Bets on the oil price have always been risky, but many investors are now witnessing much greater volatility than they have ever seen before. A combination of oversupply and collapsing demand resulted in the price of West Texas Intermediate (WTI) crude, a US measure, plunging into negative territory for the first time in history on 20 April. And Brent, the international benchmark, followed by slumping to a 21-year low.
Such volatility is likely to persist, in part because of the technicalities of oil trading. Having recovered from its 20 April low, WTI slumped again a week later after a major oil exchange traded commodity (ETC) began offloading its short-term contracts in the commodity.
Ipek Ozkardeskaya, senior analyst at Swissquote Bank, notes: "One big problem with oil is that no one wants or needs it now. Therefore, at the end of each month contract, we could see major price swings to the downside, as investors liquidate their positions to avoid physical delivery. Under these circumstances, medium- to long-term investors are nowhere to be found. So the oil market is left in the hands of short-term traders and price volatility is here to stay with a clear positive skew to the downside."
As we pointed out in the Big Theme of 9 April ('Investment trusts and funds to buy on the cheap', IC, 9 April 2020), making pure plays on the oil price via the likes of energy or oil ETCs can be highly speculative and “akin to tossing a coin”. Your losses can be exacerbated by the way certain ETCs function, and any such positions should only represent a very small proportion of a balanced portfolio.
Price volatility and any broader hit to the energy sector will also have consequences for many mainstream funds. Investors with such exposure may need to brace for further volatility, although bargain hunters may see opportunities to top up on certain holdings, and adventurous investors may wish to invest in markets and funds that have been unduly hit by any uncertainty related to the oil price. But if you plan to do this, be aware of which areas might be affected by severe problems in the energy sector and carry out even more due diligence than normal before investing in a fund with exposure to them.
Below we have highlighted the types of funds affected by movements in the oil price and looked at what sort of impact it will have on them.
Renewable infrastructure
Renewable energy infrastructure investment trusts have looked well placed recently because they invest in assets such as wind farms, which are broadly unaffected by the coronavirus lockdown. As we discussed in the Big Theme of 17 April ('Alternative investment trusts for the dividend drought', IC, 17 April 2020), renewable energy infrastructure trusts generate a good deal of their revenue and income from subsidies, but can be affected by falls in the power price. And moves in the oil price can have a knock-on effect on the sale of power from renewable sources.
The severity of the moves in the oil price mean that renewable infrastructure trusts could now experience a bigger hit to their net asset values (NAV) and greater share price volatility. Analysts at broker Stifel recently downgraded this type of investment trust from positive to neutral on the basis that their share prices had made substantial gains in recent weeks, leaving them vulnerable to falls. The average renewable infrastructure trust, as categorised by analysts at Winterflood, traded at a premium to NAV of 7.1 per cent on 27 April.
“In the past month, the UK day ahead power price has fallen sharply, declining by one-third to £20MW/h," explained analysts at Stifel. "The price has halved since last summer and is down two-thirds since the first quarter of 2019. Fortunately, renewable [energy infrastructure trusts] get around 60 per cent of their revenues from subsidies, with only around 40 per cent linked to market prices. Many trusts also fix much of their market price exposure a year or two in advance, which provides some short-term protection from the market price.”
But they added that many renewable energy infrastructure trusts would be “vulnerable to revenue shortfalls and reduced dividend cover when they come to renew price agreements, unless there is a substantial recovery (ie doubling) in power prices.”
And this seems to be happening. Renewables Infrastructure Group's (TRIG) board announced on 22 April that it had reduced its power price forecasts, implying a reduction of 5p per share to its NAV. The NAV per share was 115p at the end of 2019.
“Covid-19 is having a materially adverse impact on wholesale power prices as a result of reduced economic activity due to movement restrictions introduced across Europe,” said the trust's board. “The global pandemic has led to a reduction in demand for electricity, and caused gas and carbon prices to fall. These impacts are expected to continue over the near term, impacting all power generators. In addition, expectations for gas prices in the medium term have continued to ease, due to expected softer demand and increased supply.”
The chart below suggests that other trusts may be even more exposed to shifts in the power price than Renewables Infrastructure Group.
