers and Meat Processing Facilities
Another headline that we have been hit with day in and day out is the imminent meat shortage the US will start experiencing. As with everything in economics, we look to data and prices to understand what is going on in the market. Graph 2 illustrates the price of live cattle in the market year to date. Graph 3 shows the price of lean hogs in the market also year to date. Looking at Graph 2 we can immediately see that there has been a 29.13% drop in price. A similar scene is seen in Graph 3 where a 12.50% drop in price has been seen year to date. How did this occur? During the Covid-19 pandemic, we have witnessed several outbreaks occur in meat processing facilities. This has led to both a shut down and a decrease in the labor force at these facilities. When this occurred, farmers had nowhere to sell their livestock for slaughter. This has recently lead farmers to euthanize their herd because of this disruption in the supply chain. Although President Trump signed an executive order restricting the closure of these plants, many still remain closed and many more are still dealing with safety issues for their workers. Many of these workers are walking out at the job to protest the re-opening/continued open of these facilities. Even once the meat processing facilities get back to normal, we need to realize that it takes 18 months to raise cattle to slaughter, and 5-6 months to raise pigs to slaughter.
Graph 2
Year to Date graph of Live Cattle Future Contract Prices
https://markets.businessinsider.com/commodities/live-cattle-price
Graph 3
Year to Date graph of Lean Hog Future Contract Prices
https://markets.businessinsider.com/commodities/lean-hog-price
The Consumer Impact
What can everyday consumers expect from this supply chain disruption? Well, less supply will translate into higher prices for meat at the supermarket. This will most likely exacerbate conditions for the average American who is already suffering from the financial impact of the Covid-19 pandemic. Meat shortage will most likely be seen in the coming weeks if it hasn’t already been seen where you live. I can say that in Reno, NV we have seen grocery stores limiting the amount of pork, beef, and poultry a shopper can buy to stop from panic buying.
I’ve included Graphs 4 and 5 to help illustrate what consumers have been experiencing at the supermarket on average across the US. Graph 4 represents the average per pound ground beef price in the US, while Graph 5 represents the average per pound price of pork chops. Unfortunately, this information does not yet include April, but I suspect there is a higher price seen. In Graph 4, it is clear that there has been an upward tread in prices over the past year in ground beef. Graph 5 does not show that as clearly, but this is likely because it takes less time to raise pigs to slaughter than it does for cattle. I still do expect prices to be higher for both for the month of April.
Graph 4
Ground Beef, per pound in the US City Average over the last year
https://fred.stlouisfed.org/series/APU0000703112
Graph 5
All Pork Chops, per Pound in the US City Average over the last year
https://fred.stlouisfed.org/series/APU0000FD3101
The Federal Reserve
April 29th
Jerome Powell, chairman of the Federal Reserve, announced on April 29th, that the Fed would keep the Fed Funds Rate unchanged at 0 to 0.25.
One thing I’d like to explain is what the Fed Funds Rate is before we get into this further. The Fed Funds Rate is the rate at which banks lend money to each other, typically on an overnight basis. Now, you might be wondering why banks lend to each other if it’s only over night. There is a law that requires a percentage of client’s deposits to be on reserve at the bank, so banks try to stay close to their required limit without going under, and thus lend to each other to make that happen.
How does the Fed Funds Rate play into the economy? It’s used as a way of controlling the supply of available funds which is connected to inflation. By lowering or in our case, keeping interest rates low, it is incentivizing borrowers to borrow since its now cheaper. In theory, a low interest rate would lead to higher inflation, but since we’ve been experiencing what I believe to be a Neo-Fisherian Model for the past 10 years or so, the relationship between inflation and interest rates have stayed positive. At some point though, one will start to wonder if inflation will be something that we will have to deal with, especially with the Federal Reserve printing so much money.
In Powell’s teleconference, he highlighted many things he was worried about in the long-term spurred by the Covid-19 pandemic. He stated that the Fed was in no rush to raise interest rates until the US economy recovers from the financial fallout of the Covid-19 pandemic. He mentioned, as many economists have, that some businesses may close for good, while many workers face the challenge of being dropped out of the labor force. The Fed is trying to fight the short term effects of the pandemic, but the most important fight will be against the after effects from all of this. The economy will not just switch back on like a light switch, it will take time. The Fed saying that means a lot.
