Who benefits from low oil prices?

The COVID-19 pandemic has led to many historic moments for the world; the huge death toll, the Government-imposed lockdowns and the move to remote working. 

One of the largest changes has been the dramatic decline in travel with flights grounded indefinitely and fewer cars and public transport on the road as everyone stays at home. 

This has led to one of the most unusual consequences of the pandemic with the price of oil turning negative for the first time in history. 

After an earlier failed meeting, the Organisation of Petroleum Exporting Countries (OPEC) finally agreed on 10 April to a production cut to 10 million barrels per day from 1 May, a 10% production cut, in hope of boosting prices. 

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The price of WTI crude oil fell to US-$37 (-$56) in mid-April, its lowest price on record, as the combination of limited demand and rapidly-shrinking capacity led to oil producers paying people to take it off their hands. As of 20 May, the price had risen back up and was US$33 per barrel, although this remains far below the US$63 at the start of the year.

While the prospect of low fuel prices at the pump would normally be celebrated, like most things in the world at the moment, COVID-19 has meant this is not the case. 

Those countries which are net exporters are having their economies hit by the low oil price at the worst possible time while those which are importers are unable to take advantage of it due to the travel restrictions, no matter how cheap it gets. Around the world, oil tankers are sitting idle as producers struggle to contain supply. 

Legg Mason emerging markets portfolio manager, Alistair Reynolds, said: “If something goes on sale, you buy it at a bargain but you’ll only buy however you have much room for, you don’t want to be re-organising the house. It’s the same for oil, it may be cheap but if there is nowhere to store it then the price won’t matter”. 

IMPACT ON EMERGING MARKETS 

There are two segments of emerging markets most affected by the change; those which are oil producers such as Saudi Arabia, Brazil and Russia and those such as China and India which are oil importers.

Oil exporters 

While the US is the largest oil producer overall at more than 16.2% thanks to its shale production, emerging markets producers include Saudi Arabia (13%), Russia (12.1%) and Brazil (2.8%).

For Russia and Saudi Arabia, managers said the countries would largely be able to withstand the fallout. Saudi Arabia requires oil to be priced at US$88 per barrel to achieve breakeven while Russia, where oil makes up just half of exports compared to 80% of Saudi Arabia’s exports, only needs a price of US$42 per barrel. 

“For Saudi Arabia and Russia, these countries and their oil-producing companies can cope with the pressure. Oil makes up 80% of Saudi Arabia’s exports and they would need oil to be at US$88 per barrel to balance what they are spending on population. We are nowhere close to that so they will have a fiscal deficit but it won’t be the end of the world for them, they are exposed but are in a better position,” Reynolds said.

“In Russia, they are more diversified and less reliant on oil than Saudi Arabia and have a low level of debt so they are in a good position to survive.”

Alastair Way, emerging markets portfolio manager at Aviva Investors, said his fund had exposure to Russian oil company Lukoil and he felt more comfortable having exposure to the energy sector now than he did six months ago.

“We have exposure to Lukoil as this looks resilient and the cost of production is low. There are political risks we worry about in Russia but it has a resilient economy and one which is geared to the oil price.”

However, for Brazil, it already had significant economic problems and a large fiscal deficit so the price crash would exacerbate these existing problems at the worst possible time. As well as oil, the price of other commodities such as iron ore – which is Brazil’s largest export – copper and ethanol had also fallen.

Rohit Chopra, portfolio manager and analyst in Lazard’s emerging markets equity team, said: “For energy exporters, the collapse in oil prices may compound the fiscal costs and emergency measures enacted in response to the pandemic. 

“[For Brazil] the low oil price could result in lower 2020 gross domestic product (GDP) growth estimates, lower oil prices and a series of emergency spending measures are likely to result in a revenue shortfall and a higher fiscal deficit.”

Reynolds, whose Legg Mason emerging markets fund had 3.9% invested in Brazil, said: “The last thing Brazil needs is an economic slowdown combined with weakness in oil markets. Brazil already has a fiscal deficit even when oil was at US$60 per barrel. It is reliant on oil for taxation so I expect the fiscal deficit will balloon to 10% of GDP.

“Petrobras also hold a lot of debt unlike the Saudi or Russian companies so they could do without this. Petrobras has been the emerging market company to avoid in funds lately.”

Nick Price, manager of the Fidelity Emerging Markets fund which holds 4.5% in Brazil, said: “The Brazilian market sold off sharply on the back of the twin shock of the pandemic and lower pricing environment for commodities. 

“No exposure to Petrobras boosted returns, as oil prices slumped on the back of the OPEC+ breakdown and lower demand.”

