Asset management research. Oil market dynamics. Global Asset Views Thematic Edition

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1 Asset management research Oil market dynamics Global Asset Views Thematic Edition

2 2 Oil market dynamics and their potential impact on asset classes and economies

3 Formulating our global asset views Assessing the economic and market environment is a key part of UBS Global Asset Management s investment strategysetting process across all investment areas. Our Cyclical Market Forum (CMF), open to representatives of all investment teams, regularly debates important economic and market themes and their potential impact on our investment strategies. The CMF s purpose is to examine the main economic and market drivers typically through scenario analysis over a 12- to 18-month time horizon and to foster debate between the teams managing different asset classes. The way in which the output from the CMF is used varies across UBS Global Asset Management s investment teams, and it is just one of a number of inputs into each team s investment process. One of the key benefits of the Cyclical Market Forum is the opportunity to exchange research and viewpoints from the various investment specialists and to examine the intersection between top-down and bottom-up drivers. As such, it broadens the input into our strategy-setting process in a structured format. Building upon the success of the CMF, we recently held our inaugural theme-specific CMF focusing on recent dynamics within oil markets and their potential impact on asset classes and regions. The debate was intense and wide-ranging. In this publication, we expand on the discussion from the Oil CMF and provide our outlook on the implications for asset classes. Curt Custard Head of Global Investment Solutions Chair of the Cyclical Market Forum UBS Global Asset Management March

4 Expectations for the price of oil The collapse in the price of oil from the second half of 2014 now sees major crude indices trading at levels not seen since the Great Financial Crisis six years ago. Rising global supply of oil has been a key culprit, but lower demand may have played a role as well. Saudi Arabia, which traditionally played the role of the Central Bank of Oil by modulating supply to balance the market, in November declared that it had abdicated this responsibility to the market itself. Since then, markets have been searching for the price level which brings supply and demand into balance. So what should we expect from oil prices going forward over both the short and medium term? Short term Rising oil inventories point to an oversupply in oil markets. The size of the oversupply, however, is not certain. In February, the International Energy Agency (IEA) put the oversupply in H at approximately 1.6 million barrels per day (mb/d), or about 1.7% of global supply. A number of prominent analysts believe this number is overstated, pointing to more robust demand than the IEA factors into its early estimates. Either way, inventories continue to climb, particularly in the US. As storage becomes more scarce and storage costs rise, there could be more downward pressure on prices as the oil that cannot be stored must find a buyer. The market can be brought into balance in two ways: through changes in quantity or changes in price. Quantity could be corrected if global growth accelerates rapidly, but it is more likely that any correction in quantity could come through supply. Firstly, Saudi Arabia, as the world s lowest cost and highest capacity oil producer, could reinstate itself as the Central Bank of Oil, but there is no sign that it is ready to do so just yet. As Saudi Oil Minister Ali al-naimi said, If I reduce, what happens to my market share? The price will go up and the Russians, the Brazilians, US shale oil producers will take my share. But it is not just a matter of these non-opec oil producers: Saudi Arabia may be exerting pressure on other OPEC nations that are producing too much. A short period of painful prices would bring discipline to the cartel driving prices higher if enacted. If OPEC does not restrict supply, it is unlikely that any other producers will. The oil market is left to operate like any other non-cartel commodity market, and prices will continue to move to bring demand in line with supply. Recent forecasts from OPEC, the IEA, and the US Energy Information Administration (EIA) all anticipate the market coming back towards balance in the second half of The IEA in February predicted demand to climb by 2 mb/d over the course of the year as growth recovers. By comparison, supply is forecast to increase by only 0.8 mb/d over the same period. This should correct most but not all of the overcapacity. Capital expenditure is being reduced extensively. Rig counts in the US are down by a third since November and the IEA has forecast US supply to increase by less than a fifth of the rate it grew at over the last three years. The issue here, though, is that US shale (and other forms of tight oil) isn t like traditional inelastic oil supply it is very price sensitive and reacts quickly. Efficiency gains in drilling speeds, mobility of capital equipment and scalability have fundamentally changed the flexibility of this type of production. This flexibility is likely to cap prices in the short run. The political vulnerability of oil supply will also remain crucial, where shocks could send oil prices sharply higher. Libya, Iran, Iraq, Venezuela, Russia, Nigeria and many other countries face non-negligible political risks. Ultimately, prices below USD 50 per barrel are likely to be unsustainable. That said, the length of time it would take natural market forces to restore prices to materially higher levels goes beyond the short term. Medium term The key to determining oil prices in the medium term is forecasting oil demand growth. Oil is an intermediate product: consumers do not demand oil in itself, but rather the benefits it brings: transport, heating, electricity, etc. Supply is likely to respond to demand, with producers more likely to invest in extra capacity when demand is expected to grow. By forecasting demand growth, the number of additional barrels of oil supply required can be estimated. Analysing the additional number of barrels relative to both 2

