This week marked the one-month anniversary of the harrowing events in Israel and Gaza, our thoughts continue to be with all of those affected by the conflict. Knowing that geopolitical risks can cause concerns for our clients, we hope to provide some reassurance on our approach to protecting your investments.
Despite the initial concern, the nervousness in the financial markets around the conflict in the Middle East seems to have subdued, with main market indices, along with our portfolios, showing resilience over the period. Whilst this shows how important it is to not make rash decisions during times like these, it is still vitally important that we assess what is going on and consider whether anything can be done to create support in the portfolios in the short term. It is important to point out that we are long-term focussed investors and do not seek to make short term changes unless we deem them entirely necessary.
Oil and Politics – Are we heading towards a 1970s oil crisis?
One of the main implications financially from the ongoing conflict is the upward pressure on oil prices. Whilst we have a focus on sustainable investing, with those clients clearly not invested in oil, the impact of oil prices has a wider ranging effect on macroeconomics and markets, which will weigh on all portfolios.
One of the key geo-political comparisons that we see, is that between the current situation in the Middle East and the circumstances that led to the 1970s Oil Crisis. On the surface it is easy to understand why this comparison has been made, but when you delve a little deeper into where we are now compared to where we were in the 70s it is different.
With this comparison, it’s first important to understand who the main oil producers were, then vs. now:
In the 1970s the five biggest oil producing countries were:
- United States
- Soviet Union
- Saudi Arabia
Today the make-up of the top five is as follows:
- United States
- Saudi Arabia
As you can see, whilst a few have not changed, the inclusion of both China and Canada makes for a different overall global make up with certain countries being more aligned with others. We hope that this diversification in oil producers, as well as different levels of diplomatic cooperation, could temper any major price shocks.
One of the key triggers for the price shock in the 1970s came in October 1973 when the Arab members of OPEC (Organisation of Petroleum Exporting Countries) imposed an oil embargo on the United States and other countries that had supported Israel in the Yom Kippur War. This risk remains, but we believe it is reasonable to suggest that the diplomatic relationships between the West and the Middle East are better today than they were in the 70s, particularly between the U.S. and Saudi Arabia, the two global superpowers of oil production.
The figures around the amount of oil production also tell their own story:
- 1973 – Global oil production stood at about 75 million b/d (barrels per day).
- 2022 – Global oil production stood at roughly 100 million b/d an increase of c25 million barrels.
The growth in production is not surprising, but when you take into consideration that the global population has almost doubled from c3.7 billion people in 1970 to an estimated over 8 billion people today it would suggest that despite needing more oil, efficiency, new technologies and the rise in renewable energy has meant that we have become less reliant on oil.
As it stands currently and reported by the IEA (International Energy Agency) and the World Bank, in 2022 the world consumes on average 4.3 barrels of oil per year per person compared to a 4.2 barrels figure that was estimated in 1973. We believe that this shows that oil production should be more resilient to price shocks. Assuming hard hitting embargoes are not put in place.
Another important factor when making comparisons between 1970s and now is that the share of OPEC production has fallen from 56% to 37% from the 1970s to the current day with non-OPEC production now having the dominant share.
When looking at oil prices themselves since Hamas’ attack on Israel on 7th October the WTI (West Texas Intermediate – one of the main global oil benchmarks) has fallen from $86.38 on 09/10/23 to $81.80, whilst Brent Crude has dropped from $88.15 to $86.05 at the time of writing.
The portfolio considerations we made
We thought it would be useful to explain our thinking over the past few weeks in relation to what we could have done and still could do to the portfolios. It is important to understand that none of the levers discussed here have been put into play and nor is this confirmation that they will. It is presented as an insight into our thinking and how we manage your portfolios.
With the potential for rising oil prices and the knock-on impact of these, we focussed on three areas:
- Introducing a physical gold investment into our portfolios. Historically gold has been considered a safe haven asset that in theory provides downside protection and uncorrelated return in times of stress. Considering it is a non-yielding asset class whose price is driven by both demand and supply, it tends to favour a lower interest rate environment than we are in currently. Having said this, the asset has performed well over one year with the current price sitting below its yearly high. With the potential of central banks pausing rate hikes, and the potential for a recession ever growing, the introduction of gold into portfolios is still a consideration.
As specialists in the sustainable space, we are also carrying out research into a sustainable gold offering.
- Energy sector specific exchange-traded funds (ETFs). With the potential of rising oil prices caused by the conflict we considered whether we should include a sector specific ETF that would benefit directly from this if oil prices were to spike. As we were not convinced of the potential for a huge spike in oil prices, we considered that making this decision may be a knee jerk reaction based on limited information. At the point of writing, oil prices have gone down since the attacks of Hamas in Israel. A further consideration we made is that whilst it would be fine to hold these in conventional portfolios, these would not be suitable for sustainable portfolios.
- Increasing exposure to bonds. Bonds have historically been considered as protection in times of negativity in the market. Unfortunately, we have seen this negative correlation between equities and bonds broken in the last couple of years as interest rates have risen considerably higher and in a very quick manner. If we were to see a spike in the oil price, this would lead to inflation which would ultimately lead to Central Banks raising interest rates further, this would be a negative for bonds, particularly longer dated bonds.
Our portfolios already have an overweight to very short duration, cash like instruments and we felt at this juncture it wasn’t right to increase that exposure further. On the flipside, when a recession hits, longer duration/longer dated bonds will do well as the expectation will be that monetary policy will come into play and interest rates will be cut. At this point we are comfortable with how the fixed income elements of the portfolios are allocated but we are doing considerable work on this moving into next year.
Understanding the impact on sustainable portfolios
While our sustainable portfolios attempt to avoid the oil sector, fluctuations in oil prices will have a direct impact on economic output. Higher oil prices increase costs on the supply side, therefore potentially affecting output/inflation. While many companies will hedge against short-term fluctuations in energy prices, through future contracts for example, any increase in energy prices will lead to negative sentiment from markets and share prices will reflect this. When looking at renewable sources of energy, these will typically move in tandem with oil prices. We see this following the invasion in Ukraine, where many renewable investments benefitted as energy prices spiked, however, this was ultimately stifled by rising interest rates.
In our opinion, although the impact on commodity prices has been limited so far, it underlines the need for countries to strengthen their own energy security so that they are less exposed to spikes in oil prices by transitioning to renewable energy.
What is the impact on Inflation?
Bringing it back to the potential risk in oil price spikes, key concerns about this is the impact that it would have on inflation, with oil and gas making up a large proportion of inflation figures as well as personal spend. Despite it being a component of inflation itself, it is in fact inflation as a whole and the response of the major global Central Banks to inflation that is still the key concern of almost all investment managers.
With the U.S. Federal Reserve and the Bank of England pausing rate hikes for the time being as signs start to emerge of global economies cooling, it is this and the path forward that remains our main focus. Both the US and the UK stock markets had stellar weeks last week as market participants are beginning to think that the hiking cycle is coming to an end, and the prospect of a recession could lead to interest rates being brought lower.
What’s next for our portfolios?
Q4 is the period in which we start to think about how we set our strategic asset allocation for next year. Much of what has been discussed is already helping us formulate our thinking for next year. As we complete the work in the coming months, we will update you on our outlook and plans for 2024.
Global oil production:
- OPEC, “World Oil Outlook 2023”
- OPEC, “Annual Statistical Bulletin 2023”
- U.S. Energy Information Administration, “International Energy Statistics”
Oil consumption per capita:
- International Energy Agency, “World Energy Outlook 2023”
- World Bank, “World Development Indicators 2023”