- The Oil Price Plunge and Emerging Markets Impact
- Russian Roulette?
- Global Impact
- Investment Implications
- Important Legal Information
- What Are the Risks?
- Why an ‘oil shock’ sent the Dow down 2,000 points and upended global financial markets
- What happened to oil?
- Why is falling oil a problem for stocks?
- Falling yields about more than a flight to safety
- Bad news for corporate debt, emerging market bonds
- Dollar, commodity currencies sink
The Oil Price Plunge and Emerging Markets Impact
The collapse in OPEC+1 negotiations over the weekend of March 7 and Saudi Arabia’s subsequent, aggressive undercutting of its official selling prices signals a break from four years of cohesion and co-ordination in oil strategy.
Once again, Saudi Arabia has effectively abandoned its role as swing producer, sparking a price war which has the potential to inflict major costs if sustained for a prolonged period. This compounded the impact on oil markets of slowing demand amid a dip in global economic growth due to the spreading coronavirus.
The result was a March 9 plunge in oil prices—the largest one-day oil price decline since the 1991 Gulf war.
Saudi Arabia’s foreign reserves of over US$500 billion (73% of gross domestic product [GDP]) and significant further debt-raising capacity (given debt-to-GDP of merely 25%) means the country has enough financial capacity to withstand oil prices in the US$30-$40 per barrel (bbl) range for several quarters.2
In our view, Russia ly has the greater ability to sustain lower oil prices, having substantially raised reserves in recent years, with US$436 billion in foreign exchange (see chart below) and zero net public debt, while conservative budget assumptions were made regarding both the oil price and exchange rate. However, the added geopolitical dimension to Russia’s behavior, involving retaliation against recently imposed US sanctions and more generally countering the rising market share of shale, adds to uncertainty.
Saudi Arabia and Russia compete at the very bottom of the cost curve in terms of lifting costs (i.e., from existing wells) as well as full-cycle costs (which capture all costs of production).
However, at current production levels, Saudi Arabia’s fiscal breakeven oil price stands at US$83/bbl, which is roughly double the US$42/bbl of Russia (see chart below).
Moreover, Saudi domestic political sensitivity to economic stress is much higher than that of Russia given the importance of public project spending and welfare provision, suggesting this move is a high-stakes gamble by the Saudis.
The Gulf Corporation Council (GCC) countries will ly be most impacted, which, according to the International Monetary Fund, require an oil price varying between US$45-$100/bbl for fiscal breakeven points.3 In Africa, Nigeria appears to be at greatest risk of currency devaluation in this environment.
In Latin America, Pemex, the state-owned oil producer in Mexico, has considerable debt and employee obligations, which will be difficult to service. However, the Mexican government has low leverage and therefore any intervention should be manageable, in our view.
In Brazil, while the market reaction has been extreme, government reform efforts across the economy, including a specific focus on the oil industry in terms of privatizing assets and deleveraging, should mitigate some of the negative impact.
We believe Asia is of greatest significance, where most countries are net oil and gas importers (except Malaysia where the budget, growth and currency will come under pressure).
For giants such as India and China, lower oil prices will considerably support current accounts and currencies while easing inflationary pressures, enabling supportive monetary policy.
In addition, lower energy costs act as a direct stimulus to consumers and most businesses.
Outside of emerging markets, costs in the US shale industry are on average higher than current oil prices, while funding from credit markets had already been weakening.
While US shale has proven resilient in the past, the current oil price collapse may result in more mergers and buyouts by majors, in turn driving a greater focus on cash returns to shareholders rather than production growth.
This dynamic will ly impact all high-cost producers: offshore and projects in Brazil, the Gulf of Mexico, the North Sea as well as oil sands in Canada.
We view prolonged lower oil prices, driven by extended demand weakness and continued oversupply, as a tail risk. We expect global oil prices to hover around US$30/bbl in the second and third quarters of this year, but believe they will ly move back up toward US$40-$50/bbl by year-end, and thereafter could normalize in the US$50-$60/bbl range.
