Beware of slicks!
Crude oil prices have been on a rollercoaster ride this year, similar to the experience of 2015. Brent started the year at USD 37/bbl, falling to a low of USD 28/bbl in mid-January before rallying to a peak of USD 52/bbl in early June. Oil’s second quarter rally was largely driven by large-scale production disruptions due to wildfires in Canada, militant attacks on infrastructure in Nigeria and Libya, and strike-related shutdowns in Kuwait. Unplanned global supply outages hit a record 3.65mbpd in May, according to the Energy Information Administration, around 4% of global consumption.
In July, crude oil prices fell sharply again as Canadian production resumed, and as OPEC crude output rose to an eight-year high. Brent touched USD 42/bbl in early August.
Roll costs – a pain for oil investors
Our recommendation this year has been to avoid direct long positions in crude oil and instead focus on energy equities, which have delivered returns of 14–16%. Why? Holding direct long exposure to crude oil is not attractive when adjusted for price swings – returns have ranged from –11% to 4%, with volatility around 40%. Investors could have potentially generated better returns of 25–41% if and only if their market timing was perfect, buying at the lows in January/February.
The weak returns were mainly due to elevated roll costs, which eroded direct oil investment returns. Buying physical crude oil is cumbersome – who wants to store oil barrels at home? – so investments are typically made through futures contracts. Unfortunately, these contracts expire, unlike equities. To maintain constant exposure, commodity investors need to roll futures contracts, selling close to expiry and rolling into a new contract. As the crude oil futures curve has been upward sloping (in “contango”) due to storage costs and rising inventories, investors have repeatedly had to buy the next oil future contract above the spot price.
Higher prices ahead
CIO believes the oversupplied oil market, which started in 2014, is soon coming to an end. We remain confident that the market will balance out next year through a combination of contracting non-OPEC production and rising demand in emerging markets.
As such, we feel comfortable calling for a Brent price of USD 55/bbl in 12 months. What does this mean for investors? At current prices near USD 40/bbl, investors with a horizon of more than six months could consider buying energy equities. In our global tactical asset allocation, a rebound in oil prices should support a return to growth for US earnings, underpinning our overweight position on US equities. And from a longer-term perspective, energy remains a preferred sector in the US and Europe thanks to improving cashflows and attractive dividend yields.
Global Chief Investment Officer
Global Investment Office
Oil prices are up by 12–18% this year, but investors would have hit an oil slick by buying crude directly due to high roll costs. CIO expects oil to climb toward USD 55/bbl in 12 months as supply and demand balance out.
We are still avoiding direct long oil investment, and prefer US equities and global energy stocks instead.
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