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Oil and gold: diverging commodities

19 November 2020

8 minute read

By Jai Lakhani, London UK, Investment Strategist and Gerald Moser, London UK, Chief Investment Strategist

In the year of the pandemic, gold initially shone and oil suffered. While the latter has bounced back and the latter slipped since, a second wave of cases may overwhelm healthcare systems and trigger more lockdowns. A stuttering recovery and cautious consumer could complicate the picture once more.

The oil market started the year in the backdrop of Venezuelan tensions, conflict between the US and Iran and COVID-19 rearing its head. Few foresaw major economies grinding to a halt as a result. At the same time, OPEC+, members of the Organization of the Petroleum Exporting Countries (OPEC) and other leading oil producers, initially struggled to commit to supply cuts, triggering a price war.

Oil prices plunged and benchmark West Texas Intermediate (WTI) crude futures hit a record low, briefly slipping into negative territory in April. Since then prices have recovered, hovering around $40 per barrel.

Prospects for the commodity’s fundamental

When assessing the outlook, it is important to remember that commodity prices do not anticipate growth ex nihilo but reflect a combination of supply, demand and inventories for oil. On the supply side, there are two dynamics to consider: the self-imposed supply cut for OPEC+ and how much the low oil price weighs on the financial health of other producers.

When WTI prices collapsed and prices for the UK benchmark, Brent crude, hit their lowest level since 2002, OPEC+ agreed to cut supply by 10m barrels per day (mbpd) in May and June (Saudi Arabia voluntarily cutting by a further 1.2mpbd). While cuts of 7.7mbpd were kept until the end of 2020, the group committed to potential further cuts if the situation warrants it in 2021.

Although OPEC+ grabs much attention as a group when it comes to production, it produces less than 50% of crude. With the emergence of shale oil in the past decade, the US has become the largest producing country and, together with other non-OPEC members, they now produce more oil than the cartel.

In those other countries, it is mostly the economic incentives that determine production levels. And with Brent prices at their lowest level since 2016, production has plunged, particularly in the US. The American rig count depicts production that is well below that at the start of the year (see figure one).

Inventories

But the fall in US production is not yet large enough to bring back US crude oil inventories in line with the last five-year average. Although US commercial stock levels were similar in the first quarter to the average over the past half decade, by July the crude oil stockpiles were more than 20% above the five-year average. They were also over 10% above the maximum inventory at the same point over the past five years. While supply is below demand in the US crude oil market, the adjustment in inventories is likely to continue into next year.

Demand

Demand is likely to be the most volatile component of the equation in the short term. OPEC believes that the pandemic cut global demand by 9.5mbpd on average for 2020. But IEA data shows that global demand from January to July fell by 10.5mbpd compared to last year. This period covers the most stringent containment measures in Europe and on the US eastern coast.

And while demand likely picked up in the third quarter, the autumn surge in COVID-19 cases in the US and Europe, triggering several European governments to reinstate lockdowns until December, should weigh on demand. This trend could continue into next year.

But it is likely that lockdowns will be shorter and less stringent than the ones implemented in the spring, when relatively little was known about the virus and its treatment than it is now. This could suggest a less precipitous demand hit this time. Furthermore, China’s economy is recovering strongly and this should support global demand going into 2021. On the other hand, diminished activity in aviation with no meaningful recovery likely until a vaccine is widely available should overhang the market, possibly until the latter half of next year.

Ultimately, we expect oil prices to be range-bound and volatile in the coming twelve months as supply cuts partially counter the weaker demand. However, there is upside risk and Brent crude could average around $55 per barrel with the price ending 2021 towards $60 a barrel under a solid recovery.

Gold: A diversifier that’s not done yet

In the backdrop of an unprecedented pandemic forcing economic lockdowns, record economic contractions and central banks slashing interest rates, it is unsurprising that gold has had an impressive 2020.

After touching $2075 a troy ounce in August, a record high, the yellow metal is now around $2000 an ounce. The question is can gold, the ultimate safe-haven play, provide investors with a return in 2021?

Following this year’s record breaking fiscal and monetary stimulus, the economy could find itself in the sweet spot of accommodative policy combined with economic expansion. However, should this occur alongside consumers regaining confidence in a post COVID-19 world, gold may struggle as investors look to lift portfolio risk. Historically, the precious metal has experienced mixed performance in the years following an economic crisis.

Wealth preservation tool

After this eventful year, there are many characteristics that are not the same as before. The opportunity cost of holding gold (or the inflation-adjusted, real rate) appears deeply constrained due to two factors. Firstly, turning on the spending taps does not come without its costs and one of them could be demand-pull inflation. Secondly, central banks are more likely to tolerate any inflation overshoots in order to promote recovery, keeping rates lower for longer than usual.

Both provide support for holding the zero-interest bearing asset. Furthermore, while investor demand could weaken, pent-up consumer discretionary demand for jewellery (most notably in China, which has seen more of a V-shaped recovery than many other economies), could offset this to some extent. That said, such a world remains contingent on consumers resuming normal purchases akin to that before COVID-19.

At the time of writing, with a second wave of coronavirus cases, especially in Europe, containment measures by governments are being imposed. With a vaccine far from not only being approved but being made readily available, uncertainty remains, arguably a supportive backdrop for gold.

While gold is unlikely to drive long-term growth, it remains a powerful diversification tool, in our view, helping to preserve wealth during periods of turbulence.

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Outlook 2021

Barclays Private Bank investment experts highlight our key investment themes and strategies for the coming twelve months.

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