Why the Benefits of Cheaper Oil Outweigh the Drawbacks

Why the Benefits of Cheaper Oil Outweigh the Drawbacks

January 2015

A A A

Although the plunge in oil prices is creating losers as well as winners, Standish believes cheaper oil prices will be a net benefit for the global economy.

 

We expect non-energy names in the high yield and emerging market space to outperform as oil prices stabilize. We believe US inflation-linked bonds will also benefit from stabilizing oil prices given their valuations and lack of credit risk.

Standish Mellon Asset Management

Executive Summary

Oil prices have tumbled by more than half since mid-2014 due to a combination of supply and demand factors as well as market positioning. Although there will be winners and losers, we believe the decline in oil prices will be a net benefit to the global economy. Oil exporters with large dollar denominated debts could pose risks to financial stability in a strengthening dollar environment. We expect non-energy names in the high yield and emerging market space to outperform as oil prices stabilize. We believe US inflation-linked bonds will also benefit from stabilizing oil prices given their valuations and lack of credit risk.

Gauging the Impact of Falling Oil Prices

World oil prices have plummeted more than 50% from their 2014 highs (Figure 1). This has implications for the global macroeconomic outlook, monetary policy at some of the major central banks and financial market performance. Although there will be winners and losers, we believe the decline in oil prices will prove to be a net benefit to the global economy and will create opportunities in the fixed income markets in 2015.

Figure 1 // Oil Prices Plummet
Source: Thomson Reuters as of January 2015

Oil Prices Plummet

Of course, falling oil prices will have consequences for oil producers, including the shale oil industry in the US, which has been an important contributor to investment and job growth in recent years. Lower oil prices will also aggravate disinflationary forces in places such as Europe and Japan. Perhaps most worryingly, the decline in oil prices will keep downward pressure on the currencies of some of the major oil exporters, which increases the vulnerability of those countries and companies with large dollar-denominated liabilities.

However, from our perspective, these negatives will be more than offset by the positive impact of lower oil prices on the global economy. The top 10 net oil exporters represent less than 10% of world GDP, compared to the top 10 net oil importers which account for 55% of world GDP. In general, oil importers have a higher propensity to consume and invest than oil exporters. Thus, we would expect the transfer of wealth from exporters to importers to provide a boost to global GDP of roughly a half of a percent in 2015. In addition, lower oil prices should give some of the major central banks more leeway to pursue easy monetary policy to encourage growth.

Nevertheless, financial market volatility is likely to remain elevated until the full effect of lower oil prices becomes clear. Indeed, the S&P VIX Volatility Index has doubled from around 11 last summer to more than 20 in mid-January. The most adversely affected areas of the fixed income markets have been the high yield companies and emerging market countries that have direct ties to the oil and gas industry. Yet, even unrelated sectors, such as the market for Treasury Inflation Protected Securities (TIPS), have been hurt as inflation expectations decline. Eventually, as oil prices stabilize, we believe some of these sectors will present opportunities to investors.

Why Have Oil Prices Collapsed?

The decline in oil prices has been driven by a combination of supply and demand factors as well as market positioning. Global supply has risen mostly due to increased US shale production, which has grown by 1 million barrels per day (bpd) in each of the last three years and is projected to grow 1 million bpd this year. At the same time, global demand has softened with the International Energy Agency slashing its 2014 demand forecast nearly in half from 1.2-1.3 million bpd in January 2014 to just 700,000 bpd by last summer. The IEA is forecasting an increase in demand of 900,000 bpd this year.1 The hedging activities of producers exacerbated the price move as did the November decision by the Organization of Petroleum Exporting Countries (OPEC) not to scale back output.

Despite the ongoing weakness in oil prices, key members of OPEC–including Saudi Arabia, the United Arab Emirates (UAE), Kuwait and Qatar– have indicated a continued reluctance to cut production. While sub-$80 oil is below most OPEC member nation’s breakeven price to balance their budgets, this core group can withstand low prices for some time due to their large currency reserves (Figure 2).

In the absence of production cuts, oil prices could fall further especially during the winter and spring months when consumer demand weakens and refineries shut down for maintenance. However, we believe oil prices will recover modestly in the second half of 2015 as producer hedges roll off, demand picks-up with the summer driving season, and US shale suppliers begin to slow output. Sub-$60 West Texas Intermediate (WTI) crude could reduce shale production by between 25-50% this year.

Figure 2 // Oil Breakevens
Source: IMF as of December 2014

Oil Breakevens

Who Wins and Who Loses?