5 capacity and cost of production of various producers offers insight into the longer-term expected price. Under a strong demand case (an additional 5 mb/d or more by 2020), the smaller flexible producers will not be able to keep pace. Extra supply will be needed from the inelastic, capex-heavy producers and this takes time. Supply is therefore likely to fall short, and thus USD 85+ prices are required. Under a weaker demand case (an additional 2.5 mb/d by 2020), output from the capex-heavy oil projects is not required and thus shale would remain the swing producer. This would leave supply sufficiently elastic and mean that price is likely to converge on the production average breakeven price for US shale around USD 65 per barrel. Demand growth is not only about GDP growth, but also about oil intensity the quantity of oil required to generate additional units of GDP. A drop in oil intensity could lead to lower oil prices for longer. This could come from more focus on increasing efficiency gains and increasing substitution of oil for other storable sources of energy. In much the same way as it revolutionised demand for oil over 100 years ago, the car holds the key today. Over half of global oil demand is used for transport. Environmental concerns are driving both legislation (in the US and Europe) and consumer preferences (in Asia) towards electric vehicles, the use of alternative fuels (such as cellulosic ethanol) and improved fuel efficiency. Forecasts suggest that cars manufactured in 2020 could be 22% more fuel efficient than those manufactured today. The result would be structurally lower demand for oil going forward. Equally, there are a number of different scenarios that could lead us to expect a stronger oil price response over the medium term. New large-scale, capital-intensive supply projects are being scaled back or postponed in response to lower prices. Non-OPEC supply growth outside of the US, Canada and Brazil has been largely flat over the last few years despite oil prices of around USD 100 per barrel. In a world of considerably lower oil prices the scope for less exploitation of existing wells and less drilling of new wells is substantial. For example, costly deepwater projects in places such as Brazil and Mexico won t come into consideration at all. Reduced investment is also likely amongst some OPEC countries as well, such as Venezuela and Nigeria, because of fiscal obligations and social unrest. The net impact of lower oil prices today could be lower oil supply two or three years from now. But if oil demand growth is reignited by stronger economic growth, then the global economy may need these missing barrels. Consider the amount of upstream activity that has to take place before traditional oil reaches end users: geological analysis; drilling of exploratory wells; appraising the commercial potential and viability of a well; drilling and completion of the well; and finally storage and transportation infrastructure to bring the oil to market. US shale would be able to expand quickly but not by a sufficient amount and we could enter a period where OPEC has to operate at near capacity. This scenario would be extremely bullish for oil prices. The scenario whereby there is a time lag between demand and supply decisions can be neatly explained through the Cobweb Model (see Price Adjustment: The Cobweb Model). Price Adjustment: The Cobweb Model Think of farmers growing soybeans: if soybean prices are low this year, next year the farmers will probably plant something else (for example, corn) hoping to make more money. As a result, soybeans will likely be more expensive next year as too few farmers planted them and too many planted corn. As a result, the price will tend to oscillate instead of stabilizing to its equilibrium level. This is called the cobweb model because price and quantity will hover around the equilibrium price and draw something akin to a spider web. The same is true for energy, as firms have to first explore, then drill wells and only then they can produce oil or natural gas. Therefore, if many companies stop harvesting wells this year due to low prices, then next year a number of wells will be depleted and production will be lower thus pushing prices up. 3

