3 Lessons from sub-zero oil prices

Oil prices have been falling since the Covid-19 outbreak, as global lockdowns restrained economic activity and oil demand. Efforts to reduce output and support prices have had limited impact thus far. The demand reduction due to Covid-19 is estimated at 30m bpd, and the proposed supply cuts most recently agreed between OPEC+ (including Russia) amounted to 20m bpd, failing to resolve the excess supply situation.

While a demand-supply imbalance in oil exists, Monday’s plunge in the futures price was more a reflection of US domestic conditions. The May contract expired on 21st April, and given the limited storage capacity in the US, many holders sold the contract to avoid having to take physical delivery. The price of the June contract, while it has also fallen, is still positive. Further we note that the sharpest falls in the oil price futures in the last 2 weeks have been in the shorter maturity contracts, as holders were unable or unwilling to take delivery of oil.

In contrast, the fall in the price of Brent Crude, the European equivalent of WTI was less severe as it is not facing the same storage constraints as in the US. Brent Crude is largely a seaborne crude so there is the opportunity to ship it to other higher-demand destinations.

Finding out about the facts beyond the headlines can help investors keep a cool head and not over react, especially in these uncertain times. In this instance, while the price action in oil is likely to dampen investor sentiment in the short term, we do not anticipate this situation to last for a sustained period. Lower oil prices should act as an effective consumption tax cut in oil consuming countries such as the US, Europe and most of Asia, and eventually aid the recovery.

With oil and gas credits making up 12% of the US high yield benchmark², US high yield bonds have been hurt by the sharp fall in oil prices. Asian high yield bonds however have not been spared, despite oil and gas credits making up less than 2% of the total Asian USD high yield credit market³. Given the significantly lower oil exposure, the direct impact of the fall in oil prices on the overall Asian high yield bond market is expected to be manageable.

Asia as a net energy importing region typically benefits from lower oil prices. While this round of lower oil prices may not lift discretionary spending like it did in the past given the current lockdowns on social activities in many countries, a lower oil import bill can still boost state coffers, giving some governments the fiscal ammunition, they need to blunt the economic impact of the outbreak.

Understanding the real impact of market dynamics, in this case of lower oil prices, can sometimes reveal investment opportunities. The indiscriminate sell-off in Asian high yield bonds as a result of falling oil prices and more recently, overly pessimistic default fears potentially presents attractive entry points for long term investors.

The recent development in the WTI futures market may lead Saudi Arabia and other oil producers in the recently brokered OPEC deal to bring forward the production cuts that were originally planned for June. President Trump is also keen to open the federally controlled strategic petroleum reserve to store excess oil, although this needs to be approved by Congress. These measures, together with a proposal to pay shale operators to keep their oil below ground can help the oil market find a bottom. Many US shale operators remain reluctant to stop output given the high costs of restarting operations. Further supply cuts can therefore help the oil market achieve stability. At the point of writing, both the WTI and Brent Crude oil futures curves are in contango (oil price is higher in the future than they are in the present), reflecting expectations that the demand-supply imbalance will eventually ease.

Likewise, we believe that the fiscal and monetary firepower which have been put in place will help equity and credit markets find a bottom. We remain watchful, monitoring the valuation and technical indicators that have guided us well, investing when we believe we can access value.