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Alternatives: oil and gold market hits turbulence

03 April 2020

7 minute read

By Jai Lakhani, London UK, Investment Strategist

An oil price war and Covid-19 outbreak is increasing pressure on producers around the world that shows little sign of improving soon. When might the market rebalance and the price recover? Gold has also suffered as investors flee financial markets in a flight to liquidity. What next for the precious metal?

The Covid-19 outburst and the costs of containment on global growth has significantly impacted the demand side to the oil market, triggering the Organisation of Petroleum Exporting Countries and allied producers (known as OPEC+) group to hold an emergency meeting on 6 March.

The day before the meeting, oil closed at $51.64 per barrel. While many members of the group wanted to extend agreed production cuts, Russia opposed further cuts given its ability to remain profitable at lower prices to the detriment of its US competitors.

Oil price war

However, this triggered a price war, with Saudi Arabia announcing an increase in output by two million barrels per day (mbpd). Consequently, oil prices quickly fell to their lowest levels since 2017 (at around $30 a barrel) – hitting oil producers’ profitability around the world.

Compounding the fall in recent weeks has been Saudi Arabia’s decision to increase crude oil exports to 12.3mbpd from April. Oil subsequently dipped as low as $23 a barrel, its lowest since 2003.

Over the very short term, we expect oil prices to remain under pressure as the effects of balancing market forces for supply and demand will likely come with a lag. Given that at current prices, Saudi Arabia cannot use its reserves and borrow from international capital markets, it is likely that the group come back to the table. It is also likely that the US president, Donald Trump, will intervene to prevent small American oil producers filing for bankruptcy.

Winners and losers

Countries that rely on oil for a significant proportion of their national budget, such as Russia, Saudi Arabia, Iraq and the United Arab Emirates, will be impeded by the recent production increases and oil price falls. Oil producers will also be forced to slash capital expenditure, reduce drilling and potentially cut dividends. Furthermore, those that are highly leveraged, such as US shale, will pass on the impact to the banks and investors that lent to the sector.

Other industries which are likely to face difficulties include aviation and transportation. Not only do companies in these sectors face a dramatic drop in demand, but also a hedging cost. Due to the volatility of the commodity, many companies tend to hedge their oil requirements in advance and by doing so pay the price they had hedged at (most likely significantly higher) than the price to which oil has plummeted to.

Suppressed demand set to last

What’s more is that restrictions on travel will likely remain for a few quarters. This means that even after contracts are renewed, oil demand will likely remain suppressed while no, or limited, flights/travel are taking place.

More than 55% of oil demand comes from transport, with 12% caused by the aviation industry. Assuming a 50% year-on-year decline in airline traffic worldwide for two quarters, jet-kerosene demand could decline as much as 1.7mbpd.

Oil demand

China in strong position

Countries that are likely to benefit in the upcoming months are those that are the largest importers of energy, such as China, India and Japan. Other winners include consumers and businesses globally through lower input costs and inflation.

With China the largest buyer of oil and their workforce back in action, should there be no resurgence of Covid-19, the country will be in a strong position to leverage the lower price in the upcoming months (see chart).

Congestion data

Gold suffers in flight to liquidity

March was also a difficult month for gold. The price of the precious metal struggled as a result of mass selling of assets in a flight to liquidity.

Fundamentally, we believe gold can still be used as a diversification tool within a broad, multi-asset portfolio. It should continue to be supported by exchange-traded fund flows from risk-averse investors, recently cut interest rates globally remaining lower for longer and support from central banks. While gold won’t drive long-term growth, it will most likely preserve wealth during periods of turbulence.

The economic impact of the coronavirus and falling oil prices across industries will inevitably be determined by their lifespan, intensity and geographic spread. While the recovery in the gold price may happen sooner than for oil, we continue to believe the latter market is set to be in balance in the latter stages of 2020, likely finding an equilibrium at $31 a barrel for 2020.

The economic impact of the coronavirus and falling oil prices across industries will inevitably be determined by their lifespan, intensity and geographic spread

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Market Perspectives April 2020

Financial market sell-offs, in the face of unprecedented policy measures to fight the effects of the Covid-19 outbreak, suggest any rebound may be a few months away.

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