Keith Guthrie of Cardano on why the oil price crash could upset some pension schemes’ inflation protection strategies.
We have seen the US benchmark price for crude turn negative for the first time, as the future contracts for May delivery of West Texas Intermediate collapsed to nearly minus $40 a barrel, and Brent crude plumb 30-year lows, trading as low as $16 a barrel.
For traders battling the slump, selling May WTI contracts in negative territory may have seemed the ‘least-worst’ option relative to taking delivery of oil with nowhere to store it. We have already seen the WTI slump impact Brent crude prices, and the short-term outlook for both oil prices and supply and demand dynamics remains extremely challenged.
Of course, events this week have only added to existing supply pressures across global oil markets. In early March, the supply war between Russia and Saudi Arabia sparked alarm across markets already grappling with the rapid spread of coronavirus, triggering a massive risk-off move.
Ongoing uncertainty around the pace of demand recovery post Covid-19, combined with the unpredictable geopolitics of supply, warrants near-term caution
Many trustees will be considering the knock-on impacts of this latest development on portfolios in the context of the crisis to date.
At an asset level, the impact of low oil prices will be felt most immediately in high-yield credit, where energy companies account for a significant proportion of debt across the broader high-yield bond market.
Lower-rated, highly levered businesses in both upstream and downstream segments will come under acute pressure, driving inevitable defaults among those unable to meet or refinance upcoming debt payments. Quality, flexibility and balance sheet strength will be the key metrics for monitoring across credit allocations.
Energy commodities help balance inflation shocks
Intrinsic to global transportation and industry, the oil price is one of the most significant drivers of the price of goods globally and has a major impact on inflation.
One of the risks to a traditional portfolio of equities and bonds is an inflation shock, which can be bad for both equities and bonds. Many schemes will use strategic allocations to inflation-sensitive assets in order to protect against these scenarios. Often, inflation assets include some exposure to oil and energy-related commodities.
At this point, schemes may have already taken steps to reduce portfolio exposure to energy commodities. Where exposures are maintained, positioning on the oil futures curve will be key, given that longer-dated contracts have been less affected than front month contracts.
Even in a well-structured strategic portfolio, good risk management of underlying exposures is even more important at the moment.
Offsetting future inflationary pressures?
Looking ahead, ongoing uncertainty around the pace of demand recovery post Covid-19, combined with the unpredictable geopolitics of supply, warrants near-term caution.
Protracted lockdowns and reduced travel globally may well underpin longer-term weakness in the oil price, and we expect significant further volatility.
However, on a medium-term basis looking out into 2021-22, it is likely that global oil demand will recover substantially from these very depressed levels. At current prices there will be minimal new investment in oil production, reducing supply levels, and at some point prices will need to move back up to balance supply and demand.
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In a world where inflationary pressures might be on the rise in a few years’ time, due to excessive money printing, there will come a time when it will make sense to own a more normal strategic exposure to oil in the portfolio.
Over the long term, the role of oil as an inflation hedge will come into greater question. Significant investment in greener forms of energy and the move towards electrical vehicles will ultimately lead to lower demand.
But at least until the mid-2020s, oil demand is expected to continue to increase, so it is likely that oil will continue to be a key strategic driver of inflationary pressures around the world, and therefore continue to be important in maintaining a well-balanced portfolio.
Keith Guthrie is chief investment officer of Cardano
