Oil Outlook Suggests the Only Way Is up for Bond Yields

Oil Outlook Suggests the Only Way Is up for Bond Yields

Reprinted from the FT – 16/08/2020

If the debt market crumbles it might be better to own oil-related ETFs and stocks.

Fossil fuels have suffered over the past year as a COVID-induced fall in energy demand compounded longer-term pressures on the industry. At the same time, however, many people have decided a car offers a safety bubble in the pandemic, supporting a resurgence in sales — most of them still petrol-powered.

Oil markets are caught between these two notions: one bearish, the other bullish. In the year ahead, bulls should win out. When that happens, look for inflation expectations to rise, sending bond prices lower and yields higher.

Crude prices have swung wildly over the past six months. A collapse in oil consumption sent the market into a deep slump before the world’s largest producers agreed to slash output to adjust to the new reality.

Supply and demand have this summer again found an equilibrium. Opec and Russia in April agreed to an output cut of 9.7m barrels a day, about a tenth of global output. Add to that a 2m b/d drop in production from US oil explorers in the second quarter of this year and the conditions were in place for the supply overhang to evaporate. That rebalancing kicked in from June, according to estimates by Rystad Energy.

Traders, anticipating this, sent Brent prices to around $45 per barrel, more than double the April low. But the world’s biggest producers will take their time before fully opening the taps. Consumption is still down a tenth from the end of 2019, although that should change as the economic effects of the crisis diminish in the coming year.

Most Opec watchers have focused on the relationship between Saudi Arabia and Russia, but the behaviour of the US private producers also warrants monitoring. As of the end of July, American onshore and offshore production had yet to rebound from two-year lows. The country’s onshore shale drillers can reverse direction reasonably quickly, unlike those in offshore areas such as the Gulf of Mexico.

But there are no obvious signs of a resurgence in drilling activity in key shale areas such as the Permian formation, which covers parts of Texas and New Mexico. That region provides about 40 per cent of total US output. The number of drilling rigs used there has fallen to a four-year low, according to the Energy Information Administration. The army of workers in US oilfield services has fallen back to 2010 levels, notes Rystad.

All this suggests supply will not snap back swiftly. US exploration and production companies also have more debt than ever on their balance sheets. Total borrowing, secured and unsecured, totalled about $170bn by the end of July, according to Texas law firm Haynes and Boone. That is much more than double the amount from four years ago when oil traded at a similar level. It seems unlikely that these drillers can support so much extra debt given that their cash flow — in most cases — has not risen accordingly.

This all comes at a time when some of the world’s largest oil companies have promised to cut capital spending or production, or both, threatening to crimp supply.

Saudi Aramco this week said Capex will fall about a third this year to save cash. BP not only forecasts less spending but said its upstream production would fall for the next five years, at least.

Fall in US gas flaring gives cause for optimism.

The world’s oil supermajors including Royal Dutch Shell and Chevron have slashed the value of the oil and natural gas assets on their balance sheets, leading to significant accounting losses. But quite a few still expect crude prices to rise over the next couple of years towards $60 per barrel.

If oil hits that level, the accompanying rise in inflation should cause bonds to sell off — fixed-coupon bond prices usually fall when inflation rises — and yields to rise.

A similar oil rebound in 2016 preceded a two-year bear market for bonds. Ten-year US Treasury yields, as well as those of German Bunds, have already picked up this month.

Oil can also affect inflation disproportionately. Energy has an 8 per cent weighting in the US consumer price index basket and the sector’s prices have much greater volatility than most other CPI inputs.

This tends to give the oil an outsized impact on that measure of inflation. A 10 per cent jump in the crude price raises inflation indices by between 0.5 to 1 per cent, depending on the country, according to a recent paper from the International Association for Energy Economics.

If bond markets do crumble because of a resetting of the oil price, it might be better to own oil-related exchange-traded funds and stocks rather than those tied to gold, a recent favourite.

The precious metal’s price has moved inversely with real US bond yields, which turned negative this year. If real yields started to move higher, gold’s glittering run would end. The price of oil offers a barometer on economic activity. Right now, it is rising.