The Collapse of Oil Price: Threat or Chance?
February 2016
PE
RS
PE
CT
Key Insights
՚ The decline in oil prices is, in our view, mainly a consequence of a supply shock, but the lack
of strength in global growth and the transition of China toward a more mature economic model has clearly contributed to widen the gap between supply and demand.
՚ If, as we believe, there will be a stabilization of supply/demand dynamics and the scenario
of slowdown, but no hard landing, for China holds, we see oil prices gradually returning to 45-50 USD per barrel by the end of 2017.
՚ With this outlook for oil, the global economic outlook remains moderately positive. The main
implication is lower inflation expectations, which will likely trigger a new wave of monetary policy intervention.
՚ In terms of winners and losers, we see a neutral impact on the US economy, with the benefit of
higher disposable income almost counterbalanced by lower investments, and a slightly positive effect on the Eurozone. On Emerging Markets, lower oil prices (and lower commodity prices generally) increase the dichotomy between exporters and the importers who are enjoying the oil “dividend”.
՚ Financial markets have framed the slide in oil prices more as a demand-side shock (with negative effects), than a supply side shock. Since the beginning of the year, the correlation1of all assets with oil has increased substantially and equity markets have traded very closely with oil prices.
՚ We believe that the recent market selloff has generated price dislocations that could offer interesting opportunities for investors. Yields have been pushed well above the 10 year average2on the riskier segments of the credit market (particularly in US High Yield where the
energy component weighting is about 10%). Markets are incorporating an “Armageddon” outlook for the energy sector, which is not likely in our view.
՚ A re-rating of inflation expectations has hit inflation-related assets (i.e., bond linkers), and now discounts a very negative outlook. We believe that the market is underestimating the inflation pressures that could come from wage growth (in the US), and therefore we believe that opportunities may open up in the linkers segment.
The prolonged slide in oil prices to early 2000s levels has in our view profound implications for the economic outlook and financial markets. In this piece, we try to answer some of the key questions that the oil weakness has raised, with a specific focus on investment consequences.
1. What Forces are Driving Oil?
In order to assess the effects of oil price swings, we believe it is important to first look at the forces behind them. In a simplified world, we could say that an oil price decline driven by excess supply should be positive for economic growth as
1The degree of association between two or more variables; in finance, it is the degree to which assets or asset class
prices have moved in relation to one another. Correlation is expressed by a correlation coefficient that ranges from -1 (never move together) through 0 (absolutely independent) to 1 (always move together).
2Source: Bloomberg, data as of February 22, 2016.
Monica Defend
Head of Global Asset Allocation Research
Edited by
Giuseppina Marinotti
Financial Communication Specialist
Claudia Bertino
Head of Financial Communication Team
The potential positive
effect of an oil supply
shock is not
straightforward: it
depends on its length and
depth.
Other Contributors
disposable income rises and, consequently, demand for consumption and
investment increases. Headline inflation would temporarily drop but core inflation would stay resilient. As the base effect of lower oil prices is absorbed, headline inflation should revert to pre-shock levels.
However, even in the case of a supply shock, grey areas would emerge. If, for example, the shock is prolonged or repeated, inflation expectations would tend to incorporate the decline in oil prices. As price and wage settings are a function of inflation expectations, we could see a negative impact on core inflation as well. Investment decisions and growth would be negatively affected.
An oil price slump driven by globally weaker demand would probably not be growth friendly – declines in net exports, lower investment and spiraling deflationary forces would put further pressure on growth.
In the current economic framework, we can identify the presence of both a supply shock (which seems to be dominant) and a demand slowdown behind the oil price decline.
With OPEC so far determined not to cut production and Iran pumping additional barrels into the market as sanctions have been lifted, there is more oil being supplied than the market can absorb. Added to this is the wave of production from the US energy revolution, which has lowered oil imports over the last decade.
U.S. Imports of Crude Oil and Petroleum Products (Thousand Barrels per Day)
Source: EIA, February 17, 2016.
Another factor to consider is not only the excess of oil supply but the prolonged excess of supply over time that poses problems with respect to physical storage, putting pressure on spot prices and the forward curve.
If demand shocks are not the main culprit of the oil price decline, in our opinion, the lack of strength in global growth has clearly contributed to widen the gap between supply and demand.
