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Some thoughts on post-apocalyptic capital allocations

Some thoughts on post-apocalyptic capital allocations
March 19, 2020
Some thoughts on post-apocalyptic capital allocations

Recent events have certainly shaken us out of any complacency after a decade-long bull market. But they may also precipitate a rethink on capital allocations, as prevailing assumptions on which sectors and geographies will drive growth over the long run could be tested by political upheaval in the aftermath of the outbreak, with potential negative implications for emerging market and environmental, social, and governance (ESG) positions.

The petro-states have certainly been quick to exploit confusion in the ranks. Russia’s refusal to maintain production quotas effectively blew a hole in crude oil prices just as markets started cascading in response to the deteriorating clinical situation.

Some people like to pretend otherwise, but the world still turns on hydrocarbon-based energy sources. Unfortunately, that means that global energy prices are routinely used to gain geopolitical leverage.

With the prospect of both Saudi Arabia and Russia cranking up production, supposedly in a bid to either shore up or gain market share, together with the colossal disruption to the global economy, we’re looking at a record first-half crude oil glut equivalent to between 8-14 days’ worth of demand.

The theory exists that this is a dual effort to undermine the US shale industry. As the effective swing producer within the Organisation of Petroleum Exporting Countries, Saudi Arabia already has form in this regard, when the cartel shied away from meaningful production cuts following the collapse in prices midway through 2014 (the ‘invisible hand’ in oil markets takes on a more sinister aspect).

Even though a significant number of US unconventional oil producers have their output hedged at $50-$60 a barrel, many lower-margin companies in the sub-sector are already struggling to service distressed or reassigned debt. It will be instructive to discover how many drillers the Trump administration is prepared to let go to the wall given the US has become a net energy exporter; a distinction the president would be reluctant to give up meekly.

Donald Trump favours a broad-brush approach to most things and he is normally quite bullish on low interest rates and oil prices. Admittedly, we’re in unique circumstances, but the European Central Bank (ECB) doesn’t seem to have too many doubts about the galvanising effect of the black stuff either.

In an economic bulletin, which analysed the levers behind the 2014 crash, analysts from the ECB concluded that supply-driven price falls in crude were likely to have a more positive impact on growth than those linked to falling demand, specifically that “a 10 per cent decline in oil prices that is entirely supply-driven increases world GDP by between 0.1 and 0.2 per cent”.

The price of Brent crude has fallen by 56 per cent since the start of the year, but the trouble is – with aggregate global demand collapsing – it has become more difficult to determine whether oversupply or falling energy demand is the chief catalyst for the price falls, a vexing issue given the same analysts posit that “a 10 per cent decline in oil prices that is entirely demand-driven is typically associated with a decrease in world GDP of more than 0.2 per cent”.

The oil industry may have superseded big tobacco as the whipping boy for idle puritans, but the economic shock we’re experiencing provides a foretaste of what life would be like if some political activists had their way.

But Covid-19 – and the panic it has unleashed – have brought home just what is at stake, conceivably leading to a reassessment of commercial priorities. It is the rate of change – rather than change itself – that poses the greater threat to economic stability. Once jobs, livelihoods and pensions are threatened by a rapid deceleration in economic activity, large institutional investors may start to view ESG strategies as luxuries they can no longer afford. Emerging markets may also start to lose their allure if western politicians are impelled to follow a legislative agenda that prioritises national security concerns over narrow cost considerations. One thing is certain: given the size of the stimulus packages being touted either side of the Atlantic – for good or ill – politicians will feel more emboldened to intervene in markets.