Tensions in the Middle East and North Africa have led oil prices to approach $79 a barrel for Brent Crude and around $73 for West Texas Intermediate, which Green warned will have broader economic implications on individual sectors within investor’s portfolios.

“Global investors need to take seriously the volatility in oil prices due to their direct influence on inflation, as rising oil prices can lead to increased production costs across various industries, affecting corporate profitability and economic growth,” Green said.

“Additionally, oil price fluctuations can create market volatility, influencing the performance of energy-related stocks and sectors, making it crucial for investors to monitor and perhaps adjust their portfolios in response to these changes,” he added.

Given that tensions in the Middle East introduce geopolitical risks that can significantly impact market sentiment, Green said investors often respond by reassessing risk tolerance and adjusting asset allocations.

“Safe haven assets, such as gold and government bonds, could experience increased demand as investors seek refuge from market volatility,” he said.

In terms of equity exposure, Green noted currency fluctuations and emerging market vulnerabilities will also be in sharp focus.

“Rising oil prices can contribute to currency fluctuations, particularly affecting economies heavily dependent on oil exports,” he said.

“For investors with exposure to emerging markets, currency devaluations may pose risks to their portfolios,” he added. “Countries with large external debt denominated in foreign currencies may face challenges servicing their debt obligations, potentially impacting the performance of assets tied to these economies.”

As at 2018, over 51% of global known crude oil reserves were in the Middle East.

But, unfortunately, the coronavirus pandemic has seen oil prices plunge to record lows, as people are told to stay home and only fly when absolutely neccessary.

Many countries in the Gulf Cooperation Council (GCC) region use sovereign wealth to fund basic infrastructure projects, and the reduction in oil price impacts the ability of countries to invest in that way.

Effects

Mark Sanderson, chief operating officer at Praemium, said to International Adviser that regions that do not have high levels of oil reserves, like Dubai, have been “particularly innovative” in how they have built up their economies and so, “in theory, should be more resilient”.

However, Christopher Davies, financial planner at The Fry Group, told IA that the drop will hit “huge capital projects in the pipeline”, such as UAE trying to balance government budgets.

In a bid to bolster their coffers, governments in the Middle East could look towards an income or wealth tax.

But both Sanderson and Davies do not think this is likely to happen.

“The introduction of income tax has long been mooted in countries like the UAE,” said Sanderson. “However, I don’t expect this current situation to change the timeline for that too much.”

Davies said: “An income tax-free lifestyle is a significant attraction to the region for many expatriates.

“I would expect further forms of indirect taxation before the Middle East countries consider the formal application of income tax, not least for the administrative burden this could place on tax authorities.”

VAT?

One development that arose after IA spoke with Sanderson and Davies was the sharp jump in value added tax in Saudi Arabia.

Like Emiratis, Saudis only started paying VAT on 1 January 2018, with the limit set at 5%.

The decision by the government on 11 May to triple it to 15% from 1 July would have come as a very unpleasant shock.

Shortly after the announcement was made, however, the UAE authorities confirmed that they had no plans to follow suit.

The UAE government has, as of yet, made no mention of introducing income or wealth taxes to raise cash to battle the economic impact of covid-19.

Overestimation

So, while high net worth individuals are unlikely to be hit with a wealth tax, that doesn’t mean they will have escaped the downturn unscathed.

Sanderson said: “A diversified portfolio should shield individual investors from the brunt of the impact.

“However, the resulting job uncertainty, compounded by covid-19 lockdown measures, will have an impact on investor confidence and, in theory, could mean less money to invest.

“Investors who live and work in the Middle East tend to overestimate the negative impact that a falling oil price will have and so there is often a disproportionate loss of confidence in the short term.

“While the mass affluent investor may be a bit more reticent; high net worth investors, who are less concerned about employment, will likely see this as an opportunity to invest in equity markets which could be perceived as ‘cheap’ compared to the levels over the last 10 years.”

Client outcomes

The rapid decrease in demand for oil could also mean a reduced number of executives and employees in the oil industry.

This, in turn, could potentially mean fewer high net worth individuals and expats in the Middle East.

The Fry Group’s Davies said a “significant amount of jobs” in the region are linked to the oil and gas sector, and the lack of activity in the space is likely to have “important knock-on effects for the wealth industry”.

He said that “competition” for clients “is likely to increase”, as the number of expats falls.

“This could force businesses to adopt a leaner and more cost-effective business model, focusing more on current client retention,” Davies added.

“A decrease in potential client numbers may therefore be a good thing for the industry, which will have to adapt to providing better client outcomes and focus on servicing clients effectively due to a shrinking pool of potential replacement clients.”

Adviser help

The ability to keep customers at a time like this is a real skill and can be the difference between a successful and a failing business.

