Where to invest as oil price volatility dampens

Niels Jensen, CIO at London-based investment boutique Absolute Return Partners, argues that oil prices are set to stabilise and cites who he believes will be the winners and losers as the oil price volatility dampens .

The extraordinarily high level of oil price volatility in recent years has led some to argue that oil prices are likely to continue to be extremely turbulent. I don’t believe that is necessarily so because of changing political dynamics – such as the Iranian redemption (a country that has big enough reserves to act as a very effective buffer in case there are supply problems elsewhere) – the emergence of the fracking industry and the impact of continued terror actions and/or outright (civil) wars, will do to energy markets.

On the third point, should OPEC disintegrate as a result of the Sunni-Shia divide, oil prices would probably drift lower over a period of time. Prices are almost always lower when pricing is not impacted by cartels, and that would almost certainly also be the case as far as oil is concerned.

Lower oil price volatility should also be good for overall economic activity. Where oil prices in recent years have traded in a range of $40-140 per barrel, I would expect that range to be considerably tighter going forward.

If one assumes that the price won’t drop below the cost of production for any meaningful period of time (as it rarely does), and one assumes that the average production cost today is not far from $50 per barrel (chart 1), then oil prices should trade in the range of $50-80 per barrel.

Obviously terror actions by militant groups and other temporary supply disruptions can drive the price outside that range, but probably not for an extended period of time. The days of $100-140 oil prices are most likely over, at least for the time being, unless (until) a new dynamic pops up on the horizon.

So, which types of energy strategies are likely to perform the best, given those expectations?

The winners and losers

Geographically – Oil producing nations that produce at virtually full throttle today, and have ‘adapted’ their budgeting to $100-140 oil prices, are expected to be big losers. Countries such as Venezuela, Nigeria and Algeria would all fall into this bracket.

Many nations across the Middle East also run massive fiscal deficits at an oil price below $60 per barrel (chart 2), where it stands today. Having said that, some of those countries have the capacity to meaningfully increase production (e.g. Iran, Iraq) whilst others have significant reserves which can be used as a buffer, at least temporarily (e.g. Saudi Arabia).

Russia would also (continue to) suffer. Relatively low oil and gas prices hurt the Russian foreign exchange rate which would have the effect of making imported goods, upon which Russian consumers are very dependent, more expensive. The overall result in Russia? Higher inflation.

As far as investment strategies are concerned, one would have to pay particular attention to EM equities and trend following CTAs. EM equities, because oil related revenues are very important to some of those countries. Low volatility in itself is not necessarily bad, and can actually be very good. It depends on the price level oil eventually settles at, once the full ramifications of the deal with Iran are understood.

Trend following CTAs benefit immensely from large and sustained moves in asset prices and have certainly taken advantage of the big moves in oil prices in recent years. If a tighter trading range is on the horizon, as we expect, such investors could potentially be whipsawed. In that context we note that oil is just one of many asset classes that CTAs trade.

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