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Oil prices remain under pressure from rising supply. What is the likely effect of a bearish outlook for oil on global duration and credit?
Despite a synchronised uptick in global economic growth and robust demand, commodity prices—and in particular crude oil—have been held down by persistent oversupply. While attempts by the Organization of the Petroleum Exporting Countries (OPEC) to cut production have helped reduce crude oil inventories, production continues to increase elsewhere—most notably in the US. Growing US shale output, for example, almost matches global demand growth, leaving any OPEC exit strategy difficult. Several factors contribute to the growth in shale production: improved efficiencies, cost reductions, higher cashflows and better access to financing. Furthermore, cost reductions and efficiency improvements are not restricted to US shale. Other parts of the oil market, including ultra-deepwater drilling, have also seen costs fall significantly. This leads to lower breakeven prices and further limits upward price potential. Beyond the obvious pressures to the fiscal balance sheets of oil-producing sovereign entities, this bearish oil outlook also limits the potential for a meaningful pick-up in inflation in the US, Europe and Japan.
Given this bearish scenario, oil prices are likely to remain range-bound near current levels (USD 40 – USD 55), with higher risks to the downside. US shale output and the degree to which OPEC members comply with their current production cut agreements will be key factors to monitor. Nevertheless, many parts of the fixed income universe traditionally linked to oil, such as emerging market debt (EMD) and US high yield, continue to perform well as investors remain focused on underlying positive global growth dynamics. The disinflationary impulse from oil is contributing to broader global inflation weakness, adding to other disinflationary factors, such as low quality of jobs created, increased global competition, and the mis-measurement of real output and price declines in the information technology sector. As a result, global duration remains well-bid, with US 10-year yields, for example, declining over 40 basis points since mid-March.
Stability in commodities is favourable for US Spreads
Given the backdrop of a synchronised recovery in global growth and still-accommodative global financial conditions, weak commodity prices and a more bearish outlook bias have failed to deter investor flows into risk assets. Flows into EMD remain strong for example, with net flows of over USD 24 billion into the asset class so far this year recorded by our Quantitative Research team’s flow monitor.
The dynamics underpinning weak price performance in oil markets are supply driven, and in no way reflect a dampening of global activity. Global growth conditions remain robust, underpinning the demand for risk assets, such as EMD and US high yield. With oil prices likely to remain range-bound, and biased to drift lower, the ongoing lack of inflation should continue to see duration supported.
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