“Adviser firms need to instil that confidence in their clients through regular communication and transparency,” said Praemium’s Sanderson.

“The current global pandemic, however, has made this more difficult than ever and advisers need to find more innovative ways of connecting with clients.”

Davies said that advice firms will also have to abide with “greater transparency and level of transparency” over fees as the marketplace becomes more competitive.

He added: “With a changing advice landscape in the Middle East, advisory firms are going to have to learn to adapt to remain relevant in the new market.

“As we come out of the current pandemic, working practices everywhere will likely be changed for good.”

The unprecedented slowdown, however, saw the price of West Texas Intermediate (WTI) fall into negative territory for the first time on 20 April.

A price drop like this has never happened before in the oil sector, although it has been seen in regional energy markets for both gas and power, according to Goldman Sachs.

Stymied by storage

While market conditions have been a significant headwind, the real problem stems from a lack of places to store oil, according to Tal Lomnitzer, senior investment manager on the global natural resources team at Janus Henderson Investors.

The sharp sell-off of WTI saw prices hit a low of minus $39 (£32, €36) per barrel, “driven by dynamics going beyond demand and supply for oil and into the availability of oil storage capacity”.

“Excess supply of crude oil has been filling up the available storage at the main crude hub in Cushing, Oklahoma where this oil is traded.

“Storage is normally easily accessible.”

This limited capacity meant that “bids in the market for May oil deliveries dried up, allowing prices to plummet”, Lomnitzer added.

He described negative oil prices as “an anomaly”, evidenced by the price bouncing back and ending up at $10 per barrel.

Not worth it?

Matt Adams, portfolio manager at Franklin Equity Group, expects continued price volatility as storage in Cushing nears capacity.

But “it’s important to remember that energy markets are largely self-correcting; and the lower prices go, the faster wells are shut-in and drilling activity should decline”, he added.

“Ultimately, demand will need to outstrip supply for some period of time to bring down inventories and create a healthier market.

“We believe at these price levels that all oil production is uneconomic, even from the lowest cost producers.”

Takes two to contango

But Joshua Mahony, senior market analyst at online derivatives trading platform IG, believes that firms may continue to produce oil on the basis of the future price.

“The big question for many is quite why energy producers would create the product if prices are so low.

“The contango scenario we saw on Monday help explain that, with futures prices significantly higher than the spot.

“That highlights the expectations that the rock-bottom levels seen over the past months are going to be a short-term phenomenon rather than a permanent fixture.

“With oil prices expected to rise in the future, it makes sense for many producers to maintain output with the expectation that they will achieve higher prices down the line.”

However, it is his decision to abandon the Joint Comprehensive Plan of Action, negotiated over 20 months by China, France, Russia, Germany, the UK and the USA, which is currently making waves across the oil market, he argues.

Commonly referred to as the ‘Iran Nuclear Deal’, the plan sought to ensure that Iran’s nuclear activities existed for peaceful purposes only, with its agreement resulting in the lifting of sanctions on the country’s oil exports and enabling Iran to return to crude markets.

As a result of the deal’s implementation on 16 January 2016, Iran’s oil production increased by one million barrels a day in the 12 months that followed.

The Trump effect

However, on 8 May 2018 Trump tweeted his decision to withdraw from the deal, and the 180-day wind-down period embedded in the deal to enable countries and companies to put their affairs in order is due to end on 5 November 2018.

As a result of this decision, markets have already seen a decline in Iran’s oil output ahead of the deadline. Output during the month of September was estimated to be about 10% down, a decrease of approximately 370,000 barrels per day, compared with the average during the first half of the year.

General market consensus is that this will continue to fall by up to 1.5 million barrels per day, a significant lull from its recent peak of 3.8 million.

Oil price impact

In a market that is so close to being in balance, this is a major dislocation – equivalent to about three quarters of the non-OPEC supply growth for 2018 – and the oil price has reacted accordingly.

In an attempt to ease the pressure, the US sold 11 million barrels of oil from its Strategic Petroleum Reserve in August but this had little to no impact on the global market.

Even a plea from President Trump himself via Twitter urging the OPEC ‘monopoly’ to lower its prices went unacknowledged, with the Joint OPEC-non-OPEC Ministerial Monitoring Committee (JMMC) expressing its satisfaction regarding the current oil market outlook, with an “overall healthy balance between supply and demand”.

While the market will eventually react to the positive price signal through increased production, this is often a slow process.

The recent swing producer, the US, is expected to grow its crude oil output by about 1.3 million barrels a day this year and by 1.1 million barrels in 2019. Though this will eventually fill the gap left by Iran, oil prices are expected to remain well supported for the time being and we could see some significant volatility once the 5 November deadline arrives.

