What does the latest oil price collapse mean for investors?
We started this week with more market volatility, this time originating from the oil market. Brent crude fell from USD 46 per barrel (pb) to USD 31.7pb in the morning of March 9 on the back of news that Saudi Arabia will increase production to over 10 million barrels per day in April. This represents around 10% of global supply and is up from 9.7 million barrels previously. Saudi Arabia will also offer as much as a 20% discount for buyers. More importantly, this move has broken the Organization of the Petroleum Exporting Countries’ (OPEC’s) cooperation with Russia in recent years to support energy prices by limiting output, and has triggered fears of an oil price war. As a result of the drop in energy prices, Asian equities started March 9 with another round of significant correction of around 3-5% in the morning. 10-year U.S. Treasury yields fell to below 0.5%.
Oil prices have already been under pressure due to demand growth concerns from the outbreak of COVID-19 in Europe and the U.S. This surprise break in the cooperation between OPEC and Russia simply added a supply side dimension to this pressure. The current level of USD 30-40pb would imply an operational loss for many high-cost producers around the world, which would eventually reduce supply. This would ultimately bring prices back towards a more sustainable level, which we believe would be around USD 50-60pb in the medium term. Nonetheless, the shock could cause the market to remain risk-averse in the near term.
In terms of the economic impact, lower energy prices are problematic for energy companies and commodity-exporting emerging markets. There are those who could potentially benefit from lower energy prices. For instance, the transportation sector could see lower fuel costs, although their concerns right now would be on lower load factors as air travel continues to be undermined by the outbreak. Consumers could also see higher disposable income if their fuel costs are cheaper. Again, the outbreak may weaken demand if people are staying at home. Energy-importing markets with persistent current account deficits, such as India, could also see a smaller import bill, leading to a smaller current account deficit.
Lower energy prices also imply lower inflationary pressure and this would provide more room for central banks to ease monetary policy, not that global central banks need more encouragement to do this, with aggressive rate cuts coming from the Federal Reserve and the Bank of Canada last week to protect their economies from weaker growth.
EXHIBIT 1: Global high yield energy spread to worst and Brent crude oil
Source: Commodity Research Bureau, FactSet, J.P. Morgan Economic Research, J.P. Morgan Asset Management. Global high yield energy spread to worst based on J.P. Morgan Global High Yield Index energy sector spread. Past performance is not a reliable indicator of current and future results.
Data reflect most recently available as of 09/03/20.
Investment implications
The latest market action has pushed energy prices to a level that is unlikely to be sustainable in the medium to long term. High-cost energy producing countries and companies will need to cut back production and this would restore balance between demand and supply.
Nonetheless, we are likely to see equities in the energy sector remain under pressure as their earnings are impacted by both demand and supply concerns. In Asia, energy companies are trading at around 9.3x 12-month forward price-to-earnings, only slightly below the 10-year average of 10.6x, reflecting the ongoing downward revision in earnings. Globally, the energy sector is trading at 12.2x 12-month forward price-to-earnings, versus the 10-year median of 13.5x. Hence, they are trading at a discount, but could still be vulnerable if the earnings outlook goes through more downward revision.
This is also likely to be reflected in the U.S. high yield corporate bond market, where energy companies make up over 10% of the index and their corporate credit spreads are very sensitive to energy prices. This sector has already underperformed in the past two months and the latest development can depress sentiment further. As Exhibit 1 shows, suppressed oil prices are likely to widen credit spreads more as investors become increasingly worried about rise in defaults in this sector.
With risk aversion reinforced by the latest event in the energy market, we believe investors should remain defensive. Given 10-year UST yields are at just 0.5%, the search for yield is likely to continue. Fixed income with negative or low correlation against equities, but still offering income, would include high quality U.S. and European corporate bonds, asset-backed securities and emerging market sovereign debt.
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