These trusts have resilient sources of cash flow, meaning that they should be able to continue to pay dividends and perform well in NAV terms. Renewables Infrastructure Group’s board, for example, has reaffirmed its plans to pay a dividend of 6.76p this year. But the share prices of these types of trusts could fall – at least in the shorter term – and some volatility is likely. However, more adventurous investors could use it as an opportunity to buy into them more cheaply.
UK equity income
UK equity income investors are particularly affected because the likes of BP (BP.) and Royal Dutch Shell (RDSB) are major dividend payers and major holdings for some equity income funds. Equity income investment trusts can be a good source of income and more resilient at a time of widespread dividend cuts. This is because many have revenue reserves to draw on if they need to top up the revenue they get from holdings to meet dividend payments. City of London Investment Trust (CTY), for example, continues to look robust and we highlighted more such opportunities in the Big Theme of 1 April ('Investment trusts to weather the dividend drought', IC, 1 April 2020).
However, the oil-heavy nature of the UK market means that some UK equity income trusts could still come under pressure as they are substantially invested in this area, and their share prices could continue to be volatile. But for investors with a higher risk appetite, this could present opportunities.
If you want less oil-price-related volatility one option is UK equity income funds that invest in mid and small-cap companies such as Unicorn UK Income (GB00B00Z1R87) and MI Chelverton UK Equity Income (GB00B1FD6467). Their focus on small and mid-cap companies has resulted in them underperforming some of their peers this year, but they could provide some diversification away from the energy sector.
Unicorn UK Income's managers aim to invest in well-financed companies that operate in robust end markets. Financial services was the fund's largest sector exposure at the end of March, and insurance and pensions consolidator Phoenix (PHNX) and Sabre Insurance (SBRE) were among its largest holdings. The fund's managers have recently reduced exposure to holdings hit hard by the coronavirus outbreak, such as Cineworld (CINE). And they are running a higher allocation to cash than normal to be able to "deploy capital in high-quality companies at attractive valuations, once we perceive the current crisis is close to reaching its worst".
Another way to mitigate the effects of companies cutting their dividends is to have very diversified exposure to equity income stocks. Richard Philbin, chief investment officer at Wellian Investment Solutions, suggests investing in equity income funds that hold “a large number of stocks so are less reliant on individual names”.
Bonds
Another area affected by the fortunes of oil is high-yield bonds because many of them are issued by US energy companies. These types of bonds were a high-risk, potentially high-reward investment even before the recent oil price slump and have been offering much higher yields than normal in the wake of the coronavirus sell-off. So if you decide to have some exposure to these you should be very selective about how you do it.
If mitigating the high risks of high-yield bonds is a high priority for you, it might be better to invest in them via a strategic bond fund rather than a dedicated high-yield bond fund. This is because strategic bond funds can hold defensive holdings alongside high-yield bonds, offsetting their high risks. Options include Artemis High Income (GB00B2PLJN71), whose managers tend to hold a substantial level of high-yield bonds, and these accounted for nearly half of the fund's assets at the end of March. Not many of these were issued by oil and gas companies, but rather ones in sectors such as financials and telecoms. The fund also held defensive investments such as government bonds.
Emerging markets
Falling oil prices result in both winners and losers in emerging markets. India, a big net oil importer, could benefit. But oil exporters such as Venezuela, Mexico, Russia and Middle Eastern states could see further volatility feed into their equity markets.
Investors with a particular desire to exploit the divergent fortunes of different markets could invest in single-country funds. But these are a very focused form of exposure to idiosyncratic risks in a market, so single-country funds should only account for a very small proportion of your portfolio.
Because emerging market countries and businesses will fare differently, it is difficult to predict how funds focused on these regions will hold up amid the oil price volatility. So it makes sense to get exposure to them via a fund that focuses on durable businesses, especially as these are holding up better than some of their peers due to investors fleeing to 'quality' names amid the current uncertainty. Options include Hermes Global Emerging Markets (IE00B3DJ5K90), which invests in some of the more established emerging market companies and has overweight positions in Alibaba (US:BABA), Tencent (HK:700) and Samsung Electronics (SMSD).
