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Black (Oil) Monday

09 March 2020

Russia’s decision to walk away from an OPEC agreement to cut supply has spooked one area of the market very aggressively. At the time of writing oil is trading down 27% on the month following Russia’s decision to expand production and flood the market with oil. The Saudis seem to be following in a similar fashion which is all depressing the oil price from a supply perspective in the medium term.

Russia’s total cost of oil production is approximately USD 19 a barrel and the Saudis can produce down to USD 9 – the US shale industry is economically positive above USD 24, so you can see where the price of oil is going. This declining oil price will slash inflation outlooks globally – the US 5-year – 5-year forward breakeven rate is now plumbing the subdued inflation levels at the height of the 2008 financial crisis.

Separately on market structure, the oil market remains deeply in contango, meaning supply is awash in the system. There is almost not enough storage space in facilities to cope with the upcoming supply war from Russia. A barrel of oil costs GBP 24.20. That barrel has 159 litres in it, so oil is now 15p a litre. A barrel of milk would cost an equivalent GBP 105.00 at current prices. A barrel of Perrier water would cost an equivalent GBP 211.50 at current prices. One of these seems out of whack.

On the opposite side of the economic coin, we have a developing demand shock coming from Covid-19. Concerns over the Italian government quarantining a whole northern region of the country in Lombardy is the additional fear factor that is adding to the market risk off mentality. Not only is quarantining likely to exacerbate the spread as people attempt to head to the exits but it is viewed perhaps by the markets that this containment response is failing.

The economic effects of this virus demand shock are likely to push some countries into technical recessions as consumers and businesses scale back and enter a locked down state of affairs. Some people are still talking about the possibility of a V-shaped recovery, but this likelihood seems further and further away as the contagion spreads across the globe. A global recession may be avoided but a sharp slowdown is now built into markets following this huge interruption to the global supply chain and that is why we are seeing such violent moves.

Unless you have the clairvoyance to see a full blown financial crisis on top of a recession, which to us looks unlikely at this point, it would seem patently obvious that the discounts in equities that we are now seeing will deliver value going forward. Markets always move to the downside in an exaggerated fashion as exogenous threats suddenly pop up. Russia’s decision on oil and the further spread of Covid-19 are big enough exogenous shocks to cause the reaction we have seen to date and first half economic data will not look great compared to the previous years’ numbers certainly. The expectation, however, is still that the damage is all booked in this first half and it does not continue into the second half of the year. Beyond that we have the potential for a big fiscal response for governments globally along with continued stimulus from central banks.

This is truly a painful “Ides of March” moment and the falls feel like they have gone too far and too quickly – things do not normally stay like this for long.

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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.