Volatility’s effect on returns

It is generally assumed that more volatility usually leads to lower returns, and that assumption is undoubtedly linked to the fact that high volatility is usually associated with falling asset prices.  

Reality is somewhat more complex, though. As far as equities are concerned, there is a virtually linear link between volatility and returns. The higher volatility is, the lower returns are (chart 1).

Commodities, however, behave differently. Some volatility is clearly better for returns than no volatility (see GSCI in chart 1), but very high volatility is, on average, even worse for commodity returns than it is for equity returns.

On that basis, it is probably fair to say that energy-related investment strategies, provided they are long biased, are likely to do the best if oil price volatility is ‘lively’ without being excessive.

So which paradigm shifts are we referring to?

Several incidents in recent years have caused fundamental changes to global oil markets. Without going through them all, we would suggest that the most important ones would include the financial crisis, the emergence of shale oil and gas, the rise of ISIS and the Iranian nuclear conflict, which has, after years of negotiations, ended only a few days ago with what appears to be a promising agreement.

These and other events have led to extreme levels of volatility. Oil prices peaked in 2008, before they collapsed when panic took over late that year. After recovering most, but not all, of their losses the following couple of years, prices stabilised in the range of $100-120 per barrel in 2011-13 before prices went south again in 2014. This year, oil prices have been relatively stable, trading in the range of $50-70 per barrel (chart 2).

The extraordinary high level of oil price volatility in recent years has led some of our peers to argue that oil prices are likely to continue to be turbulent. The Bank Credit Analyst, for example, have used the fattening of the tails to argue that investors should continue to expect extreme oil price moves (chart 3 - Please note that the text in red on chart 3 is BCA’s – not ours).

Whilst statistically correct, the argument fails to consider what for example the emergence of the shale industry has done to energy markets (more about this later). As a consequence, whilst usually in awe of BCA’s work, we don’t buy their conclusion this time around.

Iran

A short while ago the world woke up to some of the most encouraging news it has seen in a long time (Note: It would be unfair to suggest that the entire world think so. Rightly or wrongly, Israeli prime minister Benjamin Netanyahu has been very critical of the agreement). Iran finally agreed to what was presented to the outside world as a nuclear deal; however, we don’t think the full extent of the deal has yet been published and probably never will be. We believe there is much more to the deal than what first meets the eye.

The United States have not been most pleased with Saudi Arabia for a number of years. Saudi, which is a Sunni Muslim country, has openly supported Sunni militants in Iraq with the intention of weakening Shia dominated Iraq and Iran. In addition to that, the U.S. appears keen to downsize its presence in the Middle East, full stop. Much lower oil imports have, in the eyes of the U.S. government, made the region less important politically.

This is where a deal with Iran fits perfectly. Iran has aspirations to play a bigger role on the political stage, and it can supply the world with oil (and gas – more about this later). We wouldn’t be at all surprised if Iran has been ‘granted’ a bigger role to play in Middle Eastern politics. The U.S. will step back and effectively pass the regional superpower role to Iran. This could quite possibly give Netanyahu a few sleepless nights.

Such a deal would have significant implications. As far as energy prices are concerned, there are at least two. Firstly, the ‘Hormuz Strait premium’ (i.e. the risk premium on oil prices caused by regular incidents in and around the Hormuz Strait) is likely to all but disappear. Iran is the only naval power in the region with enough firepower to cause serious problems in the Hormuz Strait, and the 17 million barrels of oil that pass through the strait every day will be able to do so at much lower risk now.

Secondly, and surprising to many people, Russia is not the biggest proprietor of natural gas reserves in the world; Iran is (chart 4). Germany has, for quite some time, been looking to reduce its dependency on Russia for natural gas supplies, upon which it is very reliant. With export sanctions now lifted, Russia’s influence on European energy politics could be greatly reduced, and volatility should drop as a result.

Overall, the agreement with Iran should reduce oil price volatility meaningfully. Iran has big enough reserves that they can act as a very effective buffer in case there are supply problems elsewhere. Lower oil price volatility should also, as indicated earlier, be good for overall economic activity. As far as the absolute price level is concerned, the first reaction to the deal has seen price falls of $1-2 per barrel. The longer term implications are not yet entirely clear, but we don’t expect the agreement to have a massive effect on prices in the short term, given how much prices have already fallen in the last year.

ISIS

The emergence of ISIS, and the problems it is causing, is in many ways a reflection of a broader divide between Sunni and Shia Muslims. It may be premature to write off OPEC as a result, but continued terror actions and/or outright (civil) wars will do nothing to keep OPEC together. Cartels never work when members are at each other’s throat.      

If ISIS had the military power to instigate more wide-ranging infrastructure damage, we would be far more concerned about the price, and volatility, of oil but, at least in the short to medium term, that is not the case. ISIS can certainly create some short term havoc, which can move oil prices modestly over a few days or weeks. Having said that, ISIS is not (yet) capable of creating the sort of oil price volatility that we have seen in recent years, i.e. 50%+ price moves over relatively short periods of time.

Should OPEC disintegrate as a result of the Sunni-Shia divide, oil prices would probably drift lower over a period of time. Prices are almost always lower when pricing is not impacted by cartels, and that would almost certainly also be the case as far as oil is concerned.