It was not just the oil price either that was troubling the country, Brazil has been dealing with its own domestic problems under President Jair Bolsonaro who is trying to implement reforms. These include reforming the pension system, privatising state-controlled companies, reducing bureaucracy, simplifying the tax system and restructuring public sector wages. 

It is also one of the worst-faring nations in terms of COVID-19 cases with more than 363,000 cases and 22,000 deaths, the third-highest in the world and two health ministers quit within a month after clashing with the president.

This highlighted the challenges of investing in emerging markets as the countries can often be more politically turbulent than developed markets, have volatile currencies and less equipped to cope in a crisis such as COVID-19. There is also less transparency meaning it can be hard to get a hold on accurate figures regarding their finances. 

Chopra said: “Brazil’s main challenges centre around the federal Government’s response to the pandemic as well as renewed political uncertainty following the resignation of Sergio Moro, the former justice minister and speculation that the current economy minister Paulo Guedes may do the same.

“Though 2019’s approval of pension reform was encouraging for the potential savings, debt-to-GDP trajectory and economic growth prospects for the country, the immediate priorities are emergency spending measures and unconventional monetary policies to support the Brazilian economy during the pandemic.”

The Ironbark Copper Rock Emerging Market Opportunities fund, which has 11.7% allocated to Latin and South America, said six of its worst 10 detractors from performance during March were Brazilian companies. 

“Brazil had been performing strongly on the back of the Government pushing forward much-needed reforms. However, recent actions by Congress unwound some of that progress. Those steps backward, combined with the risks related to COVID-19, have significantly impacted the currency and equity markets,” it said in its most recent factsheet.

Way said: “The departure of the health minister has shaken investor confidence in Brazil, they need politicians to be doing a good job right now. Brazil was slow to go into lockdown and has handled it worse than other emerging markets so is one of the least attractive emerging market countries at the moment.

“We have some exposure to Brazil but are defensively positioned and have limited exposure to those companies which are exposed to the domestic economy.”

However, there was a silver lining as PGIM Latin American economist Francisco Campos-Ortiz, thought the dual shocks might prompt Brazil to address its economic problems.

“The outlook for Brazil looks challenging on both the political and economic side, they will have a deep recession. 

“The debt to GDP ratio is 90% which is high for an emerging market and that has consequences for its monetary policy so we expect to see rate cuts to their lower bound. 

“The relationship between the legislative and the judicial branch has been deteriorating and this situation has worsened it. But we can’t rule out that the situation reverses and cooler heads will prevail. A political or economic crisis is not in anyone’s interest and maybe a silver lining will be that there may be an increased sense of urgency to address the country’s economic vulnerabilities, fiscal position and structural growth problems.”

Oil importers

For those countries who are net importers of oil, at first glance the lower price looks to be a benefit for them. The largest emerging market net importers of oil are China (12.5% of overall oil imports), India (9.7%) and South Korea (6.6%). 

Conrad Saldanha, portfolio manager at Neuberger Berman, said: “The governments that import oil such as China, Korea, India and Indonesia will benefit from the oil decline through low inflation, better current accounts and better fiscal deficit so that’s a silver lining”.

But the restrictions on travel plus the lack of manufacturing in factories mean there is minimal need for oil right now. This means what would ordinarily be a boost to these countries’ economies, is instead having little impact. 

The only countries currently able to benefit from the low price were China and South Korea as these countries had slowly begun opening up again. 

“The low price has fallen on deaf ears this year,” said Reynolds. “China and South Korea are the only two countries which are up and running again and they are net importers of oil so they can take advantage. 

“But in China, as prices tumbled, they have not fed that price decline through to consumers as the Government is keeping the benefit in a reserve fund to fund other projects like emission reductions and alternative fuels rather than passing it onto consumers.”

Asked what would happen when other countries began to re-open up, he said the production cuts which came into force in May would mean the price would likely have recovered by the time most countries were consuming at full capacity.

“Oil demand will spike up in the second half of the year but oil will cope very easily as there is so much supply of it and we are running out of places to put it.

“But now every country has agreed to cuts, it will take some time for that storage to be drawn down and it could be another 12 months before oil production returns to normal levels. As demand recovers, the 10% production cut will be enough to balance the market.”

Way said: “The extent to which life goes back to normal will be a key issue. With the shift to working from home, will people still go back to an office everyday? Will they still use public transport or start to drive more instead? That’s an upside for the oil price although it will be worse for the environment. 

“As the first one out of lockdown, China is a role model for other countries and the recovery there has been sharper than was first expected so could that happen in other parts of the world?”