What does the collapse in oil mean for your investments?

The oil market has hit historic lows in the past week, which could have a knock-on effect on equity and bond prices. Danske Bank’s strategist assesses developments and the likely consequences for investors.

For the first time ever a barrel of oil was traded at negative prices earlier this week – in other words, buyers actually received money to take the oil, as much as USD 38 per barrel.

So-called May futures (the price for oil deliveries in May) on US WTI oil expired – but demand for US crude was at rock bottom and US oil storage facilities were full, which meant investors had to pay to offload their futures contracts.

“Oil prices collapsing is no great surprise at the present time. Demand has plummeted as a natural consequence of a world overshadowed by the corona crisis. However, we admittedly had not expected negative prices – an unprecedented event, though we should remember the oil market is highly speculative,” explains Danske Bank’s investment strategist, Lars Skovgaard Andersen.

We are at an absolute low right now

The extremely low demand for oil is due to China only now beginning to pick up again after its coronavirus outbreak, while economic activity is probably at an absolute low right now in both Europe and the US. Millions of cars are off the roads at the present time, thousands of planes are grounded and a generally weaker demand for goods is reducing the need for oil in the manufacturing and transport sectors.

After the May futures expired, the price of June futures became the new reference point for US WTI oil, and June futures are trading in positive territory, though at a very low level of around USD 15 per barrel as we write. Brent oil prices from the North Sea, which are the reference for Middle East oil, were initially sliding this week, though they are far from negative territory at around USD 22 per barrel after rising in recent days.

“These are still crazy prices, but we expect oil prices to rise as economies reopen and gradually begin to pick up, while the low prices will likely also result in lower production and hence reduced supply,” says Lars Skovgaard Andersen.

Wake-up call for the financial markets

Plunging oil prices also produced significant price falls across equity markets earlier this week. Global equity prices have otherwise generally been on an upward trend since hitting bottom on 23 March.

“Investors had so much focus on the situation probably looking significantly brighter in six months that they tended to forget about the losers in the meantime – but the crash in oil prices has served as a wake-up call. Falls in the price of oil do not only hit a long list of energy companies, but also have knock-on effects on the manufacturers that deliver infrastructure to the oil sector, banks that lend money to the sector, and so on,” says our investment strategist.

Moreover, oil price falls do not only hit the companies’ equity prices, but also the corporate bonds issued by the companies. Many of these bonds are high-yielders – in other words, bonds that already lie at the risky end of the scale and thus are not overly solid to begin with. Steep falls in oil prices also have a negative effect on government bonds issued by the major oil-producing nations.

Short-term disruption for equities – not long-lasting problem

“Naturally, the great fear among investors is that the fall in oil prices might set in motion a chain of negative effects in the financial markets, but we are convinced the problems can be contained and that major snowball effects can be avoided – for example, via the central banks’ support programmes that buy up corporate bonds. As mention, we also expect oil prices to rise as the year progresses, so we more consider the events of the past week to be short-term disruption rather than a long-lasting problem,” says Lars Skovgaard Andersen.

At the same time, he also underlines that low oil prices are essentially positive for the economy, and that they, together with the large economic assistance packages from the politicians and central banks plus low interest rates, provide a solid foundation for economic growth later this year.

“All things taken into consideration, we expect to see a sensible, single-digit return from equities over the coming 12 months, though the time ahead will of course see plenty of volatility and uncertainty, with investors probably still nervous about the coronavirus flaring up again later in the year and how that might be tackled,” notes our investment strategist.