Oil price settled broadly unchanged-to-slightly-higher yesterday (with the notable exception of the CME RBOB contract, which fell) as US economic data strengthened the dollar. Retail sales in America unexpectedly rose by 0.7% last month against a forecast of a 0.8% dip. If it is a proof of a solid economic backdrop then the Federal Reserve might start withdrawing its monetary support this year, which in turn will weaken stocks and support the dollar. Initial jobless claims rose to a seasonally adjusted 332,000, roughly in line with expectations and possibly boosted by Hurricane Ida.
The lukewarm stock market performance (S&P 500 index settled 0.16% down) and the perky dollar acted as a break on the oil price rally. This pause, however, has not changed the underlying picture. Global and OECD oil inventories are widely expected the decline in coming months due to rising demand and falling non-OPEC supply. It will be intriguing to see how China and the US would react in case oil prices remain stable. In the past weeks the two biggest oil consumers with a combined demand of over 35 mbpd, more than a third of the total, have made it abundantly clear their tolerance starts wearing thin around these price levels. Will more Chinese SPR barrels be released, and can we expect renewed pressure on OPEC+ from the Biden administration? Further headwind came in the form of the gradual restart of oil production in the Gulf of Mexico. The BSEE estimates that now only 28% of production was shut in. It is undoubtedly a welcome development, nonetheless, crude oil inventories in the region are bound to register yet another weekly drawdown when the next stock report is published on Wednesday.
Equity markets have been outperforming oil for quite some time now. This is not only true for the last 20-24 months, since the pandemic broke out (stocks have performed considerably better in 2020-to-date than oil), but historical evidence also suggests that equities are a more reliable investment vehicle than black gold. Casting our minds back to the pre-Lehman times confirms this view. Just before the sub-prime crisis oil peaked at $147/bbl, it is now worth around half as much. The MSCI Global Equity Index, on the other hand, is over 70% higher than the peak reached in 2007.
There are several reasons for this detachment. Firstly, the days of high correlation between equities and oil are long gone. Prior to 2012 the performance of the equity markets was the harbinger of global oil demand expectations. Oil supply received little attention apart from the occasional supply disruptions as OPEC was always there to be relied upon to balance the market. The relationship was upended with the rise of US shale output and in the past 6-8 years healthy oil demand does not necessarily mean higher oil prices.
Secondly the transition from fossil fuel to renewable energy gradually slows global oil demand growth (albeit peak oil demand is still quite a few years away). Thirdly, the transformation from manufacturing to service economy supports tech companies, which, in turn, helps the tech-heavy indexes, like Nasdaq, outperform not only oil but its industrial peers. Since the end of 2019, for example, Nasdaq has gained 69% compared to 22% of the DJIA. Stimulus measures from central banks have also proved more efficient to support the economy than efforts from the OPEC+ group to deplete global oil inventories although the latter group has not failed either.
In sanguine economic environment investors face the challenging task to allocate their money between different asset classes. Making decent returns is the ultimate objective, however, this target must be achieved in the most structured and risk-averse way. In other words, an investor is more content with an annual return of, say, 12% if it comprises constant and reliable monthly performances of 1% than with 20% where one month its investment suffers a loss of 10% only to see its portfolio gain 15% the next.
A rule of thumb is that low volatility is the hallmark of a bull market. From this respect equities are currently also more favourable than oil as the S&P 500 index shows a price volatility of less than 10% (basically it has been moving higher steadily) whilst price movements in Brent, for example, are more vicious as the current volatility stands over 30%.
Volatility is also used by investors to measure monthly returns to decide which asset class offers a safer investment environment. By employing a formula called Sharpe ratio the investor will understand the risk associated to the past or an expected future return. It is calculated by subtracting the risk-free return (usually US Treasury yield) from the return of the portfolio and divide the outcome by the standard deviation (volatility) of the excess return. The result is a risk-adjusted -past or potential future- return. The greater the Sharpe ratio the more attractive that particular investment is.
Comparing the performances of the five main oil futures contracts with that of the main stock indices since the pandemic broke out at the beginning of 2020 confirms the long-term underlying trend. The Sharpe ratio of the S&P 500 index or Nasdaq is markedly higher than the potential risk-adjusted return of oil. No wonder that that the value of the S&P 500 index that equalled to 20 barrels of Brent in 2014 ballooned to 41 barrels by 2018 and to 63 barrels currently. Oil will remain an attractive asset class for investors in the future as it has been in the past. It is used as a hedge against inflation, it promises decent returns and it has liquid derivative markets, the structure of which offers extra profit. Its weight in a portfolio basket compared to equities, nonetheless, will only grow again if the volatility of its monthly returns is tamed considerably.