OPEC nations and Russia met this past weekend to agree a freeze on oil output and get the supply glut under control, but the meeting failed to reach a consensus – contrary to market hopes. Disappointment quickly translated into tumbling oil prices – but was this failed meeting the final death blow for oil? We think not!
Speculation on an imminent agreement contributed to oil prices rising in recent weeks, which is why the failed negotiations have created further uncertainty on oil prices in the short term. But while we are by no means optimists with respect to oil prices reaching and being sustained at around, say, USD 70 a barrel, nor do we expect the no-deal to send oil prices spiralling downwards again. Remember there were many factors involved in the oil-price collapse earlier in the year.
Oil prices hit their lows in January and February, with the global benchmarks Brent and WTI bottoming out at USD 26-27 a barrel. Much has been written about the current disparity between supply and demand, which we view as the main reason for prices collapsing from more than USD 100 a barrel. US shale oil output is a major factor here, though other issues were also at play earlier in the year. Huge uncertainty on China and the emerging markets put a question mark against structural demand growth for oil in the coming years. Fears of a new US recession were also plaguing the market, while many fretted over how future losses on US corporate bonds would affect financial stability in general.
Economic outlook more positive
Now, less than three months later, Chinese growth has picked up, the US economy is continuing its robust expansion and we have greater clarity on corporate bond losses.
Starting with the last point first, the default rate on low-rated corporate bond issues (traditionally termed high yield) has risen steeply from close to 2% to around 5% at present. However, more than half of these defaults stem from oil- and commodity-related companies, which is two to three times their share of the broader market. Default rates in the vast majority of other sectors remain very low. And while we estimate that the credit quality of US high-yield bond issues has deteriorated substantially since 2009/2010 and expect a significantly higher default rate in this segment going forward than in the past five years, we still see no real sign of a major credit crisis. Our main argument here is that both the US and the European bank systems are now in much better shape – via improved capital and liquidity resources – to withstand periods of stress in the financial markets.
As regards the US recovery, we expect more of the same. Housing market strength, a healthy bank system and growing investment will support robust job creation and rising wage growth – which should be enough to ensure economic growth of more than 2% in the coming quarters.
In China, the authorities have successfully stabilised both overall economic growth and its storm-tossed currency (CNY) – and we expect this stability will continue for some time yet.
Finally, US oil production, in particular, is now showing signs of a more pronounced fall on the back of dramatic cutbacks in both investment and manpower. This should ensure we do not descend into further chaos in the form of collapsing oil prices.
Why we expect no major price increases
However, we are still pessimistic about the longer term. Our key points from earlier – and the scenario we invest in – are still intact. Oil prices are in a new regime of greater volatility around a structurally lower level. We do not expect to see sustained oil prices of much above USD 50 a barrel in the coming years, mainly due to the following factors:
On the supply side, we would highlight that US companies have proved to be surprisingly flexible. They have swiftly and significantly cut costs and hence made themselves more competitive. If prices rise – due to an OPEC deal or geopolitical events, for example – US oil companies are likely to quickly ramp up production again. Likewise there are currently many oil wells in the US that have been drilled but do not yet pump oil – in the expectation (or hope) that prices will rise again. That puts a lid on how much oil prices can increase in the coming quarters.
Iran, meanwhile, has so far surprised most observers by sharply increasing production – a development that also appears to have been the main reason behind Saudi Arabia’s unwillingness to agree a deal at the weekend. The Saudis want Iran included in any agreement to ensure Iran does not win large market shares.
Finally, from a demand perspective we remain sceptical on emerging market growth, not least in China. While the Chinese authorities have secured growth in the short term, it has been via short-term stimulants, such as reduced down-payment requirements for homebuyers. The economy cannot be stimulated forever, so growth will likely slow again at some point and create renewed uncertainty on long-term demand.
We would stress that we are not attempting to predict whether the oil price will be USD 45 in one quarter and USD 37 in another. Instead, we are trying to paint a scenario that could support our assessment of the environment the various asset classes move in, not least equities and corporate bonds. Hence, in the short term our message is that we do not expect further sharp falls in the price of oil – and therefore we do not expect oil will have the same repercussions for other asset classes as it had earlier in the year.