We think that the current oil price of USD 65 per barrel is within its equilibrium range, which we believe lies between USD 60-70 per barrel:
- We expect demand to continue rising, especially in Asian countries including China and India
- Our view is that additional demand would be primarily covered by supplies from the United States. The breakeven point for US producers lies between USD 60-65 per barrel
- We believe the OPEC+ group is likely to take steps to support the balance in oil supply/demand. The group is due to meet at the start of December to discuss the issue. However, Saudi Arabia has already announced it will cut its output in December.
Why had oil prices reached their high in 2018?
The OPEC+ countries cut supply by more than expected. In November 2016, they agreed to reduce oil output by 1.8 million barrels per day (mbpd) from the current level at that time. In 2018, the actual cut has been larger than that: in May 2018, the compliance rate was 150%. This was partly due to disruptions in supplies from Venezuela, Iraq, Nigeria and Libya, mainly due to the unstable political situations in those countries. But it was also due to Saudi Arabia cutting its output by more than it initially planned.
Market observers began to foresee shortages in global supply due to US sanctions against Iran. In May 2018, the US stepped away from the Iranian nuclear deal and reintroduced sanctions against the country. These came into effect on 6 November with the aim of blocking Iran’s entire oil exports. Iran is the third largest producer among the OPEC countries, so investors likely priced-in the anticipated fall in Iranian oil output.
What caused oil prices to fall?
In October, the compliance rate of the OPEC+ agreement to cut oil production by 1.8 mbpd had dropped to 78% from 150% in May. This was due to decision by Russia and Saudi Arabia to soften the OPEC+ deal. They took the view that oil prices were too high due to the political disruptions in the countries mentioned above and decided to gradually increase output to cover losses from those regions.
Investors became concerned over slowing global economic growth. The International Monetary Fund warned that growth in a number of major economies, i.e. China, the Eurozone and the US, could slow in 2019. The risk of a trade war between China and the US heightened the negative investor sentiment.
Reflecting the potential slowdown in economic growth, OPEC downgraded its global oil demand outlook for 2019. It now expects demand to grow by 1.3 mbpd next year, down from the 1.6 mbpd it forecast in July. It also expects non-OPEC countries to increase supply by 2.3 mbpd in 2019. This could mean global oil market supply/demand falling out of balance by the end of this year and into 2019.
The US relaxed its sanctions against Iran, allowing some countries to continue importing Iranian oil for an additional six months. This lifted the immediate threat of an oil market deficit.
How are falling oil prices affecting the Russian equity market?
No material effect on the overall Russian equity market. It has fallen by 7% in US dollar terms between the start of October and the present. However, this fall was mainly due to the global sell-off in stocks and capital outflows from emerging markets: the MSCI Emerging Market index has also fallen by 8% over the same period.
Energy companies have underperformed, as the correction in oil prices triggered profit-taking in those stocks. For example, Gazprom has fallen by around 10% in US dollar terms, Rosneft by around 13% over the same period, and Gazprom Neft by around 4%. Nonetheless, all three stocks have risen over the year to date, by 4%, by 31% and 32%, respectively, in US dollar terms, thanks to higher oil prices this year.
How does all this affect our outlook on Russian equities?
We have not revised our outlook for the Russian economy or Russian equities.
· The Russian economy should be relatively resilient to falling oil prices. The new budget rule suggests that the budget receives revenues from oil taxes based on an assumed oil price of USD 40 per barrel. All additional profits go to the Reserve Fund. The government has restricted its spending and achieved a budget surplus for the year to date equivalent to 3.5% to GDP. The Russian budget would come under pressure should oil prices fall below USD 40 per barrel.
· We still hold to our base case assumption of the long-term equilibrium oil price being USD 65 per barrel. Even with this conservative assumption, we foresee a 40% upside to fair price level for the Parvest Equity Russia fund over a three to five-year period. In annual terms, this could mean 7%-12% of addition return. For Parvest Equity Russia Opportunities, the potential upside is 45% based on the same assumption. This potentially implies annualised additional returns of 8%-14%.
We continue to expect the average dividend yield from the fund’s holdings to be around 8% over the next 12 months as we have not changed our assumption regarding the average oil price.
Disclaimer
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets.
For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Past performance is not indicative of future performance.