Market views: How should instos react to an oil price war?
The decision by the world’s biggest oil exporter, Saudi Arabia, to offer big discounts to the fossil fuel’s selling price on Saturday (March 7) caused the Brent crude oil benchmark to fall by 24% on Monday (March 9) – one of the largest drops in history. At one point, the price of US oil slid by as much as 34% to $27.34 a barrel.
The surprise move by Saudi Arabia followed Russia – which is not a member of the OPEC [Organization of the Petroleum Exporting Countries] – refusing to heed the organisation’s proposal to cut production as the coronavirus continues to crimp global demand.
The dissolution of the alliance between the two nations to stablise oil prices and subsequent standoff may jolt the oil market further. Saudi Arabia has since pledged to ramp up crude supply to 12.3 million barrels a day in April, more than 2 million barrels higher than the amount it had previously been producing.
The impact of the dispute between the oil-rich nations is likely to be felt across the industry. Shale oil producers in the US, for example, could struggle to compete with crude oil prices around the $30 mark.
In addition, the ramifications of cheaper and more plentiful oil is likely to have broader market impacts. AsianInvestor asked eight experts to provide their views on the short- and medium-term consequences, and how long the standoff might last.
The following extracts have been edited for brevity and clarity.
Jitipol Puksamatanan, head of market strategy
SCB Securities
From investor’s point of view, I do not think we should rush to buy or sell any directional assets base on these collapse in oil prices because markets’ narratives can change quickly [due to] many uncertain things such as the development of corona virus and policy responses. However, I think there is an opportunity in products that receive a benefit of short-term rising in oil prices’ volatility, such as structured notes that can short volatility for a huge premium.
In medium-term, I still believe the upside for oil prices are limited but the downside could be massive if western economies like US and Europe enter into a technical recession.
Asian fuel importers’ currencies, such as Japanese yen, Indian rupee, Korean won and Singapore dollar, will obviously be my top picks from this fallout. Yet, we should remember that the root causes of these dramatic oil price movements do not come only from a political issue but a sharp slowdown in global growth. Thus, I still expect to see defensive assets, i.e. investment grade credits and low-beta stocks, to outperform high yield and cyclical stocks this year.
David Chao, global market strategist, Asia Pacific (ex-Japan)
Invesco
I am concerned about the fallout from the recent oil production spat between Saudi Arabia and Russia – as this can easily boil into another black swan event for 2020. That being said, I don’t see a resolution any time soon since this production disagreement seems to be more about politics than economics.
The collapse in energy prices is pressuring the highly levered energy sector, many of which rely on the high-yield bond market and the US banking system for their financing.
In the near term, the fallout from crude oil prices is causing credit and interbank lending spreads to widen. More specifically, credit spreads have widened out to over 500 basis points (bp), a noticeable move but to a level still below that of 2016 and 2018.
Longer term, we estimate that spreads would likely need to widen over 600bp over a sustained period in order to lead to a meaningful contraction in credit growth and economic activity. There are optimistic signs though – policy makers are responding with overwhelming force to support the economy and market liquidity. We continue to expect market fluctuation as investors look for signs that the number of Covid-19 coronavirus casualties has peaked.
In this volatile period, we expect a continued flight to quality and safe-haven assets. Bargain opportunities are emerging though – US equities per the Fed model are as cheap to bonds as they have been at any point in this market cycle, with around 95% of the S&P 500 companies having a dividend greater than the 10-year US Treasury rate.
Wilson Au, senior market specialist
HSBC Global Asset Management
There will be winners and losers from this oil price shock, both at the country and sector level. But on balance we see this supply-driven fall in oil prices as providing some support to the global economy. Lower oil prices provide further room for policy easing by global central banks – a key reason why, in our view, maintaining a moderate pro risk investment strategy still makes sense, based on current valuations.
Recent market moves have made relative valuations even more favourable for risky asset classes. However, we believe there is still a strong case for a more cautious near-term view and believe investors should focus on greater selectivity in risk assets. The greater potential for policy stimulus in the US, China and many emerging markets means it makes sense to allocate a higher weight to the latter and US equities relative to the eurozone and Japan. Investors should also diversify, including alternative asset classes, as a way to build up portfolio resilience.
Asian policymakers have greater flexibility in policy support and in some instances have acted preemptively to counter the potential economic fallout. Asian credit is faring quite well, although high yield credit is experiencing extreme spread widening across the world.
The renminbi fixed income market is also performing well as the currency has rallied in response to improvement in the situation in mainland China. Similarly, Chinese equities have been a bright spot, outperforming US and regional benchmarks.