The recent murder of the journalist Jamal Khashoggi has added to the uncertainty. However, reports suggest that Saudi Arabia will not respond to any sanctions imposed in the wake of his murder by using a 1973-style oil embargo; Khalid Al-Falih, the Saudi Arabia Oil Minister, recently eased fears of oil shortages by saying that OPEC is in “produce as much as you can mode” and this saw the oil price retreat from its recent high.

Global repercussions

Despite this, the strength of the US dollar means that for many countries the oil price is within spitting distance of the levels seen in 2014, despite the fall in Brent from $100 to $77 (via $26) since then.

This is certainly the case for UK citizens with sterling still suffering in the wake of last year’s Brexit referendum pushing petrol prices close to record highs, but can also be seen more widely with consumers in the Eurozone, Canada, Brazil and South Africa all having similar experiences.

Consumers in India have also been hit hard. While the Indian government has cut duty rates on petrol and diesel in an attempt to ease the burden, local retail prices remain at an all-time high. Despite this burden, the country’s trade figures are pretty healthy – its trade deficit for September was the lowest in the last five months – and its economic growth, at 7.3%, is expected to outpace that of China this year and next.

Investors cheer

Though a higher oil price is bad news for consumers at the pumps, it is great news – at least in the short term – for investors in the oil sector.

For one, the recovery has allowed BP to increase its dividend for the first time since 2014, albeit only by 2.5%.

Elsewhere, the resulting ‘tsunami of cash’ has also enabled Royal Dutch Shell to begin its long promised share buyback programme having already spent over £1.5 billion since these developments were initiated back in July. Currently, the business is able to spend an average of over £25 million every day and is looking to spend at least $25 billion in total by 2020.

Despite this, dividend yields for BP and Shell are almost 6% meaning they will be a shoe-in for ISAs.

Shifting sands

Nonetheless, while investors have cheered the rise in oil price over the last few months, as we move into the longer term it will be harder to determine the investment outlook for the sector with so many moving parts.

The ongoing rhetoric of Donald Trump, OPEC’s stance, as well as the impact of those outside the bloc will continue to keep consumers and investors alike on their toes. Within this rapidly changing environment, one thing will remain key for prudent investors – the value of diversification in a strong portfolio.

Mike Stoddart is Head of Equities at Brown Shipley

Currently, the energy sector is a value opportunity, London-based Waghorn told our sister publication Fund Selector Asia during a recent trip to Asia.

His forecast for the cyclical industry is for a 7% average return-on-capital-employed (ROCE) ratio in 2018 and 2019, which is still under the average of 11% based on data from the past 20 years.

Wagorn said that, in terms of ROCE, the energy sector is expected to perform better over the next two years if oil prices remain relatively high. He said the whole sector should also start benefiting from infrastructure investments made over the past few years.

A question of cash flow

At the end of September, Guinness AM’s 30-stock portfolio had roughly 30% of its assets allocated to large-cap companies that were under-valued and are expected to generate higher free cash flow than historically, Waghorn said.

“The free cash flow level among the large-caps is dramatically higher than we have seen for a number of years,” he said. In 2016, energy companies on average had negative free cash flow. He believes that was the worst period and it has now reversed.

“But the market remains very sceptical. It doesn’t believe that the energy industry around the world will keep its capital expenditure low and deliver much cash. Therefore, the market is unwilling to pay a larger premium for that.”

According to data provided by Guinness AM, energy stocks are priced at around 1.5x price-to-book ratio, reflecting the same valuation multiple as in 2015 and 2016, when the energy sector reported zero and even negative cash flow.

Waghorn noted the operating environment for oil and gas companies has largely improved. Operating costs today are significantly lower than five years ago, when the oil price per barrel stood at $100 and above.

This low-cost environment enables energy companies to retain cash, which is reflected in the small growth of capital expenditures among companies in the sector.

“The companies will need to increase their capex at some point to invest for the future. But at the moment, they show that they are being careful and disciplined on how they spend their money,” he added.

Although the manager is bullish, he said one risk is that oil and gas companies resume spending irrationally.

Oil prices

In addition to bottom-up research on company cash flow and profitability, Waghorn’s team analyses data for oil price movements and demand and supply to plot the valuation estimates for each stock in the universe of 370 publicly-listed companies.

“The oil price is a factor in the performance of energy companies, but not the only factor,” he said.

Moreover, the fund adopts an equally-weighted structure. This compares to other equity funds which typically allocate assets with reference to each stock’s market capitalisation.

Therefore, in Waghorn’s fund, none of the 30 stock holdings exceed 3.33% in weighting after rebalancing every four to six weeks. He believes the mechanism can help control stock-specific risk and provide a level of sell discipline.

Three-year performance of the Guinness Global Energy Fund

Source: FE, in US dollar terms. The fund is distributed to professional investors only.

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