To read the Fed’s statement click here:
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200429a.htm
Policies being used
Theoretically, lower interest rates should spur economic activity because it’s less expensive to borrow and there is a lower incentive to keep money in the bank. But as I have mentioned before, Covid-19 is an exogenous catalyst and by lowering interest rates economic activity won’t suddenly start to happen. Although the Fed, as well as many economists, are worried about the economic fallout, the Fed is asking Congress to take more control and use more of their fiscal powers. Something that hasn’t been said by Chairman Powell before.
I think it’s necessary to take an important step back and see how much money combined between monetary and fiscal relief has been pumped into the economy since the beginning of the pandemic. Below, Chart 1 shows the Covid-19 stimulus as a percentage of real GDP. A combined 26.1% of real GDP is what the government as well as the Fed has pumped into the economy. This should be a startling number to you. Don’t get me wrong, it is necessary to help struggling small businesses, but is all of this money going to those businesses?
Chart 1
Covid-19 Stimulus as a percentage of real GDP
https://www.schwabfunds.com/content/fomc-meeting
Just last week, the Fed announced that it would expand its “Main Street” program by allowing firms with up to 15,000 employees apply for these loans. Personally, I don’t think a 15,000 employee business should be considered a small business. There has been stories both in the media and from friends of mine who are small business owners saying that they have yet to receive a penny from the government. There is definitely a huge lag time in this process and when the money becomes available for these businesses, will it be too late? Many small businesses haven’t been able to even apply for these loans. The economic fallout will continue to worsen if these issues cannot be addressed.
Another issue that I find important in the explanation of everything going on is the difference between liquidity and solvency issues in a firm. Liquidity refers to the firm’s ability to meet its short-term obligations whereas solvency refers to a firm’s ability to meet its long-term obligations as well as having a positive net worth. If these larger businesses that have been receiving government assistance had liquidity issues, then the assistance, in theory, should help. But, if they are having solvency issues, not even these government loans will bail them out. Now is a time to focus on vetting these businesses and figure out what issue they are facing.
Is now the time to buy?
Many people have been asking me if now is the right time to buy real estate since interest rates are at an all-time low. Many analysts, including myself, see the Federal Reserve holding interest rates near or at the current rate for the next 5-10 years. We see this because there really won’t be an incentive to increase interest rates for that period of time. Let’s take a look at what happened historically. Graph 6 shows the Federal Funds Rate from April 2007 to April 2020. The shaded area refers to the period of the Great Recession. In April 2007, the Fed had interest rates at 5.25, the Great Recession then took place and, as shown in the graph, declined to near zero. Then we had this massive economic expansion that lasted 11 years, where we saw interest rates no where near what was observed before in April 2007. The highest point that we saw it hit was in July 2019, when it was 2.40. Let that sink in, a massive economic expansion took place and interest rates remained relatively low for 11 years. This is why many analysts, like myself, don’t see interest rates going anywhere any time soon. So if you are feeling pressured to re-finance, remember this chart. One of the ways the Fed can help during times of economic crisis is to lower interest rates, if the interest rates go any lower, we will be in negative territory which will be the first time in US history to see something of that nature.
Graph 6
Effective Federal Funds Rate from April 2007 to April 2020.
https://fred.stlouisfed.org/series/FEDFUNDS
Back to the original question of this section, is now the time to buy? I would say no. I’ve already showed that I don’t see interest rates going anywhere in the near future, but I also see a big question mark when it comes to the value of the underlying assets. Last week, Wells Fargo announced that it stopped applications for home equity lines of credit because of the uncertainty. We do not know how hard real estate prices have been impacted by the Covid-19 financial fallout, but I do think we will see a dip in many real estate markets around the US.
Risk Vs. Uncertainty
I think it’s important to point out that in the business world there is a major difference between risk and uncertainty. Risk can be measured by the probability of an adverse outcome; uncertainty cannot be measured. In times of uncertainty, we are left to strategize the most extreme scenarios, as we are doing right now.
Closing Thoughts
We are currently living in uncertain times. There are several moving parts, politically, economically, but most of all medically. We don’t know if the phased re-opening of states will lead to a second wave, or if it will work out. We don’t know if a vaccine will be available in the near future. We don’t know how this will all financially impact us. We’ve never lived through a time like this and don’t really know how to navigate these waters. One can always hope for the best, but prepare for the worst; that’s how I live my life at least. I hope you look forward to my next blog post in 2 weeks! Stay safe and healthy!