Ricky Tang, deputy head of multi-asset product for North Asia
Schroders
In times of market volatility, investors should ensure their portfolios have the right mix and enough protection via diversifying assets such as duration and Japanese yen, or more explicit hedges like put options. That is more effective than selling your exposures at a distressed price.
PineBridge Investments, Hong Kong
In oil markets, a perfect storm of actions resulted in lower oil prices. First was the lower growth expectations in 2020 as the global business cycle ages, second was the supply and demand shock from the coronavirus outbreak that dampened the overall growth trajectory, and third was the collapse in Opec/Russia talks amidst an already well-supplied global environment.
From a fundamental perspective, the most recent action exacerbates an already volatile market, especially for some US energy companies.
With the spread of the coronavirus seemingly going “east to west” and a higher likely hood of lower oil prices for longer, we are starting to view at some Asian assets, particularly China A-shares and Korean equities, as attractive. We’re particularly encouraged by the severe containment measures taken by the Chinese government as well their comprehensive fiscal package, which may be amplified in the coming weeks.
The slower rate of confirmed cases, smattering of daily indicators, and bottoms-up reporting showing signs of normalisation as positive signals. Lower for longer oil prices should also aid China’s growth, since it deflates some of inflationary pressure and allows the People’s Bank of China to maintain a dovish bias. A similar story can be said for Korea.
We also starting to favor copper, which should recover along with Chinese manufacturing since the country represents around 50% of global copper demand. At the same time, there has been virtually no supply growth for the past several years.
Lale Akoner, market strategist
BNY Mellon Investment Management
After Monday’s largest one-day oil price drop since 1991 Gulf War, Tuesday’s improved overall market sentiment has so far led to minor recovery in oil prices. In our view, the short-term market volatility aside, the fundamental drivers for both the demand side and supply side imply downward pressure on oil prices until at least the second half of the year.
This is due to our view that global demand will follow a V-shaped trajectory in 2020. In our view, China, essentially the world’s biggest factory and world’s largest oil importer, will likely encounter a deep economic contraction in the first quarter and second quarter (and a strong recovery during the second half of the year) with rest of the world following suit in the second quarter (albeit less severe slowdown compared to China, the epicentre of the virus).
This implies subdued global oil demand until the second half and a contraction on a year-over-year basis. On the supply side, it remains to be seen what price level will be able to bring back Russia and Saudi Arabia to the table and put a halt to the price war between the two parties.
Tai Hui, Asia chief market strategist
JP Morgan Asset Management
Lower energy prices are problematic for energy companies and commodity-exporting emerging markets, but some could potentially benefit.
For instance, the transportation sector could see lower fuel costs, although their concerns right now would be on lower load factors as air travel continues to be undermined by the outbreak. Consumers could also see higher disposable income if their fuel costs drop, but the outbreak may weaken demand if people stay at home. Energy-importing markets with persistent current account deficits, such as India, could also see a smaller import bill and lower current account deficit.
Lower energy prices also imply lower inflationary pressure, offering more room for central banks to ease monetary policy – not that they need any encouragement, with aggressive rate cuts coming from the Federal Reserve and the Bank of Canada last week.
It is important to recognize that the sell-off in equities and rally in fixed income has already begun rebalancing portfolios. As such, investors need to think about portfolios as having three parts: protection, income, and risk.
Protection can come via cash and US Treasuries, although with the current rate backdrop, high quality fixed income no longer offers real income. So investors should also embrace core real assets like real estate and infrastructure, which provide credit-like yields and low correlation with equities. Finally, investors still need risk assets – within equities and lower-rated credit, we would focus on companies with healthy margins and minimal leverage.
Maurice Meijers, managing director – fixed income investment
Robeco
The oil markets were already facing a demand shock due to the coronavirus but have sunk deeper after Saudi Arabia slashed its official prices by the most in at least 20 years and signalled it would increase output.
The global spread of the coronavirus has forced policymakers and investors to reassess their outlook. To counter the fresh downside risks, central banks have started a new wave of easing. Meanwhile, in an environment with zero or negative interest rates, fixed income investors need to invest in credits to generate positive returns.
While it is always difficult to call the bottom in credit markets, we think that at current valuations it is worth considering increasing allocations. Credit markets have repriced by 70% to 90% year to date, and our credit team sees several parts of the market now look attractive.
The team’s use of sustainable development goal (SDG) screening for some of our strategies has also helped mitigate the negative impact from the poor performance of the energy sector, as those strategies are not expected to have a high allocation to the energy sector due to its negative SDG profile. These demonstrated the importance of one’s investing philosophy, especially in a volatile market.
Article updated to add JP Morgan Asset Management and Robeco contributions.