The main beneficiaries of low oil prices are oil importing countries. China surpassed the US as the largest net importer in 2013 with 5.6 million bpd. By our estimate, the decline in Brent Crude oil prices to $50/barrel could add as much as 0.7 percentage points to Chinese GDP in 2015 if it is sustained. The comparable figures for the US would be 0.6 percentage points to US GDP. Unfortunately, these gains will partly be offset by losses for the largest net exporters such as Saudi Arabia, Russia, the UAE, and Kuwait. Yet, because net oil importers generally have a higher propensity to consume their windfall rather than save it, we believe the net add to global GDP in 2015 could be more than a half a percent. We are currently forecasting world GDP growth of 3.4% this year compared to 3% for 2014.

Although we are relatively sanguine about the impact of lower oil prices on the global economy, we are concerned about the risks to financial stability posed by certain emerging market (EM) oil exporters with large dollar-denominated debts, especially in a strengthening dollar environment. This dynamic is most evident in Venezuela and Russia, but it also applies to Colombia, Mexico, Kazakhstan, and Brazil. The pressures on these markets will most likely manifest itself in increased currency volatility. Yet, Venezuela could face the risk of outright default given its fixed exchange rate.

Default risk also remains a concern for some of the most highly levered names in the US high yield space. The energy sector, which makes up roughly 13% of the Merrill Lynch High Yield index, has been one of the most aggressive borrowers in recent years with issuance topping $50 billion in 2014 (Figure 3: High Yield Energy Issuance Rising). Even so, we do not expect to see a large wave of defaults in 2015 –perhaps five out of the 180 names in the index– given hedging, liquidity and cuts to capital expenditure. However, that amount could double or maybe even triple in 2016 if $50/barrel oil persists. In the meantime, we anticipate that the pace of consolidation will start to pick up this year as stronger companies purchase liquidity constrained companies on the cheap.

Figure 3 // High Yield Energy Issuance
Source: Bank of America Merrill Lynch as of January 2015

High Yield Energy Issuance

How Can We Take Advantage?

We believe the move in oil prices will be one of the most important factors shaping financial market performance in 2015. For the time being, we are keeping risk budgets low given heightened market volatility, but we are positioning ourselves to take advantage of the move in oil in several ways.

First, although the energy sector is likely to dominate high yield performance in 2015, the market is becoming increasingly comfortable with credits outside energy. For example, the travel, consumer discretionary, and auto sectors are expected to benefit from continued US growth. There also remains strong demand for ‘BB’ paper from investment grade crossover buyers. Unfortunately, non-energy credit spreads are much tighter at around 448 basis points (bps) compared to 828bps in the energy sector.2 Furthermore, large outflows still have the potential to destabilize the sector with forced selling of energy and greater selling of non-energy, liquid credits. Thus, caution is still warranted.

The same is true in emerging markets where the negative trend was in place even before the collapse in energy prices. Lower oil prices have simply heightened the risk of downgrades and defaults. This is especially true for those sovereigns and corporates who have borrowed heavily in dollars and face a potential currency mismatch between their assets and liabilities as the dollar strengthens. As a result, we believe it may be premature to add significant exposure emerging markets at the present time.

We are a bit more bullish on the US TIPS market given that it is not subject to the same credit risk as emerging markets or high yield. In addition, our valuation models suggest it is one of the cheapest areas of the fixed income markets. However, even here, we really need to see some stabilization in oil prices before TIPS breakevens move meaningfully higher.

 

1 The International Energy Agency. 2014 World Energy Outlook. November 2014.

2 Merrill Lynch High Yield Index as of January 20, 2015.

BNY Mellon Investment Management is one of the world’s leading investment management organizations and one of the top U.S. wealth managers, encompassing BNY Mellon’s affiliated investment management firms, wealth management organization and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.

The information in this document is not intended to be investment advice, and it may be deemed a financial promotion in non-U.S. jurisdictions. Accordingly, where this document is used or distributed in any non-U.S. jurisdiction, the information provided is for Professional Clients only. This material is not for onward distribution to, or to be relied upon by, retail investors.

Any statements and opinions expressed in this document are as of the date of the article, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of BNY Mellon or any of its affiliates. The information contained in this document has been provided as a general market commentary only and does not constitute legal, tax, accounting, other professional counsel or investment advice, is not predictive of future performance, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful. The information has been provided without taking into account the investment objective, financial situation or needs of any particular person. BNY Mellon and its affiliates are not responsible for any subsequent investment advice given based on the information supplied. This document is not investment research or a research recommendation for regulatory purposes as it does not constitute substantive research or analysis. To the extent that these materials contain statements about future performance, such statements are forward looking and are subject to a number of risks and uncertainties. Information and opinions presented in this material have been obtained or derived from sources which BNY Mellon believed to be reliable, but BNY Mellon makes no representation to its accuracy and completeness. BNY Mellon accepts no liability for loss arising from use of this material. If nothing is indicated to the contrary, all figures are unaudited.

