Oil recovery hinges on second wave, gold and equities shine

The oil market continued its road to recovery in July. Since April, supply cuts and better than expected economic activity have flattened the Brent and West Texas Intermediate futures curves, with futures prices notably more stable over the past few months.

The futures markets suggest a transformation from a significant surplus in the first half of 2020 to a deficit in the second half of the year. However, a second wave of COVID-19 infections impacting sentiment and re-imposing containment measures could be a headwind.

Global oil supply falls to nine-year low

OPEC+, a group comprising members of the Organization of the Petroleum Exporting Countries (OPEC) and other leading oil producers such as the US and Canada, is showing its commitment to abide by production cuts in order to put a floor on prices. The OPEC+ compliance rate with the supply agreement was 108% in June, as a result of Saudi Arabia cutting further than the agreement by one million barrels per day (mbpd).

Global oil supply fell by 2.4mbpd in June to a nine-year low of 86.9 mbpd. Since April, world oil output has been cut by nearly 14mbpd. According to the International Energy Agency (IEA), if the OPEC+ cuts agreed remain, global supply could fall by 7.1mbpd in 2020.

However, supply cuts may have hit their peak. OPEC+ are set to ease the 2mpbd cut this month. Given high inventory levels worldwide and a higher oil price, non-OPEC supply could also return simultaneously. US production may have bottomed out and could increase, with the economy for the large part back up and running.

Demand continues to recover

IEA data shows that for the first half of 2020, oil demand fell by a substantial 10.75mbpd. However, high-frequency indicators, as well as economic and mobility data points, suggest that the worst might be over. Encouragingly, China’s crude oil imports continued to pick up in June, growing by 34% year on year. With potential for further fiscal stimulus, demand could be furthered as global economic activity resumes.

COVID-19 is key to a balanced market

Supply-side compliance to production cuts and a recovery in demand has helped the oil market to stabilise somewhat. That being said, getting fully back into balance will depend heavily on how damaging any second wave of COVID-19 is. The re-imposition of quarantining in regions in the US and Latin America is a concern.

Furthermore, as we mentioned in July, some activities will take time to fully normalise, such as air travel, and the oil price is unlikely to continue to rise as fast as in the initial recovery. Ultimately, we expect oil prices to be range-bound in the near term but the risk of a second wave overwhelming healthcare systems, denting confidence and the shutting down of economies remains an issue that cannot be ignored.

Long-term support for gold even as equities drive higher

Gold continues to extend its rally from the March low (see chart), up 30% so far this year.

In the backdrop of equities recovering and the precious metal breaking the prior all-time high, investors have questioned if the momentum in gold can continue. Indeed, typically, the two tend to move in opposite directions as the yellow metal is added to risk-averse investors' portfolios in times of uncertainty, economic downturns and geopolitical tensions.

In this context, the recent positive correlation between the pair may seem odd. However, we believe it can be explained by the unprecedented levels of fiscal and monetary stimulus introduced globally. This wave of liquidity has kept real interest rates low, reducing the opportunity cost of holding a non-yielding asset like gold. At the same time, although stocks have been grinding higher, this strength can be attributed almost entirely to a few “growth” companies as opposed to a broad-based universe of cyclical industries, pointing to some degree of investors’ cautiousness about the outlook.

Useful diversifier

Thus, we do not see the recent equity rally as a reason preventing gold from delivering further strong performance. And with equity markets seemingly ignoring the risks associated with a second wave in COVID-19 infections, a US November presidential election and Brexit negotiations, we see the precious metal as a useful diversifier in a portfolio context.

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