10 March 2020
The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Ninety One as a whole.It is important to place Monday’s sharp decline in the oil price in the context of recent events. The coronavirus (COVID-19) has severely dented oil demand, with the International Energy Agency (IEA) forecasting demand may contract compared to 2019, from its prior expectation of a 1.2 million barrel per day (bl/d) increase. In response, OPEC and allied producers, including Russia, had been considering further production cuts to support prices, in addition to the pact to cut output by 1.7 million bl/d until the end of this month.
With Russia refusing to make even deeper cuts to output following the coronavirus outbreak, Saudi Arabia’s response — to raise output and offer its crude at unprecedented price discounts – will ensure the mutual destruction of both economies unless there is some form of face-saving compromise. Saudi Arabia needs about US$60/bl to balance its budget, while 65% of exports and c.40% of its federal budget are dependent on oil and gas. Non-OPEC producers could attempt to mitigate some of the impact by taking production off the table when prices fall below the cost of production – this will primarily be onshore rather than offshore producers, as the former can take production offline more easily – but this is still a significant ask and we may see the oil price testing US$20-25/bl before there is a sustained reaction.
Much of the US exploration and production sector is already financially stressed, with memories of a raft of bankruptcies in 2014 still fresh in the memory. A mutually acceptable outcome for both Saudi Arabia and Russia could be another round of shale companies entering bankruptcy proceedings. This would allow both sides to claim they have beaten down the prospects for further shale production (although realistically not much will disappear as such companies will continue to trade in Chapter 11 bankruptcy).
The global oil sell-off adds another potential pressure on financials. It is worth pointing out that banks are in a much better position today than in the oil sell-off in late 2014 to 2015, as they have pared back exposure to the sector. Overall exposures are relatively contained and are typically investment grade; however, oil-price weakness will slow down fee income and could lead to higher impairments. Furthermore, the key question now is what knock-on effects potential defaults may have on high-yield, leveraged-loan and CLO markets, with CLOs seeing exponential growth in recent years and being where banks and insurance companies are most exposed.
Taking a step back, financials had started the year well, but the coronavirus outbreak resurrected fears of a global slowdown and potential recession, which the market believed had been laid to rest following a successful end to phase one of the US-China trade talks in late December. The shock 50 bps cut by the US Federal Reserve has done little to quell markets — and banks, being geared macro plays, have reacted extremely negatively, especially in the US and Europe. Further rate cuts are being priced in, and banks and insurers are facing further downgrades, with names selling off indiscriminately.
The 4Factor investment philosophy and process are focused on bottom-up, long-term drivers of share prices. Currently, our Global Core Equity and Global Dynamic Equity strategies are underweight energy. In Global Core Equity, we are also underweight materials and overweight gold.
Specifically, more than half of Global Core Equity’s exposure by revenues is to downstream that can benefit from lower input raw material prices, as opposed to upstream, which is more affected by selling on raw materials at lower cost.
In our Global Strategic portfolio, we are overweight energy, but this includes defensive exposure to the oil price, such as a tanker company that delivers refined products and a downstream refiner. These companies are beneficiaries of lower oil prices and so we believe they will be resilient in the current environment.
In terms of financials, all the Global Equity strategies have been underweight banks for some time, but in some of the portfolios we have taken overweight positions in capital-market-related names within exchanges and ratings agencies, which are typically much more defensive in a downturn.
Within banks, our US interest-rate exposure sits with global banks while we are underweight US regionals which are most exposed to both rates and oil and gas. Banks have arguably reduced exposure following the oil-market sell-off into 2015, which we believe puts them on a better footing today.
As a further means of dampening rate exposure, we are exposed to housing finance which typically benefits from lower rates, while we are underweight US life insurance.
Again, in Global Core Equity, we have a small exposure to European financials, spread across insurers and banks. As in the US, the uncertain rate environment continues to weigh on valuations. Our exposure here focuses on names with strong balance sheets that aim to deliver solid (and potentially rising) capital returns.