In particular, China’s slowdown has been one of the most important contributors to the weakness of oil (and commodities) prices. China’s evolving economic structure is moving towards domestic consumption and away from heavy manufacturing and exports, marking a structural change for future demand.
Such developments affect oil prices, but more so metal prices.
0 2000 4000 6000 8000 10000 12000 14000 16000 1 9 7 3 1 9 7 6 1 9 7 9 1 9 8 2 1 9 8 5 1 9 8 8 1 9 9 1 1 9 9 4 1 9 9 7 2 0 0 0 2 0 0 3 2 0 0 6 2 0 0 9 2 0 1 2 2 0 1 5 Th ou sa nd B ar re ls pe r D ay
Fears of an excessive
Chinese slowdown
weighed on the last leg of
the oil price correction.
In the current economic
framework, we can
identify the presence of
both a supply shock
(which seems to be
dominant) and a demand
slowdown behind the oil
price decline.
The fear of a stronger-than-expected deceleration of Chinese growth at the end of 2015 has led the most recent wave of oil declines, almost halving the price between the summer and the January lows.
China Rebalancing Weighting on Oil and Metal Commodities Prices
Source: Bloomberg, CEIC, Pioneer Investments, as of February 17, 2016.
Looking ahead, we see some stabilizing forces for oil prices coming with the gradual closing of the supply and demand gap in 2017 (a reduced pace of growth in oil supply mainly driven by non-OPEC producers and a gradual post-sanction return to full capacity by Iran) and draw on oil inventories in the second half of 20173.
World Liquid Fuel Production and Consumption Balance (Million Barrels per Day)
Source: EIA, February 16, 2015.
If our central case of China transitioning relatively smoothly and avoiding a hard landing materializes, we expect the demand for commodities to keep growing in 2016, albeit at a slower pace than in the past. Partly offsetting the Chinese slowdown, if US and European economies remain resilient, this could give some support to oil demand, and help to gradually reduce the overcapacity gap.
Note the outlook for the US is to reduce the amount of oil it supplies to the market. In this scenario we see the possibility of a rebound of oil towards 45/50 USD per barrel by the end of 2017.
0 5 10 15 20 0 100 200 300 400 500 In de x re ba se d at 1 0 0 Q 1 2 0 0 4 -1,5 -1,0 -0,5 0,0 0,5 1,0 1,5 2,0 2,5 3,0 82 84 86 88 90 92 94 96 98 100 M ln B ar re ls pe r da y M ln B ar re ls pe r da y
Oversupply (right axis) World production (left axis) World consumption (left axis)
If, as we believe, there will
be a stabilization of
supply/demand dynamics
and a slowdown, but no
hard landing, for China,
we see oil prices gradually
returning to $45-50 USD
per barrel by the end of
2017.
Chinese Secondary Sector (RS) Brent Price (LS, Rebased) Base Metal Index (LS, Rebased)
West Texas Intermediate (WTI) Crude Oil Price (dollars per barrel)
Source: Short-Term Energy Outlook, January 2016, Pioneer Investments. STEO means short term energy outlook.
2. Impact on Growth and Inflation?
If we include the above scenario for oil prices, our outlook for the global economy remains moderately positive. Although revised marginally down, our world trade forecasts (and implicitly our assessment of a recession probability) remain benign; we do not see a collapse in world trade following a sharp contraction in any major country, particularly in China.
In our opinion, the excess supply story had a substantial role in the oil correction, so we may expect some support on demand especially for consumption (this is already visible in countries with higher elasticity of consumption to disposable income).
Contribution to Global GDP Growth
Source: Bloomberg, IMF, Pioneer Investments, Thomson Reuters Datastream. Data as of February 22, 2016.
We believe economies that are increasingly relying on the service sectors (typically Developed Markets) rather than manufacturing or natural resources, and are less linked to commodity and oil prices, are generally more resilient to the downturn in commodity prices.
On the inflation side, lower oil and commodity prices have contributed to further lowering the inflation path. Inflation-related market indicators (inflation swap forward 5Y5Y) indicate that headline inflation is perceived as likely to stay low, which makes the central banks’ goal of keeping inflation expectations anchored quite challenging. However, it is worth noting that core inflation (which excludes energy and food) is gradually recovering, although more so in the US than in Europe. 0 20 40 60 80
Historical spot price STEO price forecast NYMEX futures price
-4 -2 0 2 4 6 %
BRIC Other EM EU (UK included) US Other DM
Global Growth with Forecasts
As a consequence of falling
oil prices, we have
marginally revised down
GDP forecasts and
inflation expectations.
