Crude awakening: why the oil price fell

1. Demand for oil has fallen because of the coronavirus

Covid-19, the coronavirus that has recently spread from Asia to Europe, has caused a rapid slowdown in oil demand, particularly in China. As the world’s largest consumer and importer of oil, China accounted for 80% of global oil demand growth last year.

This year, however, there’s been a sharp contraction in Chinese manufacturing activity. As factories closed and travel restrictions were put in place to try to contain the infection, China found it needed less oil. Global demand sharply contracted too. Global oil use is now expected to decline to 860,000 barrels a day this year, instead of the 1,330,000 barrels a day that were previously forecast, according to S&P Platts Analytics.

2. US sanctions angered Russia

Russia is one of the world’s largest oil and gas producers, third behind the US and Saudi Arabia.  In December 2019, the US signed a law imposing sanctions on any firm that helps towards the construction of Nord Stream 2, a major gas pipeline led by Russia that aims to connect Siberian gas fields with mainland Europe. The sanctions angered Russia because Europe is a key market for Russian gas. Last year, Russia accounted for about 40% of the European Union’s natural gas imports.

3. OPEC anarchy leads to a loss of price control

In recent years, the Organisation of Petroleum Exporting Countries (OPEC), an international alliance of the world’s major oil producers led by Saudi Arabia, has collaborated with other major petroleum producers, such as Russia, to control the supply and price of oil. Russia has an incentive to cooperate with Saudi Arabia – both countries are being forced to compete with shale oil produced in the US. Surging US production in recent years has increased overall market supply making it more difficult for OPEC to maintain high oil prices.

Russia-Saudi cooperation broke down on Friday at a meeting between the nations’ oil ministers. With weakening global demand, Saudi favoured big cuts to production to help support crude prices in the wake of the coronavirus outbreak. Russia disagreed. Instead of cuts, Russia opted to continue with normal production and take the fight to the US shale producers more directly. Russia appears disappointed that several years of compliance with OPEC’s strategy has yielded relatively poor results. Its change in strategy was also inflamed by the aforementioned sanctions.

4. Saudi Arabia retaliates with huge price cuts

Displeased with Russian defiance, Saudi Arabia aggressively cut the price at which it sells crude oil by the most in at least 20 years. Riyadh announced it will raise production and offer oil at a deep discount to win new market share, effectively solidifying its position as the world’s top oil exporter and punishing producers, such as Russia, whose cost to produce oil is higher than Saudi Arabia’s. The shock to oil and gas markets was akin to a tablecloth being pulled out from under them.

The market impact of the oil price shock

The oil price crash reverberated through equity and bond markets globally. Energy stocks suffered the most, alongside equity indices with a high exposure to energy such as the FTSE 100, which has approximately 12% exposure to oil and gas stocks. High yield bonds also suffered because some of the major issuers in this space are oil and gas companies. In effect, energy markets face a demand shock and supply flood simultaneously.

The current situation is uncharted territory, a period of weak demand, low price and high supply with prices expected to remain low or fall further until either Riyadh or Moscow flinches, or US output is sharply curtailed.

There ought to be some benefits. In the medium term, cheap oil should support oil importing economies. Oil is a fundamental component in many manufacturing processes. It also powers industry, particularly in emerging markets. Lower prices will reduce input costs, increase profit margins and boost profitability and consumption.

But it’s unclear whether these economic benefits will be felt amid a global economic slowdown caused by Covid-19.

How are Nutmeg portfolios affected?

Nutmeg portfolios do not have direct exposure to oil and gas companies, but they do have allocations to the energy sector as part of globally diversified exposures. The chart below shows the sector exposures of our fully managed portfolios at each risk level. At risk level one, the exposure to the energy sector is 0.71%, rising to 5.64% for risk level ten. We recently blogged about the sudden fall in the oil price and the economic effects we expect.

Source: Nutmeg data

Sources

1. International Energy Agency – March 2020 Oil Market Report, https://www.iea.org/reports/oil-market-report-march-2020
2. European commission – https://ec.europa.eu/eurostat/statistics-explained/pdfscache/46126.pdf

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.