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Oil is losing its power to shock as its risks have been better discounted into financial markets, while the passing of time will bring the positive impact of lower oil to the fore, says Robeco’s Lukas Daalder.
The astonishing collapse in the oil price from over USD 100 a barrel in the summer of 2014 to a low of USD 25 in February this year has sent stock markets tumbling in tandem, mostly on the belief that a low oil price is bad for energy-related companies and signifies economic slowdown. Markets have subsequently risen as the oil price has recovered since then.
However, the link between oil and equity prices is set to erode as markets are now much more aware of the risks involved, says Daalder, Chief Investment Officer of Robeco Investment Solutions. He also believes that better market dynamics mean that we have seen the low in the market, though accurate predictions are very difficult to make.
“Oil has been the leading theme in financial markets from the first day of the year, acting as the catalyst for both the sharp decline in stocks and credits, as well as the subsequent recovery that took place from the middle of February onwards,” says Daalder. “There has been a clear correlation between the intraday levels of the S&P 500 versus those of the West Texas Intermediate oil price, and those of the Stoxx 50 versus the Brent oil price respectively.”
‘The rule of thumb has been that a decline or rise of the price of oil by USD 1 coincided with a loss or gain of approximately 1% in stock markets. As oil has been trading within a USD 15 bandwidth since the start of the year, this has made stocks rise or fall by 15% as well. But if history is any guidance, it is clear that the one-dollar-one-percent link is set to weaken moving forward.”
Daalder says markets have now become accustomed to low and volatile oil prices and are basically losing interest in it. “We are not claiming that oil is not important anymore; we only raise the question of whether the oil trade will remain as dominant as it has been, irrespective of the future development of oil,” says Daalder.
“Isn’t it a familiar pattern that major market themes slowly lose their ability to dominate the markets over time? Remember the time we were all transfixed by the movements in the European peripheral bond markets? Long before ECB President Mario Draghi uttered his “whatever-it-takes” statement, peripheral spreads had lost their ability to send markets plunging.”
“And do you recall the horror with which everybody was looking at the bloodbath taking place in banking stocks? Sure, markets remained edgy, but the spillover to the broader market steadily diminished over time. If a theme is new to the market, and it is unexpected, it is clear that the impact is still significant: risks have not been priced in, and knowledge is insufficiently incorporated. For example, when oil was still trading at USD 70, hardly anyone was expecting (or trading on) the possibility of a drop to USD 50; by the time we had hit the USD 30 mark, major investment banks were sending out research notes that USD 20 was within reach.”
‘The much feared meltdown does not take place’
“Once that happens, it is clear that the risk profile in the market is much more evenly spread, making it much less of a one-sided bet. Protection has been bought and hedges have been put in place, if not by the whole of the investment community, at least by the more active part of it. Markets are no longer simply hurt by a further decline: some of the market participants even stand to gain.”
“Added to this is the fact that the world continues to turn. Companies report earnings, economic data is released, central banks change their policy stance. The world economy does not collapse, the much feared meltdown does not take place, and slowly but surely, attention shifts to different topics. The third time that Greece was about to leave the Eurozone, it was reduced to a regional, local event, and was no longer the main event that drove financial markets around the world.”
Predicting oil prices given the vagaries of the market is almost impossible, says Daalder, though he does believe the general trend is upwards. “If there is one lesson we have learned over the past year and a half, it is to stay away from trying to make accurate predictions on this topic, as the oil market has turned out to be impossible to predict,” he says. “There is too much uncertainty on both the demand side over economic growth, China and the structural shift to alternatives, as well as the supply side on the rise of shale or Saudi Arabia defending its market share, to be able to come up with a specific level of oil prices for a specific timeframe.”
“But in general, it is clear that the very low levels of oil prices that we saw in February have resulted in a steady but slow decline of supply coming to the market, with investments in bringing new production online clearly slumping. In time, this will mean that supply and demand will balance, but it should be stressed that this rebalancing can take quite some time to materialize: the International Energy Agency estimates it will be at least 2017 before this happens.”
‘It is unlikely that we will revisit the low of USD 25 per barrel’
“From a demand perspective, we expect the current low prices to lead to higher (relative) demand, with the attractiveness of alternatives like solar and wind looking less attractive, at least for now. All in all, we think it is unlikely that we are going to revisit the February low of USD 25 per barrel, but as long as there is still excess supply coming to the market, the upside for oil is also limited for now.”
“The most likely outcome is a broad trading range, with an upward tilt from the current level as time progresses. Such a scenario would only enhance our belief that the dominance of oil as the leading market theme is set to decline moving forward.”