Overall, we expect ISIS to cause occasional volatility to oil prices, at least in the short term. Longer term, ISIS is a joker. Nobody has a clue how the whole situation will unfold eventually.

Shale oil and gas

The development of fracking (Note: Fracking is nothing but a short name for hydraulic fracturing) techniques, whether shale or other, undoubtedly represents the most important development in the oil and gas industry in recent times.

U.S. domestic shale oil production is now in excess of 5 million bbl/day. If you add to that the over 4 million bbl/day which come from Canadian oil sand deposits, much of which is exported to the U.S., one can begin to understand why the U.S. now import only 2-3 million bbl/day of oil from OPEC (chart 5).

Apart from improving the U.S. trade balance considerably, shale is having the important effect of putting a lid on oil prices. The shale industry is not enormously informative about production costs, etc., but it is estimated that the average U.S. shale oil producer is now capable of producing oil at $70-80 per barrel (chart 6).

This level is fast becoming the top end of the trading range. Should the price of oil trade at higher levels for any meaningful period of time, shale production will simply expand until the price drops again. At present, only the U.S. has the technology to quickly ramp up production, should the price warrant it, and ramp it down again if required. However, as we have seen more recently, one country is enough to unsettle a market that has effectively been controlled by OPEC for many years.

Oil to trade in a tighter range

All of this implies that reduced volatility is to be expected going forward. Where oil prices in recent years have traded in a range of $40-140 per barrel, one would expect that range to be considerably tighter going forward.

If one assumes that the price won’t drop below the cost of production for any meaningful period of time (as it rarely does), and one assumes that the average production cost today is not far from $50 per barrel (chart 6), then oil prices should trade in the range of $50-80 per barrel (give or take).

Obviously, terror actions by militant Muslims and other temporary supply disruptions can drive the price outside that range, but probably not for an extended period of time. The days of $100-140 oil prices are most likely over, at least for the time being, unless (until) a new dynamic pops up on the horizon.

The winners and losers

Some geographical observations first:

Oil producing nations that produce at virtually full throttle today, and have ‘adapted’ their budgeting to $100-140 oil prices, are expected to be big losers. Countries such as Venezuela, Nigeria and Algeria would all fall into this bracket.  

Many nations across the Middle East also run massive fiscal deficits at an oil price below $60 per barrel (chart 7), where it stands today. Having said that, some of those countries have the capacity to meaningfully increase production (e.g. Iran, Iraq) whilst others have significant reserves which can be used as a buffer, at least temporarily (e.g. Saudi Arabia).

Russia would also (continue to) suffer. Relatively low oil and gas prices hurt the Russian foreign exchange rate which would have the effect of making imported goods, upon which Russian consumers are very dependent, more expensive. The overall result in Russia? Higher inflation.

As far as investment strategies are concerned, one would have to pay particular attention to EM equities and trend following CTAs. EM equities because oil related revenues are very important to some of those countries. Low volatility in itself is not necessarily bad, and can actually be very good. It depends on the price level oil eventually settles at, once the full ramifications of the deal with Iran are understood.

Trend following CTAs benefit immensely from large and sustained moves in asset prices and have certainly taken advantage of the big moves in oil prices in recent years. If a tighter trading range is on the horizon, as we expect, such investors could potentially be whipsawed. In that context we note that oil is just one of many asset classes that CTAs trade.

Amongst the winners, oil consuming countries will be amongst the biggest. We have maintained for quite a while that economic growth will be disappointingly low in the years to come, and we are not about to change that view. Having said that, lower oil price volatility will certainly (on the margin) help economic growth, which could possibly be a reason behind the sudden breakthrough in the negotiations with Iran.

Countries that have the capacity to expand production (e.g. Iran, Iraq) also stand to benefit. So do oil infrastructure builders – in particular in ‘new’ oil producing countries like the U.S. The growing reliance on shale has created a need to modernise and expand the infrastructure (pipelines, etc.); an opportunity which can probably best be taken advantage of through private equity.

In that context we note that, here in the U.K., expectations are now that shale oil and gas deposits in the Surrey Hills exceed those in the U.K. part of the North Sea at the peak. Whilst very exciting, there are still many issues to be resolved, most importantly related to the environment, but it is yet another argument why the days of $100-140 oil prices are well and truly over. Should oil prices stay at current levels, the Surrey Hills will probably remain untouched; however, should oil prices suddenly take off again, some solution will probably be found and the oil extracted.          

There should be plenty of opportunities arising in the equity world (both the private and the public one) from the shale adventure, and one wouldn’t necessarily have to go to emerging markets to find the best opportunities anymore. Having said that, we believe commodity trading firms that benefit from modest, but not excessive, volatility levels could possibly be even bigger winners. Commodity trading firms will provide a key balancing mechanism between markets in deficit and those in surplus and, in that respect, bigger will be better.  

Finally, the transportation industry (and airlines in particular) should also benefit from oil (fuel) prices that are relatively predictable. Aircraft lessors won’t necessarily be directly impacted in a major way, but will certainly be so indirectly, as lower oil price volatility is likely to have a significant – and positive – effect on the biggest clients – the commercial airlines.

Niels C. Jensen

14 July 2015