Any indication of past performance is not a guide to future performance. The value of investments can fall as well as rise, so you may get back less than you originally invested.

This document is not intended for distribution to, or use by, any person or entity in any jurisdiction or country in which such distribution or use would be contrary to local law or regulation. This document may not be distributed or used for the purpose of offers or solicitations in any jurisdiction or in any circumstances in which such offers or solicitations are unlawful or not authorized, or where there would be, by virtue of such distribution, new or additional registration requirements. Persons into whose possession this document comes are required to inform themselves about and to observe any restrictions that apply to the distribution of this document in their jurisdiction. The investment products and services mentioned here are not insured by the FDIC (or any other state or federal agency), are not deposits of or guaranteed by any bank, and may lose value.

This document should not be published in hard copy, electronic form, via the web or in any other medium accessible to the public, unless authorized by BNY Mellon Investment Management.

This document is approved for Global distribution and is issued in the following jurisdictions by the named local entities or divisions: UK and in mainland Europe (excluding Germany): BNYMIM EMEA, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorized and regulated by the Financial Conduct Authority. • Germany: Meriten Investment Management GmbH which is regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht. • Dubai, United Arab Emirates: Dubai branch of The Bank of New York Mellon, which is regulated by the Dubai Financial Services Authority. This material is intended for Professional Clients only and no other person should act up on it. • Singapore: BNY Mellon Investment Management Singapore Pte. Limited Co. Reg. 201230427E. Regulated by the Monetary Authority of Singapore. • Hong Kong: BNY Mellon Investment Management Hong Kong Limited. Regulated by the Hong Kong Securities and Futures Commission. • Japan: BNY Mellon Asset Management Japan Limited. BNY Mellon Asset Management Japan Limited is a Financial Instruments Business Operator with license no 406 (Kinsho) at the Commissioner of Kanto Local Finance Bureau and is a Member of the Investment Trusts Association, Japan and Japan Securities Investment Advisers Association. • Australia: BNY Mellon Investment Management Australia Ltd (ABN 56 102 482 815, AFS License No. 227865). Authorized and regulated by the Australian Securities & Investments Commission. • United States: BNY Mellon Investment Management. • Canada: Securities are offered through BNY Mellon Asset Management Canada Ltd., registered as a Portfolio Manager and Exempt Market Dealer in all provinces and territories of Canada, and as an Investment Fund Manager and Commodity Trading Manager in Ontario. • Brazil: this document is issued by ARX Investimentos Ltda., Av. Borges de Medeiros, 633, 4th floor, Rio de Janeiro, RJ, Brazil, CEP 22430-041. Authorized and regulated by the Brazilian Securities and Exchange Commission (CVM).

The issuing entities above are BNY Mellon entities ultimately owned by The Bank of New York Mellon Corporation.

BNY Mellon Cash Investment Strategies is a division of The Dreyfus Corporation. • BNY Mellon Western FMC, Insight Investment Management Limited and Meriten Investment Management GmbH do not offer services in the U.S. This presentation does not constitute an offer to sell, or a solicitation of an offer to purchase, any of the firms’ services or funds to any U.S. investor, or where otherwise unlawful. • BNY Mellon Western Fund Management Company Limited is a joint venture between BNY Mellon (49%) and China based Western Securities Company Ltd. (51%). The firm does not offer services outside of the People’s Republic of China. • BNY Mellon owns 90% of The Boston Company Asset Management, LLC and the remainder is owned by employees of the firm. • The Newton Group (“Newton”) is comprised of the following affiliated companies: Newton Investment Management Limited, Newton Capital Management Limited (NCM Ltd), Newton Capital Management LLC (NCM LLC), Newton International Investment Management Limited and Newton Fund Managers (C.I.) Limited. NCM LLC personnel are supervised persons of NCM Ltd and NCM LLC does not provide investment advice, all of which is conducted by NCM Ltd. Only NCM LLC and NCM Ltd offer services in the U.S. • BNY Mellon owns a 20% interest in Siguler Guff & Company, LP and certain related entities (including Siguler Guff Advisers LLC).

©2015 The Bank of New York Mellon Corporation.