6 Even if Saudi Arabia does not reinstate itself as the Central Bank of Oil over the short term, it could easily do so over the medium term. It is important to note the distinction between the breakeven cost of production (the oil price above which production is profitable, around USD 20 per barrel for Saudi Arabia) and the fiscal breakeven price of oil (the oil price at which the government budget is in balance). Even though Saudi Arabia can produce oil cheaply, its spending plans are predicated on a far higher oil price. The fiscal breakeven for Saudi Arabia is probably around USD 85 per barrel; anything less will force the government to run down reserves or reduce expenditure. There is limited scope for spending cuts: sharp cuts in domestic expenditure increase risks of political instability. Saudi Arabia already has the third largest defence budget in the world, and with regional instability increasing it will be loath to cut back. In the short term, Saudi Arabia can withstand lower oil prices for longer than many others by dipping into its foreign reserves, but its net wealth will still be drained rapidly. At USD 60 per barrel its net wealth would hit uncomfortable levels within a few years. Saudi Arabia is therefore likely to return to profit maximisation through price (by restricting supply) after no more than two years. The current scenario can be neatly explained through the Stackelberg Oligopoly (see Competition with a large incumbent: Stackelberg Oligopoly) whereby Saudi Arabia dictates price and market participants compete on quantity. Competition with a Large Incumbent: Stackelberg Oligopoly Suppose that there are two firms dominating the market for donuts in a city. If one firm is bigger, it can be the leader. If the leader wants to pursue market share, it will set a price trying to maximize its profits and increase market share. The follower will only choose the quantity it produces, as the leader can enforce price discipline. It turns out that in equilibrium the leader s chosen output is a positive function of the follower s marginal cost and a negative function of the leader s own cost. This is called Stackelberg oligopoly from the name of the German economist who first studied it. In practice, the leader in oil production is Saudi Arabia. A price of USD85/bbl is expected to balance the Saudi government budget and therefore is indicated as the leader s medium term price. Several analysts suggest that Saudi Arabia wants to keep its market share and therefore will let prices go down. As a result, some high-cost competitors such as Canadian tar sands will have to exit the market. In addition, some high-cost entrants such as Brazilian deep water will not enter the market given that demand is expected to grow at a moderate pace. The political result is that countries needing high energy prices to balance their budgets such as Venezuela, Russia and Algeria may find themselves in a high-risk situation as long as Saudi Arabia wants to pursue profit maximization via market share rather than by increasing prices. 4

7 Winners and losers The key question for investors is who stands to benefit and who stands to lose out as a result of changing oil dynamics? For oil consumers a drop in oil prices should offer a significant boost to GDP, acting akin to a tax cut. The boost will come firstly through net exports, because the trade balance improves, and secondly through consumption if consumers decide to spend (rather than save) the extra disposable income. While many investors may have entered the market last year on the expectation of a boost to growth, some may now be losing patience. Consumers have saved rather than spent their oil dividend, perhaps because it is seen as temporary. The longer oil prices remain low (or at least significantly lower than the prior norm), the more likely they will be to spend what will be seen as a permanent gain. There are early signs of this, such as recent increases in spending on restaurants. For oil producing economies, the impact is obviously negative. A producer can react in several ways. They can attempt to compensate for lower income by producing more, but this will exacerbate global oversupply. They can let their currency depreciate against the USD, which will increase their local currency revenues at the expense of making imports more expensive. Or they can take the hit and cut spending drastically. In estimating the relative gains and losses, economists tend to look at the impact through macroeconomic models. The impact primarily depends upon the interplay of numerous factors: oil production; oil consumption; oil imports and exports; marginal propensities to consume or invest; and second round effects on trading partners. Within many economies there will also be individual winners and losers. Estimates from UBS Investment Bank based on the Oxford Economic Forecasting Model show the modelled impact on GDP below after one year. Note that many members of OPEC are not separately identified in this model. Chart 1: Effect on real GDP relative to baseline after a 50% drop in oil prices (USD 95 to 47) Philippines Thailand South Africa Chile Hungary Hong Kong Turkey Slovakia India South Korea Singapore China Mexico Brazil UK France Germany Italy Belgium US Portugal Spain Ireland Indonesia Austria Finland Switzerland Japan Sweden Malaysia Norway Russia Source: OEF, UBS Investment Bank 5

