May 5, 2016    5 minute read

Why Is Oil In A New Spotlight?

   May 5, 2016    5 minute read

Why Is Oil In A New Spotlight?

Everyone’s attention is focusing on oil prices, which is not necessarily good news for financial markets. However, this is not the case, and it seems investors can take a seat for a while.

Oil prices have reached the highest monthly rebound in seven years and gained 70% in the last three months. The graph below shows the Brent Crude Futures’ pattern over the year, while posing a few threats regarding potential pitfalls in the future. Is this the kind of rebound we had already seen between March and June 2015 when prices raised up to $65 and then moved down $45 in less than four months? In other words, there will be another decreasing blue arrow following on from April? Financial markets are not black nor white. Therefore, there is no a unique answer. However, there are significant aspects underpinning current oil price performance that are worth an explanation, coupled with a few insights outlining what is happening.

Brent Crude Futures

(Source: Bloomberg)

Up to the last market session, Brent Crude and WTI oil traded respectively at $47.14 and $45.67 and the Benchmark U.S. Oil Futures increased by 20%  in April. Energy stocks within the S&P 500 have rallied by 9% month. Although profits have fallen by 63% so far this year, shares of Exxon Mobile Corp. have finally risen by 0.4% on Friday and by 13% on a year base.

What are the triggers of such a rebound?

There are perhaps two main factors:

  1. A decrease in production
  2. A weaker U.S. Dollar

Firstly, U.S. production, which has somewhat doubled over past several years, has now taken a pause and it seems to have started decreasing. Despite demand in Europe and developing countries remaining weak as they are becoming increasingly energy-efficient, there are signs that the demand in U.S. is recovering. This is the major factor impacting upon oil prices, which are set by the law of supply and demand. Furthermore, a new deal amongst OPEC nations is expected to be reached as soon as possible. At the Doha meeting on 17th April, there was no consensus regarding next steps to take to reduce production and find common ground, while nowadays there is much more involvement from key countries such as Iraq. The issue of redefining production’s standards is likely to be tackled with more concretely.

Secondly, the U.S. Dollar has weakened, mostly due to a reluctant Federal Reserve to pump a little bit more in terms of interest rates. The fear of not growing at a stable rate have restrained Ms Yellen from raising interest rates. As a consequence, the U.S. Dollar Index has lost 40bp on Friday and currently trades at 93.437.

Why is the weakening of the U.S. Dollar an important aspect to be taken into account? Because oil is priced in U.S. Dollars. If the currency weakens, investors who may want to purchase oil gain automatically purchasing power, which means they spend the same amount to buy more oil. Put it differently; they pay less to buy the same amount of oil. This way of reasoning leads obviously to a rise in investments, which then boost prices.

At this point, it is worth outlining who benefit from the increase in oil prices.

First, those oil companies that have issued debt, which now can finally rely upon a stronger creditworthiness. In other words, investors are more willing to buy high yield corporate debt, leading yields lower which causes bond prices to rise. Let’s explain the chain through a simplified example.

To access more funding, companies may want to issue debt or bonds (corporate bond). By considering the latter case, when companies issue bonds, they receive cash from investors. The higher the price of the bonds, the greater the amount of cash raised. Then, companies must accomplish an essential duty, which is repaying investors through interests repayment plus the principal at the end of the investment. The lower the yield on bonds, the less a number of cash companies must pay back to investors. It is important to remember that yields represent a measure of risk, that is they reflect the fears of market participants regarding the ability of the company to repay back the money. If investors do believe the company is not able to meet its duties, either for systemic or systematic (idiosyncratic) reasons, they will move away from that investment, therefore leading prices to go down and yields to rebound. If the company wants to issue new debt, for instance, it will be forced to do that at higher yields and lower prices, which is not the best deal. Of course, if the price of oil goes down, companies receives less money for the product they sell: oil. Accordingly, they lose their first source of income, and the probability for investors to get back the money desperately lowers. Simply put: companies may do not have enough money.

This has been the mechanism that had underpinned the risk of default during January when oil prices reached $29 per barrel. Now, however, things are getting better, which is proved by the rebound in the high yield bond market. Therefore, both oil producers and investors are being compensated from a more bullish trend in oil prices.

Who is getting hit, conversely? Those who produce oil or merely countries importing oil instead of exporting it. And this is not surprising: when someone wins, someone other loses.

To conclude, one thing for sure. Risks must not be taken away and several analysts have already pointed out the possibility that oil prices will lose about 300-400bp in the upcoming market sessions. However, both oil companies and investors can now take a breath, at least for a while.

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