04 Jul 2019
By Scott Thiel
Tensions in the Persian Gulf – the world’s key oil exporting region – have risen sharply. Yet oil trades well below its late-2018 peaks — and oil-related equities have lagged the broader market. What explains the disconnect? We delve into both short-term and long-term oil market fundamentals, geopolitics and the macro outlook.
Oil prices and Gulf tensions BGRI, 2018-2019
Source: BlackRock Investment Institute, with data from Refinitiv, June 2019.
Notes: Under the BGRI framework we identify specific words related to geopolitical risk in general and to our top-10 risks, including Gulf tensions. We then use text analysis to calculate the frequency of their appearance in the Refinitiv Broker Report and Dow Jones Global Newswire databases as well as on Twitter. We then adjust for whether the language reflects positive or negative sentiment, and assign a score. A zero score represents the average BGRI level over its history from 2003 up to that point in time. A score of one means the BGRI level is one standard deviation above the average. We weigh recent readings more heavily in calculating the average. Oil is represented by Brent crude oil futures.
Market attention to Gulf tensions has been on a steep climb since the start of May, when US President Donald Trump imposed new sanctions on Iran and ended waivers for countries to buy Iranian oil. Our BlackRock geopolitical risk indicator (BGRI) on Gulf tensions, which scans and analyses broker reports, financial press and tweets for keywords related to this risk, has spiked to 5.5 standard deviations above its historical average. See the chart above. The downing of a US drone and a series of attacks on shipping vessels in the Gulf and off the coast of Yemen have increased tensions, and sent oil prices rallying in recent weeks. Yet Brent crude oil prices, an international benchmark, are still down 6% since early May.
What could be holding oil back? Fears of a global downturn – which would hit oil demand – are one reason cited for the muted oil price reaction. The International Energy Agency (IEA) has trimmed the global oil demand outlook for two months straight, citing weakening economic sentiment. Yet we see a limited near-term risk of the usual catalysts that bring economic expansions to an end – financial vulnerabilities leading to a deleveraging, or overheating that prompts central banks to overtighten policy. And we see a dovish pivot by global central banks extending the lifespan of this economic expansion, even as trade disputes have increased macro uncertainty.
The Organization of the Petroleum Exporting Countries (OPEC) members and their allies are expected to roll over the current output cuts at a policy meeting this week, as the market is faced with moderate oversupply. Yet OPEC output curbs can do only so much to prop up oil prices. The US – thanks to the rise in shale production - has become one of the key swing producers alongside the likes of Russia and Saudi Arabia, and is not subject to the OPEC production cuts. Shale producers have historically tended to ramp up production when prices are high, effectively capping oil price gains. This phenomenon may be less prominent today, as even shale producers have come under pressure to curb capital spending and to deliver positive free cash flow. We see these forces likely to keep oil prices in a range, with Brent oil trading between $60 and $70 a barrel in the near term.
What does this mean for investors seeking opportunities in the energy space? Global energy stocks have risen about 12% year to date, below the nearly 15% performance of the broader market. We still see opportunities, and favour companies with the ability to generate income and withstand late-cycle volatility. One example: integrated oil companies in Europe, for their income-generating ability and capital discipline. Their dividend yields are even more attractive for those investors hedging back into US dollars, thanks to the hefty US-eurozone yield differential. We also like midstream companies (transportation and storage) for their strong free cash flow yields and income potential. We caution against US shale names in the high yield credit space due to few positive catalysts including limited upside in oil prices.
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