8 The most apparent winners are those who import a lot of oil relative to the size of the economy. Countries like Japan, India, Philippines and South Korea that are highly dependent on energy imports are the biggest winners. For the most part these are also countries with substantial, liquid markets that are easily accessible by investors. Despite the impediment to the shale industry, the US is still a net energy consumer so ends up being a clear winner from lower oil prices. The benefit to the Eurozone is estimated at over half a percent of extra GDP. Russia stands out as a clear loser in the same model with almost a quarter of the country s GDP derived from oil and gas. For oil producers like Russia, price and production volume are both relevant as revenues comprise a large part of government revenues. It is important to bear in mind that wider analysis of any economy is required to appraise its asset markets as an investment. Consider Turkey, seemingly a huge beneficiary of a lower oil price but with many other issues to deal with, not least of which being that a large amount of its private sector debt is denominated in US dollars. The strong US dollar, arguably linked to the oil story, is one potential shift in the world economy that can cause a large offsetting negative impact. Translating the global impact into equity performance over the medium term, a lower oil price should prove supportive for firms earnings, but the effect is far from homogeneous. Energy is clearly the most negatively affected sector, but the effects are much more widespread. UBS Investment Bank has published a detailed assessment of the impact on non-oil value chains. For example, lower-income consumer stocks should win over luxury stocks as the percentage impact on spending activity is amplified in this space. Luxury is adversely affected by a reduction in revenues amongst rich oil producers. Interestingly, solar energy is hardly affected if oil prices are at USD 60 per barrel as solar mainly competes with gas. Within industrials there are strong winners and losers dependent on the sectors to which they provide services. Financials tend to outperform, benefitting from greater credit card activity, a positive GDP impact and consumer credit growth. From a regional equity perspective, the US winners and losers look likely to offset each other due to the strength of the USD and a higher oil component compared to some other indices. Examining European equities after two previous oil supply shocks (1986 and 1996) reveals that earnings-per-share and price-earnings ratios have tended to expand in the wake of the shock. Couple this with quantitative easing from the ECB and the overall impact can be concluded as positive. A change in oil prices is essentially a redistribution. The winners benefit at the expense of the losers. Extra money in the pocket of US consumers means less money in the pocket of OPEC exporters. This change in flows has impacts for currencies but also for asset flows. Many oil exporters peg their currencies against the USD by recirculating much of the USD-denominated oil revenues back into the global economy. Many also put money into sovereign wealth funds, money which they may now have to dip into to fund their new budget deficits. Sovereign wealth funds have grown in size and significance to global markets over the last few years and now total approximately USD 18 trillion across asset classes. A large part, but not all, of that funding comes from the petrodollar flows out of oil exporters. A lower oil price will reduce the amount of US dollars earned through oil exports. Analysis by the Institute of International Finance estimates that net USD 226 billion less petrodollars will be invested this year, albeit in light of the magnitude of central bank quantitative easing programmes, it is likely that markets won t notice their absence. For oil-producing economies, the fiscal impact of changes in the oil price can be huge. Depending on the size of their budget commitments and their cost of production, each country has a fiscal breakeven price of oil: the oil price which allows the government budget to break even (chart 2). When the oil price is higher, there will be surplus; when lower a deficit. 6

9 Chart 2: Fiscal breakeven price of oil (USD) Price in USD that balances the budget assuming unchanged levels of expenditure, 2015 Norway Kuwait Turkmenistan Qatar Iraq United Arab Emirates Kazakhstan Saudi Arabia Azerbaijan Oman Bahrain Iran, I.R. of Russia Nigeria Algeria Angola Libya Mexico Yemen Colombia Source: IMF The vast majority of nations require a materially higher oil price than the current level. Middle East countries face the largest hits to their budgets, with most moving from surplus to deficit at an oil price of around USD 50 per barrel. Norway is the only country with a breakeven significantly below that level. So how can these countries address the shortfall? There are a number of options: running down foreign currency reserves; cutting government expenditure; raising taxes; increasing oil production; cutting production (for a large producer to affect global prices); issuing more debt; or currency devaluation. In reality, not every country has all these options for example, most cannot increase oil production further. And only Saudi Arabia really has the option to unilaterally cut production to push up the oil price. Whichever option is chosen, it could prove problematic, putting a number of these governments under increased scrutiny, particularly in light of the Arab Spring. Our expectation is that the majority will chose to run down foreign currency reserves in the expectation that the low price is largely temporary. Indeed, the impact of the oil price on nations creditworthiness is likely to have an asymmetric impact, with net importers experiencing negligible improvements in the cost of financing while net exporters stand to suffer more on account of increasing risk aversion manifest through credit spread widening. 7

