Investors have reacted with some alarm to the steep drop in oil prices this year, with futures contract prices briefly falling below zero before rebounding to low double digits. We look at the drivers of activity and oil’s connection to equity and fixed-income allocations.
A perfect storm
Demand for oil has dropped considerably due to the coronavirus-driven economic contraction. The U.S. Energy Information Agency (EIA) forecasts “significant decreases in U.S. liquid fuels demand during the first half of 2020 as a result of COVID-19 travel restrictions and significant disruptions to business and economic activity.” The EIA expects that the largest impact will occur in the second quarter of 2020 before gradually dissipating over the course of the next 18 months.¹
The supply side of the equation isn’t helping the situation. Production actually increased in March and early April, despite the economic slowdown; at their March 6 meeting, Saudi Arabia and Russia failed to agree to extend production cuts beyond those that expired on March 31, and instead engaged in a brief price war that flooded the market with supply. Cooler heads eventually prevailed, and OPEC+ subsequently agreed to the largest production cut ever negotiated—slashing 9.7 million barrels a day in May and June—but even that agreement fell short of what markets were hoping for, given the dramatic pullback in demand. Futures prices briefly went negative in thin market trading due to the fact that holders of futures contracts are obligated to take physical delivery of oil once trading ends. The supply/demand imbalance has stretched storage capacity to the limit—unlike other commodities, oil can’t be recycled or put back in the ground—and it’s possible the world could run out of oil storage space in a matter of months.²
The amount of supply available suggests that there will need to be a drawdown in inventories before new production can be used, and while there were hopes of broader production cuts from OPEC+, enforcement of even the agreed-on cuts will be difficult. With demand down meaningfully, the typical cooperation of major producers to stem production has become less influential on the market.
Energy has a small weight in major equity indexes
The collapse in energy is relevant for equity market investors, but only to a certain extent. Sectors with a greater connection to oil prices, such as industrials (think shipping and rails) and financials (think loans to energy companies) could come under pressure as prices fall; however, the influence of the energy sector on the broad market has diminished considerably since oil prices peaked in 2008. In fact, energy accounted for just under 3% of the S&P 500 Index at the end of March, with over 50% of the sector made up of just two stocks—Exxon and Chevron—so equity diversification is key.³ Beyond headline risk, it’s unlikely that oil, in isolation, will be a significant driver of broad stock market activity. Equities likely have other elements that are more important drivers, such as the massive fiscal and monetary stimulus, which will act as counterforces to the current economic contraction.
Fixed income is where it can get tricky
For fixed-income investors, oil fluctuations can have varying degrees of impact depending on your allocations. U.S. Treasuries, mortgages, and other high-quality bonds tend to act as diversifiers from oil prices and have exhibited a negative correlation over the past three years. In other words, as oil prices fall, high-quality bonds can benefit (one key reason for this is that a lower oil price can be deflationary, a beneficial condition for high-quality bonds). Credit, including bank loans and high-yield corporate bonds, tends to be much more sensitive to oil prices, the primary reason being that energy companies have tapped the debt markets for capital, and these indexes have greater exposure to those businesses than other asset classes. Given that bonds are typically used to balance equity risk, prudent investors may wish to evaluate the composition of their fixed-income holdings to ensure they’re not overexposed to oil. Note that ESG strategies have had a natural advantage here.
Where do we go from here?
In our view, oil prices have likely overshot on the downside in the near term; the perfect storm of unprecedented demand destruction caused by COVID-19 along with oversupply driven by a lack of cooperation between OPEC+ nations should be temporary. Demand should increase modestly from current levels by the end of 2020, as the worst of the COVID-19 crisis passes and economies reopen. We’re also likely to see more production cuts, as companies can’t profitably produce oil at these price levels. A number of U.S. and Canadian oil producers have already announced production cuts, and more are expected to detail cuts alongside earnings results in the coming weeks.⁴
While we do expect a higher price point equilibrium by the end of the year, we foresee a very challenging path for oil and the energy sector before getting there. Demand will remain muted as the global economy slowly opens back up, while production cuts may have only a modest impact on prices, depending on enforcement. Ultimately, we believe there are better opportunities to deploy capital today. As described in our Q2 Market Intelligence outlook, those include relatively cheap parts of the market (based on low P/E ratios) that are more diversified across sectors, such as mid-cap U.S. equities.
1 “Short-Term Energy Outlook,” U.S. Energy Information Administration, April 7, 2020. 2 “Oil Glut May Overwhelm Global Storage Tanks Within Weeks,” Bloomberg, April 15, 2020. 3 FactSet, as of March 31, 2020. 4 “Half of announced North American oil cuts come from just three companies,” Reuters, April 17, 2020.