Wealth Management: Strategy blog – Oil and troubled waters

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Strategy team - Victor Balfour (Wealth Management)

On 3 January, US-Iran tensions pushed oil prices up nearly a tenth over a three-day period to $71/bbl (Brent). Today, however, they are languishing at $54/bbl, down almost a fifth since the start of the year.

Oil prices are often volatile. It is the single largest component of global trade, a vital input and the principal fuel for transportation. Moreover, it can be also be an investment asset: its price reflects not just user supply and demand, but speculation too.

Supply-side changes have driven most of the dramatic moves historically: demand usually grows reasonably steadily, and is met by variable OPEC and US shale output. This time, however, faltering demand may be playing the dominant role.

The disruption associated with the Wuhan virus seems set to hit demand hard, if temporarily, and has prompted an emergency meeting of OPEC+, which is still mulling whether to implement an output cut (following a 1.7m bpd cut in December), in a bid to stabilise prices. 

China is the largest marginal buyer of oil by some way (oil imports rose to an all-time high of 10.5m bpd last year - for context, global oil consumption in 2019 was c.95m bpd). The viral outbreak has significantly curtailed China's short-term demand for fuels: flights have been cancelled, road traffic volumes are down as much as 80% and refineries are fast approaching capacity limits for refined fuels. This challenging environment has prompted local oil demand to fall by a quarter, equivalent to 3% of global oil demand.

Arguably, this might be something of a silver lining to this otherwise traumatic crisis. Generally, lower oil prices transfer spending power from producers to oil consumers. Oil users typically spend more of their income, so the net result - after some delay - might be some support for consumer spending (albeit muted by a hit to corporate profits: there are more big oil producers in the main stock market indices than oil users).

Less constructively, perhaps, it leaves the global energy sector, which has underperformed the wider stock market for most of the past decade, looking even cheaper than it already did. The sector faces major structural headwinds, of course, and we have not yet been tempted to recommend investing in it. 

Nor are we thrilled by the impact on bonds. Lower breakeven inflation rates, which correlate closely with the oil price, and that near-term disruption, have prompted bond prices to rally. But even though yields had risen a little since the autumn lows, bond markets had still looked expensive to us, and now look even more so. 

Policy is unlikely to change. Central banks often see such oil-related economic effects as transitory (many of them focus on underlying or 'core' rates of inflation, for example) and seem unlikely to warrant any further easing of policy.

Overall, we suspect the lower oil price may help - with a lag - to offset the disruption caused by the virus, which may not last long anyway. We still remain constructive on the global growth outlook, and risk assets, this year. But we remain in no hurry to buy into the oil sector - or government bonds.




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