10 Many investors gain exposure to the opportunities within some of the oil producers via emerging market credit default swaps (EM CDS). Oil producers constitute around 70% of this basket. Venezuela, for example, represents 8% of an EM CDS benchmark investment. Although the fiscal breakeven is not available (due to insufficient data), it is clear that Venezuela faces some of the most difficult of choices given current oil prices. It can probably only last one more year without significant reform and the threat of default remains particularly high. Venezuela is not alone; other major producers, in particular Algeria and Nigeria, will face similar issues if prices remain low. It is not just the price level that matters, but the length of time for which prices stay at the low level. Lower oil prices in the short term are clearly deflationary. But inflation is a year on year metric and a low price now creates a low base in one year s time, making the impact transitory. The conventional wisdom is therefore that central banks should look through low inflation and not react through monetary policy. While this may be the case for the US Federal Reserve, the complication for the European Central Bank is that broader deflationary forces are already present. Inflation expectations are important for future inflation and central banks need these expectations to remain anchored. A strong downward movement in expectations could induce a deflationary spiral through delayed expenditure on account of perceived lower future costs. This explains the variety of responses central banks may take to lower oil prices. The net result if the US Federal Reserve stays on course for hikes is a stronger US dollar which in turn, has implications for asset classes as considered previously. Should the oil price stay low for the next few years, with shale remaining the marginal barrel of oil, widely diverging paths will be experienced by economies. Countries such as India could enjoy a huge tailwind while others such as Venezuela could face a stark choice between reform and default. That said, if low prices and the elasticity of shale cause inelastic new supply to be abandoned whilst demand picks up, then the world could face a shortage and a very different oil price later in the decade. We believe that the price at which oil trades over the next 18 months and crucially, the length of time it stays at these levels will be a major determinant of asset markets. While we have shared our view on the asset classes, sectors and economies which potentially stand to gain and lose from lower prices (summarised in the table below), taking time to consider the first and second order effects on asset prices will help investors understand what risks different potential scenarios pose to their portfolios. 8

11 Winners and losers from lower oil Losers from low oil price Winners from low oil price Equities Energy LatAm USA Mining Japan Eurozone North Asia Cons. St. Cons. Disc. Fixed Income EMD CDX US High Yield JACI INR Currencies RUB CAD MXN USD A change in oil prices is essentially a redistribution. Net oil importers like the US, Japan, Eurozone and North Asia benefit from lower oil prices, which is beneficial to their equity markets. The same is true for some of the countries in Latin America, but the impact on Brazil, Venezuela and Mexico as oil exporters more than offsets that. Consumer discretionary equities benefit on account of consumers having more disposable income to spend while consumer staples benefit on account of falling input costs related to oil. Many investors typically think of energy and mining together. The drop in oil price obviously hinders energy however the lower price reduces operating costs for energy-intensive mining. Although non-energy US high yield is likely to benefit in the same way that consumer discretionary stocks benefit, the emergence of the US shale industry has made energy a very important part of the index. As a result, US high yield has suffered on account of lower oil. Emerging Market Debt (EMD) is composed of a number of oil producer nations whose financing costs have risen on account of concerns around their creditworthiness in light of falling oil revenues. JACI (J.P. Morgan Asia Credit Index) is composed of a number of lower quality Asian oil importing economies. They represent the other side of the fiscal transfer that negatively impacts emerging market debt JACI stands to benefit. The Russian rouble (RUB), the Canadian dollar (CAD) and the Mexican dollar (MXN) have suffered on account of the impact of falling oil revenues on current account balances. The Indian rupee (INR) has benefitted as lower oil reduces its current account, trade, and fiscal deficits while also reducing the cost of fuel subsidies, allowing the government to reform energy policy. A lower oil price in itself can spur on oil demand both globally and in the US. This in turn can bolster economic growth. Given that oil is priced in US dollars (USD), this benefits USD. 9

12 The views expressed are as of March 2015 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for any errors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. Asset allocation, diversification and rebalancing strategies do not insure gains nor guarantee against loss. The use of leverage, shorting, and derivative strategies may accelerate the velocity of the potential losses. The use of currency strategies involves additional risks. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered forward-looking statements. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Management s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. Services to US clients for any strategy herein are provided by UBS Global Asset Management (Americas) Inc. which is registered as an investment adviser with the US Securities and Exchange Commission under the Investment Advisers Act of UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved A

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