Falling Inflation Expectations, Especially in Europe
Source: Bloomberg, Pioneer Investments, data as of February 16, 2016.
3. Who are the Winners and Losers in the Oil
Price Plunge?
Oil prices have declined about 50% since the summer of 2015. The immediate consequence of such a move is a wealth transfer from oil exporting countries to oil importers.
In theUS, the scenario in which oil prices are lower but do not follow a persistent downward spiral strengthens the case for a resilient Personal Consumption Expenditure as the main contributor for growth. In fact, we expect consumption to benefit from higher real disposable income (coming from mild wage increases and lower projected inflation rather than from further strong gains on the employment side). We expect some downside pressure on the outlook from Investments in energy related sectors and manufacturing sectors, and also via weak export performance. Stressing our forecasting model for a persistent 10 USD drop in oil prices (oil prices remaining around 30 USD/bl persistently over the next 8 quarters) would leave GDP growth almost unchanged, as the improved consumption growth would be offset by lower investments growth. On inflation, persistently low oil should drive a 0.4% YoY fall of headline CPI in both 2016 and 2017.
InEurope, the decline in oil prices is expected to bring further fuel to private consumption that was the main engine of Eurozone growth in 2015. We also expect a positive contribution to growth from investment, triggered by the lower oil price. While declining oil prices act as a drag on inflation in the Eurozone, the sensitivity of auto fuel prices (the one directly perceived by customers) to falling oil prices is probably overestimated. 1,2 1,4 1,6 1,8 2,0 2,2 2,4 2,6 2,8 3,0 3,2 %
US inflation swap forward 5Y 5Y EU inflation swap forward 5Y 5Y
The net impact on the US
economy of lower oil
prices should be neutral,
with the positive impact
on disposable income
offset by lower
Change in Brent Crude Oil Prices (Loc. Curr.) and Auto Fuel Prices
(Dec 2012 to Dec 2015)
Source: Pioneer Investments. Datastream data as of January 28, 2016.
If we engage in the same exercise for the US, an average 10 USD/bl move lower for oil prices than in our central case scenario for 2016 ceteris paribus would further impact inflation, by lowering our projections over 2016 by 0.2% YoY on average. GDP, Personal Consumption Expenditures and Gross Fixed Capital Formation should be impacted positively, in both 2016 and 2017, instead.
InJapan, the growth outlook is quite weak. However, GDP growth in 2016 should be driven more by internal demand components, such as consumption and investment, in contrast to the “poor quality” of growth seen in 2015, when 0.5% out of 0.7% of GDP yearly growth was contributed by Inventory accumulation.
Stressing the model for the 10 USD oil price decline, ceteris paribus, would lower GDP mainly because of the drop in investments, and would lower the inflation path. We continue to expect a mild positive trend going forward, but inflation will remain increasingly distant from the Central Bank's target of 2.0% YoY.
InEM, the first visible impact of the collapse in oil price has been a deterioration of the overall outlook: the not-so-rosy picture provided at the end of 2015 has weakened a bit further, exacerbating the dichotomy between commodities/oil exporters and net importers. The chart below gives a clearer picture of the countries enjoying the oil dividend and the countries suffering from depressed oil prices.
Oil Net Balance (Export – Import) on GDP
Source:Pioneer Investments. Morgan Stanley data as of December 31, 2015 -90% -80% -70% -60% -50% -40% -30% -20% -10%0% P ri ce C ha ng e (% )
Auto Fuel Change Crude change
-10,00% -5,00% 0,00% 5,00% 10,00% 15,00% Taiwan Thailand South Korea South Africa India Chile Hong Kong PhilippinesJapan Turkey Indonesia ChinaUS Australia Brazil MalaysiaMexico Colombia Russia
The Eurozone should
receive a net benefit from
persistently low oil prices.
