Oil’s well that ends well
Even though tensions in the Middle East have helped pep up prices of late, the shale revolution has brought down medium-term risks to oil prices and dramatically reduced future price expectations.
While many financial assets have struggled somewhat in the first few months of 2018, oil has continued to ooze higher. Yet we believe that the long-term outlook for the commodity may be less glistening than this move implies.
Mounting tensions in the Middle East appear to be the main short-term driver of the rally, in which Brent crude has hit its highest price since 2014, even as equity investors have fretted over monetary policy, trade wars and an unpredictable inhabitant of the White House.
The US looks set to withdraw from the nuclear deal with Iran by May, a move that could result in the re-imposition of sanctions on the Islamic Republic – a major OPEC producer. There is also some talk that the cartel will extend its supply cuts into 2019 and that Saudi Arabia is looking for prices to rise above $80.
At the same time, global demand for the commodity remains strong and Venezuelan production has slumped over the past half year, in part due to a separate set of US sanctions.
As we’ve outlined in a number of previous blogs, it’s tough to gain a genuine edge predicting political outcomes. But we can take a view on the risks they pose, and position accordingly.
We have been long US energy stocks versus the S&P 500 index for about a year, as a diversifying position in our multi-asset portfolios informed by our long-term views on the outlook for oil.
Interestingly, the Brent futures market suggests that the oil price will decline over the medium term, with the curve showing spot prices significantly higher than those for delivery in the coming years.
This structure, referred to as backwardation, indicates prices will settle at around $55-60 per barrel in the early part of the next decade – implying about a 20% decline in oil prices over this period, or a 30% drop in real terms.
These forward prices look too low to us, partly due to the risk of production shortages beyond 2020 (see our analysis on the subject here). But we do share the market’s concerns about the sustainability of spot prices. As a result, while we retain our position in energy stocks against the index, we have reduced it somewhat.
Moreover, we can all take some comfort in the fact that the market does not appear to be pricing in a shock like that seen in 1973 or 1990 – involving a precipitous drop in crude output – reflecting in part that OPEC and Russia are currently limiting production and so have the ability to step in if there are disruptions in individual countries. Reduced risks of an oil price spike help mitigate recessionary risks through to 2020 at least, providing welcome positive news for economies and investors.