A year ago, a barrel of Brent crude would have set you back around $55, but you would now be looking at $83.25. That’s a pretty steep elevation in just 12 months, but it mightn’t end there, even though Saudi Arabia and Russia have indicated they’re willing to raise output to partially mitigate expected disruptions to Iranian supplies once US sanctions kick in next month.
It’s generally held that the supply of crude oil is relatively inelastic, at least in the short term, but even if that wasn’t the case there’s only so much producers can do nowadays. As our energy analyst Alex Newman has been saying for some time, the ability of OPEC members to step up production has been severely degraded by the collapse in industry capex budgets following the 2015 oil price slump. Spare capacity shrinks every time the cartel cranks up production, thereby rendering the oil price susceptible to a range of potential supply disruptions, including involuntary shortfalls in countries such as Venezuela and Libya.
Obviously, global oil traders such as Vitol and Trafigura view the level of spare capacity as a key determinant in futures pricing, and although estimates vary, with the likes of Goldman Sachs and the International Energy Agency somewhat at odds, it’s perhaps telling that Brent markets briefly shifted into contango in April, when forward contracts outstripped real-time spot prices. The traders got their bets right, but the shift implies that they’re not convinced that any moves by OPEC to mitigate the loss of Iranian production will adequately make up for the loss of seaborne supplies. Land-based crude supplies are viewed as far more secure, a point borne out by the increased divergence between Brent crude prices and those for West Texas Intermediate (a profitable scenario for US refiners).
For an oil importing nation such as the UK, the effects of rising energy prices on aggregate demand and discretionary income will only become apparent over time, and may even support its benchmark FTSE 100 index in the short term, given the aggregate weighting of Royal Dutch Shell (RDSB) and BP (BP.) stands at 16.97 per cent.
All of this is taking place against the backdrop of rising US interest rates. And while energy stocks have tended to outperform the market during periods of rising interest rates, there is a well-worn causal relationship to take on board. At the end of last week, the yield on US 10-year Treasury bills closed at 3.23 per cent, the highest rate in over seven years. The equity-risk premium – the return investors expect for owning risk assets over benchmark bonds – has narrowed appreciably. Based on Monday’s closing price, the S&P 500’s earnings yield stands at 5.6 per cent, implying a premium of 2.37 per cent, against a long-term average of 3.7 per cent.
This dynamic was in evidence in January, when a spike in bond yields precipitated a sharp correction in US equity valuations, although market bulls could point to the strong rebound that followed. But you would imagine that even with a narrowing risk premium, any marked sell-off would require a trigger; a point worth considering given the SKEW index of the Chicago Board Options Exchange approached record highs midway through last month. Unlike its sister VIX index, it doesn’t measure implied volatility, but implied risk of future returns, or more specifically, demand for put options versus calls on the S&P 500 index.