The negative near-term impact upon energy companies, as well as the secondary effect on economic growth in oil-exporting countries, could be considerable.
That said, the oil price crash in the last decade resulted in a sustained period of company (and fiscal) deleveraging, paired with improved cost control as well as encouraging greater caution towards the sector; our holdings are limited to companies we consider top tier, often with lower oil price beta.
Of these companies, in Russia, for example, a company we favor benefits from a strong balance sheet and generous dividend policy, reflective of considerably improved corporate governance in recent years— we estimate a resilient free cash flow yield of 6% at US$30/bbl oil.
We also have positive views on upstream players in China and Thailand, where when conservatively factoring in a prolonged scenario of US$30/$30/$55/bbl oil in 2020/2021/2022 onwards, we find that intrinsic value exceeds current share prices.
These are, in our view, high-quality and efficient players, able to breakeven or be profitable in a US$30/bbl scenario, with defensive balance sheets or earnings from natural gas production supporting continuity of dividends.
In the Middle East, during 2016-2018, Saudi Arabia was able to successfully implement meaningful reforms, including the removal of certain subsidies, the introduction of taxation and increased costs on businesses. A return to these measures across the region would be a risk for our predominantly domestically orientated exposures.
Overall, however, the vast majority of emerging markets, whether measured by population, GDP or market capitalization, will benefit from the oil price collapse despite the near-term negative market reaction.
In an environment of slowing economic growth due to the coronavirus, lower oil prices represent a substantial additional stimulus to the broader asset class, particularly within Asia. Our portfolios are predominantly positioned in domestic-orientated consumer and technology businesses, plus world-leading semiconductor manufacturers—all of which stand to see benefits from lower energy costs.
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Important Legal Information
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What Are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors.
To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
1. OPEC+ is an alliance of oil producers, including members and non-members of the Organization of the Petroleum Exporting Countries.
2. Sources: International Monetary Fund, Bloomberg.
3. The Gulf Cooperation Council is an alliance between six Middle Eastern countries: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE). There is no assurance that any projection, estimate or forecast will be realized.
Why an ‘oil shock’ sent the Dow down 2,000 points and upended global financial markets
Oil prices plunged Monday as Saudi Arabia and Russia prepared for a global price war, triggering a world-wide equity rout that saw the Dow Jones Industrial Average drop more than 2,000 points at its low, as shock waves traveled through financial markets already shaken by the spread of the coronavirus.
While falling crude prices, which mean lower gasoline prices for consumers, sound they could be a balm during a period of economic stress, analysts and investors said the combination of sharply declining oil prices combined with existing fears over the economic implications of the coronavirus only heightened uncertainty and fear.
“The coronavirus presents investors with an unprecedented global problem. Investors are uncertain about the nature of the virus, its potential economic impact and the policy response. The oil shock has only added to this confusion and uncertainty,” said Paul O’Connor, head of the multiasset team at Janus Henderson Investors, in a note.
“One thing we do know, however, is that markets are now in panic mode,” he said.
Read:OPEC price war one of the three worst things that could hit virus-wracked markets: JPMorgan
Here’s a deeper look at what’s happening and some of the ways the crude-price fall is rippling through the financial system.
What happened to oil?
Oil futures fell sharply, with the U.S. benchmark, April West Texas Intermediate crude CL.1, +4.08%, falling 24.6% to end at $31.13 a barrel. May Brent UK:BRNK20, the global benchmark, dropped 24.1% to settle at $34.36 a barrel. Both grades traded at their lowest levels since early 2016 and suffered their biggest one-day percentage drops since the 1991 Gulf War.
Read:Investors brace for a race to the bottom, as an all-out oil price war erupts between Saudi Arabia and Russia
Why is falling oil a problem for stocks?
U.S. stocks plunged at the opening bell, with trading briefly halted as a 7% intraday slide for the S&P SPX, +0.69% triggered a so-called circuit breaker.
Stocks remained sharply lower throughout the session, with the Dow Jones Industrial Average DJIA, +0.59% dropping 2,013.76 points, or 7.8%. The S&P 500 tumbled 7.6%.
