Rising oil prices could be boon for equities but headache for bonds

OIL prices have found some positive impetus at last, following a difficult few years. Having reached a high of $100 a barrel in 2014, prices crashed as the world market became rapidly oversupplied — thanks mainly to US oil production reaching its highest level since 1970.

Prices have recovered since then and they moved higher again last month as US-led military strikes against Syria pushed prices above $70 a barrel to their highest levels in nearly four years. Tesla’s recent speed bumps on the road to its electric dream also suggested that the era of ‘Texas Tea’ isn’t over just yet.

Historically, Middle East tensions have always tended to push oil prices higher. However, in our view, improving fundamentals are playing a more central role in the recovery than geopolitical developments. Global oil demand growth has accelerated recently, and the latest forecasts point to growth of up to 1.8 million barrels a day this year. This underlines that the world economy is in a sweet spot right now — something that should support not only oil prices but also other asset classes, especially equities. Falling oil inventories have also enabled oil prices to march higher over the past year. The Organisation of the Petroleum Exporting Countries (OPEC) played a big part in this, cutting output by over one million barrels a day in conjunction with Russia.

This falling supply, coupled with ever-strengthening oil demand, has all but eliminated the excess supply that existed in 2014 and 2015. In our view, what OPEC and Russia does next regarding these production cuts is central to the short-term outlook for oil. During last month’s monitoring meeting in Jeddah, Saudi oil minister Khalid Al Falih stated that Saudi Arabia was targeting a price of $80 a barrel.

A strong pricing environment would clearly smooth the path for any forthcoming flotation of Saudi Aramco, its national energy company. Russia seemed less keen on continuing with the production cuts, but all else being equal, higher oil prices may also be in Russia’s best short-term interests, particularly with the threat of US economic sanctions hanging over its economy.

Taken together, the Jeddah mood music suggests that supply curbs will remain in place for the foreseeable future. The US withdrawal from the Iran nuclear agreement also represents a shot in the arm for oil, insofar as it strangles another potential source of medium-term oil supply.

Is there a risk herein that oil prices completely overheat, posing a risk to the world economy?

In our view, this is unlikely. The major oil-producing nations want to see a sustainable rise in oil prices, not another painful boom-andbust scenario such as the one they’ve just come through. Furthermore, the shale oil industry in the US is already reacting to the recent higher prices — shale oil production in the US in March 2018 was up over a million barrels a day compared to 12 months earlier. So US shale oil should act as a shock absorber to prevent prices getting to destructive levels for the world economy.

From an investor’s perspective, the improving oil outlook helps the prospects for companies in the oil sector which have underperformed in recent years. However, it also signals that the outlook for the broader equity market remains positive — to the extent that the rising oil price indicates the world economy is growing strongly.

In contrast, rising oil prices could represent a headache for bond investors. Since the turn of the year, inflation has been a key negative for bond markets. Given that climbing oil prices should feed into higher inflation readings over the next few months, this looks set to continue.

A crucial unknown for investors is how global central banks might react to higher oil-induced inflation readings. If this were to cause global central banks to be more aggressive in increasing interest rates, this could be a risk for both bond and equity markets. However, we think it is more likely they would view the impact of the rise in oil prices as a temporary one, resulting in little change to central bank policies.