Crude oil has gained more than 26 per cent since the start of 2018 yet the broad Bloomberg Commodity Index has fallen around 1 per cent
Divergence between oil and commodities markets warrants investors' attention
Brent crude oil is trading close to a four-year high, at around $84 per barrel, while commodity markets are more widely experiencing their longest losing streak in more than three years.
This dispersion between commodity returns is wide and needs investors’ attention in portfolios in a strong dollar environment and rising US interest rates. While crude oil has gained more than 26 per cent since the start of 2018, the broad Bloomberg Commodity Index has fallen around 1 per cent over the same period.
The current oil price is explicable in classic supply/demand terms. Global oil supply is around 100 million barrels per day (bpd) and with inventories close to normal levels, the market’s fear of shortages plus a series of disruptions have triggered higher prices. Opec is reluctant to risk over-supplying the market, and says it has spare capacity of another 2 million bpd. Still, Saudi Arabia says it is now producing 10.7 million bpd, close to the historic highs of the 1970s, so the additional capacity is at best only around 2 per cent of worldwide demand. While Russia, too, says it is prepared to meet any shortages once the US sanctions come into effect on Iran next month, no new decisions are expected from Opec (plus Russia) before a December 6 meeting. This means that any new supply shortages will certainly raise prices further in the short run.
The administration of US President Donald Trump has consistently complained that oil prices are too high and called for higher supply. Russia’s President Vladimir Putin responded on October 3 that if Mr Trump wanted to identify “who’s guilty that prices are growing you should just have a look in the mirror,” citing the US interventions in Iran, Venezuela and Libya.
Geopolitical point-scoring aside, the biggest supply challenge has been the Trump administration’s sanctions on Iran. While scheduled to take effect on November 4, the impact of US sanctions is already visible. Foreign companies have stopped doing business with the country rather than risk US penalties, and China and India have also decided to cut imports from Iran. The country’s production fell from 3.8 million bpd in June to 3.36 million bpd last month and, if periods of previous US/European sanctions are a guide, production could fall to 2.6 million bpd.
Venezuela’s exports are complicated by storage problems and recently damaged dock facilities that are slow to repair because of an economic recession and hyperinflation. The country’s output has already declined by 0.7 million bpd to around 1.2 million bpd over the past 12 months and while that is unlikely to reverse, we assume production will stabilise around current levels. Libya, which before the 2011 civil war produced about 1.6 million bpd, is now averaging 1 million bpd.
Even the US, which the Energy Information Administration now estimates is possibly the largest crude oil producer in the world, is suffering from temporary pipeline bottlenecks that may contribute to higher prices over the rest of the year.
Consistently higher oil prices threaten to begin to undermine demand across all regions. Nevertheless, this trend particularly affects oil-importing counties, with several emerging countries among the hardest hit, such as China, India and Turkey, whose currencies have depreciated with an appreciating dollar, thereby increasing the real cost of oil further. Meanwhile, this rising trend in the price of oil has a positive impact on net-exporting economies, such as Russia.
In the light of all these tensions, we are working with three possible scenarios shown below with our calculations for their respective probabilities:
1 Our base scenario for the three-month and 12-month outlook is for oil at $75 per barrel. We give this scenario a 70 per cent probability. Over the 12-month horizon, we see falling Iranian exports and the slow erosion in Venezuelan output compensated by Opec plus Russia, although their reactions will inevitably lag. Bottlenecks in the US pipeline should be lifted by mid-2019, triggering a re-acceleration in production growth. Demand growth remains unchanged. In this case, the backwardation of the oil futures curve (futures prices below spot prices) offers a carry of between 7 to 8 per cent per year.
2 We think there is a case for oil reaching $100 per barrel, with odds of about 25 per cent. This bullish scenario needs a new catalyst in addition to the US/Iran sanctions. That may come from escalating tensions between the US and Middle East after the Congressional mid-term elections next month and if any shortfall is not filled by Opec plus Russia.
3. Lastly, we think there is a bearish scenario with a 5 per cent likelihood that prices fall back to around $60 per barrel. On the supply side, this implies unchanged production with growth in global demand slowing, primarily driven by emerging economies’ currency weaknesses.
Turning to a wider commodity space, we see some upside ahead in base metals. More growth in the segment will be driven by China’s return to the market as the country implements a domestic stimulus plan as well as an extremely bearish investor positioning. And while many investors still think of gold as an inflation hedge, its usefulness in a portfolio is limited by rising US yields which themselves are the result of a return to a quite normal pace of inflation.
As the US economy slows in the late economic cycle conditions, we expect inflation to rise in 2019. Until now, breakeven inflation rates have been rather stable despite the high oil prices, import tariffs, fiscal stimulus and a tight labour market. Last week strong US macroeconomic data led to interest rate re-pricing, pushing nominal and real yields to multi-year highs. Most of this re-pricing was in real rates, meaning that real yields now exceed 1 per cent for most maturities. As price pressures rise over the next few months, we expect inflation-protected securities to benefit from the rise in the inflation risk premium. We therefore believe this is the right time to allocate cash into inflation-linked securities.
Based on our base case for oil, we believe exposure in portfolios remains justified, given the positive carry implied by the current backwardation of the futures curve and oil’s hedging benefits with respect to heightened geopolitical tensions.
Stephane Monier is head of investments (Private Bank) at Bank Lombard Odier