Major indexes ended the day near the threshold that would mark the start of a bear market.
See: Stocks will enter a bear market if the Dow and S&P 500 close below these levels
Oil accounts for more than 3% of the S&P 500, and banks are also exposed to the sector via loans. Meanwhile, pressure on yields tied to the collapse in oil prices is also bad news for financial stocks, analysts said.
The breakdown in oil prices also adds to fears of a global recession. And, with the U.S. now a net exporter and the world’s largest oil producer, falls in price, while offering some benefit to consumers, aren’t an unalloyed positive and may even be a net drag, economists have argued.
“Markets are trying to force a policy response — from central banks and from Washington, D.C. A basket of more aggressive monetary-policy action is coming, and how markets respond is the big question. The market will get something resembling ‘zero bound’ very soon, but that is not ly to be effective,” said David Bahnsen, chief investment officer at the Bahnsen Group, in a note.
Falling yields about more than a flight to safety
Investors flooded into havens, including government debt, sending the yield on the 10-year Treasury note TMUBMUSD10Y, 1.676% to an all-time low, finishing around 20.8 basis points lower at 0.501%, as the entire U.S. yield curve traded below 1%.
But the drop in yields, which move in the opposite direction of price, isn’t just about the flight to safety. The plunge in oil prices also takes the wind inflation expectations, adding to pressure on yields.
“The knock-on effects will slash inflation outlooks globally — the U.S. 5-year/year forward break-even rate is now plumbing the subdued inflation levels at the height of the 2008 financial crisis,” said Charles Hepworth, investment director at GAM Investments, in a note, referring to a market measure of expectations for future inflation.
Bad news for corporate debt, emerging market bonds
In addition to being bad news for energy stocks, pressure on oil prices promises pain on the credit front for leveraged companies. That adds to stresses in corporate debt that were already being amplified by the coronavirus outbreak, analysts said.
Check out:Cracks are forming in corporate bonds as coronavirus slams Wall Street
Nicholas Colas, co-founder of DataTrek Research, on Monday noted that energy has a much higher weighting in high-yield indexes used by exchange-traded funds iShares iBoxx $ High Yield Corporate Bond ETF HYG, +0.12% (10.3%) and the SPDR Bloomberg Barclays High Yield Bond ETF JNK, +0.21% (11.1%) than the S&P 500 at 3.4% and the Russell 2000 RUT, -0.17% at 2.1%.
Also see:Here’s why cratering oil prices and the coronavirus outbreak will ripple beyond the U.S. junk-bond market
The HYG fund fell 4.3% on Monday, while the JNK ETF dropped 4.7%.
Oil-exporting emerging-market countries also faced stress, putting pressure on their government bonds.
“The oil shock has jolted the hitherto-resilient markets for high-yield debt and emerging-market bonds,” said O’Connor. “The risk now is that investor redemptions will accelerate at a time when market liquidity is already under pressure.”
He argued, however, that the scale of the repricing was so rapid today that some value was beginning to emerge.
The iShares JPMorgan USD Emerging Market Bond ETF EMB, -0.14% plunged more than 8%, while the Van Eck Vectors JPMorgan EM Local Currency Bond ETF EMLC, +0.05% was down 5.1%.
Dollar, commodity currencies sink
The U.S. dollar wasn’t acting much a haven, with the ICE U.S. Dollar Index DXY, +0.25% down 0.9% at 95.09. The Japanese yen USDJPY, +0.44%, meanwhile, soared, asserting its role as a traditional safety play. The U.S. currency dropped 2.8% versus the yen to trade at ¥102.37, the strongest level for the Japanese unit since September 2016.
Currencies of oil-exporting countries were set to see weakness.
“Oil is a significant driver of GDP in Mexico, Norway, Canada, Russia, Brazil and Colombia, and, of course, the U.S. is the world’s biggest oil producer in absolute terms now,” said Kit Juckes, global macro strategist at Société Générale, in a note.
“None of those countries’ currencies is going to have a good day, though the dollar does still derive support from its reserve-currency status,” he said.