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Miton’s David Jane: Arabian nights

  • A new trend has been quietly emerging – the strength of the oil price
  • Oil operates in a geopolitically charged cartel, not a free market
  • Oil is a good defensive diversifier

David Jane, manager of Miton’s multi-asset fund range, comments:

milton-logo “Amid the recent market noise, a new trend has been emerging quietly in the background – the strength of the oil price. We, like many commentators, believed that oil was bounded into a range, but this has proven not to be the case.

“We had taken the view up until late last year that oil was bound by a range that was governed at the lower end by the breakeven cost of shale and OPEC’s desire (even need) for higher prices, and at the upper end by a rapid increase in shale productivity and capacity. These two factors still appear to be the case, so what has changed?

“It appears a new convergence of interests have emerged between Saudi Arabia and Russia, at least on the subject of the oil price, while shale capacity increases have not been as dramatic as might be expected, apparently for geological reasons.

“It is worth considering the dynamics of the oil sector in more detail and how it interacts with the wider economy. Oil is in fact a major driver of inflation and long term inflation expectations, as it remains, for now, one of the world’s most important energy sources.

 Source: Bloomberg, 25/04/2017 - 25/04/2018.
Source: Bloomberg, 25/04/2017 – 25/04/2018.

“So, higher oil prices have been a significant driver of the recent increase in inflation, and inflation is a major driver of asset prices, particularly in bond markets.

“The prospects for oil going forward are of course what really matters, which takes us into the realm of forecasting, not something we are keen on. What we can do is consider the drivers and the risk and dynamics of them to determine a range of realistic outcomes. Oil is not a normal commodity in that it operates less in a free market and more in a geopolitically charged cartel. While the non-OPEC supply and demand can be said to operate on free market principles, the price of oil is ultimately driven by the actions and intentions of a small number of politically driven individuals.

“The most important political influencer of these is Mohammed bin Salman (MbS), the heir apparent to the Kingdom of Saudi Arabia. MbS has set Saudi Arabia on two seemingly conflicting paths, both of which are expensive in the near term and therefore require a higher oil price. The apparent modernising program, such as introducing some, albeit limited, rights for women and embarking on the Vision 2030 programme to build a more diverse and dynamic economy seems at odds with the more aggressive stance the Kingdom is following in regional conflicts. While they may seem at odds, they are probably for different audiences.

“Saudi Arabia has a huge demographic issue in terms of a large young population but few worthwhile employment opportunities due to a lack of investment in human capital and a lack of diversification in the economy. Internal pressures therefore drive a lot of these moves, while the regime needs Western support to survive in both a domestic and regional context, hence wooing the West with reforms.

“Of course, the need to curry favour with the West on regional security is at odds with the desire for a higher oil price, which is harmful to real incomes particularly amongst low to middle income earners in the West. So, while a desire to see the oil price at $80 makes sense from a cash flow point of view, for the Saudis it may put real pressure on the apparently positive relationship MbS has with Western leaders, hence the goodwill tour. In addition, its willingness to be directly involved in regional conflicts may make Western support harder to secure, given the obvious human rights catastrophe unfolding in the Yemen.

“Looking more broadly, there seems to be question marks around many of the other sources of potential oil supply, such as Venezuela, Libya or some of the more marginal US shale resources, and other OPEC players do not appear to have the spare capacity or desire to confront a highly assertive Saudi regime.

“Where this leaves oil on balance is potentially in a good place; the status quo means MbS gets his way and oil makes its way towards $80. Trump may tweet negatively about price manipulation, but higher oil prices are necessary for Saudi stability, so the US is unlikely to go beyond tweeting. At the other extreme, a sustained fall in the oil price could well lead to a collapse in the Saudi regime, which has already had to backtrack on its plan to list Aramco last year, as funding will not be available either for short term measures to shore up support or long term measures to diversify the economy.

“MbS appears to have taken a high stakes gamble of expensive military and domestic plans which require a higher oil price, which if they fail may call into question the sustainability of his regime. Such a collapse would ultimately disrupt production and lead to higher oil prices. The alternative of domestic austerity to repair the finances are clearly even more unpalatable.

“Given the above, the oil sector appears to be a good diversifier and ultimately quite defensive as it benefits from many factors such as inflation and instability which are otherwise negative for equities and bonds, and therefore we have been increasing exposure over the past few months.”