Net Importers Net Exporters
We have identified two main themes relevant from the perspective of EM economies, inflation and fiscal balance:
• Inflation developments are mixed and reflect, on one side, weaker domestic demand and lower commodity prices and, on the other side, the effects of currency depreciation through imported inflation. Countries facing the risks of excessive currency depreciation and capital outflows may have limited scope for future monetary policy easing to boost the economies.
• Commodity exporters are facing a shortfall of revenues; the challenge for them is to adjust their economies to lower commodity revenues – improving fiscal efficiency, increasing revenues from different sources – without making drastic cuts in expenditure which could exacerbate the damage to their economies. It is worth adding that in addition to oil other commodity prices are at historical lows as well, making the group of countries expected to benefit from the oil collapse less crowded. From this perspective, other countries at risk are South Africa, Chile, Indonesia, Australia, Brazil and Malaysia.
4. What are the Investment Implications?
We have observed that financial markets have framed the slide in oil prices more as a demand-side shock (with negative effects), than a supply side shock. In recent weeks, correlations of all assets versus oil have increased substantially and equity markets have traded very closely with oil prices.
Correlation of US Equity and US 10 Y Treasury versus Oil
Source: Bloomberg, data as February 8th 2016. S&P500 index considered.
We believe that the market selloff has generated price dislocations that could offer interesting opportunities for investors.
It has pushed up yields in the riskier side of the credit market – i.e., US High Yield where the energy component weight is about 10% – well above the 10 year average, to levels that incorporate a very negative scenario for oil prices. This price action has also affected the EM universe, with bond yields reaching five year highs (Source: Bloomberg, February 17, 2016, JPM EMBI Global Blended Index).
-40% -20% 0% 20% 40% 60%
correlation equity vs oil correlation US yield vs oil
Financial markets
overreacted to the fall in
oil prices, reading it as a
demand-side shock.
US High Yield – Yield to Worst
4Source: Bloomberg, data as of February 16, 2016. Barclays US Corp. High Yield.
Indeed, the energy sector has been hard hit by the fall of oil prices and the default rate is expected to rise in 2016 from 3.4% in 2015 (Source: Fitch, January 26 2016) as many of the high-yield oil companies cannot operate profitably with oil below the 50 to 70 USD barrel range. However, we believe the market is now
discounting an extreme situation in terms of defaults: assuming that the oil price remains close to current levels over the next five years, which is not our main scenario. (Read also Outlook Update for US Asset Classes, January 2016) Additionally, the spillover effects on other sectors should remain contained. The energy sector now accounts for a small share of total US employment, after
declining consistently since the 80s, and the sector’s share of GDP is quite limited. If our macro scenario holds (oil price stabilization, China slowdown but no hard landing, very slow normalization of Fed policy and relative resilience of US economy) the recent selloff can provide opportunities to investors, especially in terms of income. We should, however, acknowledge that volatility is expected to remain very high, and therefore we believe a long-term approach is needed. At the same time, a re-rating of inflation expectations has hit inflation-related assets (i.e., bond linkers), which now discount a very negative outlook. We believe that the market is underestimating the inflation pressures that could come from wage growth (in the US), and therefore we believe that opportunities may open up in the linkers segment.
On the Central Bank side, we see a more dovish tone overall (compared to our outlook at the start of the year) driven by a weak inflation scenario and financial stability concerns. We believe that asynchronicity will continue to be the name of the game, with the Fed slowly normalizing rates, the ECB ready for another wave of unconventional measures and the Bank of Japan recently moving into negative rate territory. This should open up relative value positions among currencies and yield curves.
For EM equities, due to the historical high correlation between oil and global demand, lower oil is taken as a proxy of the global cycle, hence as “bad news”. This is true especially for Korea, Indonesia, Czech Republic and Brazil (Indonesia and Brazil’s economy are also very linked to oil). Some exceptions are Hungary, Turkey and Poland, where lower oil could drive a higher upside as oil is mainly a cost variable.
Selectivity will continue to be key in the EM area. Here we prefer countries, such as India, that have the space and credibility for adjustment and rebalancing the economy, and that can also enjoy the oil dividend.
4The lowest potential yield that can be received without the issuer actually defaulting.
0 5 10 15 20 25 %
We believe that price
overreaction in credit
markets and
inflation-related assets is opening
up selective opportunities
for the long term.
Important Information
Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of February 18, 2016.
The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investments product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested.
This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services.
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Date of First Use: February 23, 2016.
