Oil prices have rallied meaningfully to start 2021, and at roughly $63 for a barrel for West Texas Intermediate,¹ they have more than fully recovered from their pandemic-driven drawdown.² We examine the forces behind this impressive recovery and its impact on your portfolio.
Oil supply constraints are pushing up prices, although demand remains subdued
Supply and demand determine oil prices. In our view, the supply side of the equation has been most responsible for oil’s recovery. In 2020, OPEC+, a group of the world’s largest oil-producing countries excluding the United States, agreed to significant production cuts.³ Saudi Arabia added a further voluntary cut to start 2021.⁴ These actions have decreased global supply, helping to lift oil prices to levels last seen nearly two years ago.² We expect supply increases in 2021, as OPEC+ agrees to expand production and the United States brings additional supply online.
The demand side of the equation is less of a factor for now. The U.S. Energy Information Agency (EIA) believes global demand will remain suppressed until COVID-19 restrictions are lifted further, writing that “new government mobility restrictions in response to COVID-19 during the Lunar New Year holiday season in China and increased restrictions on travel in Europe both present the potential to keep petroleum demand lower than might otherwise be expected.”⁵ The EIA forecasts that global consumption of petroleum should rise in 2021 but will still fall short of 2019’s level. We agree that oil demand should increase in 2021 as economies reopen and travel becomes more widespread, but we would argue that much of that is already priced in.
Oil price fluctuations can have varying impact across asset classes
We’ve reviewed the relationship between oil prices and various asset classes since February 2018 to explore how oil prices have related to other asset classes in recent years. Oil prices don’t on their own determine the performance of most asset classes, but some investments have generally outperformed others in periods of rising oil prices. Oddly enough, fixed income has historically seen the largest divergence between leaders and laggards from oil price fluctuations. Equity asset classes have experienced directionally similar moves but to varying degrees.
The correlations of key fixed-income asset classes to oil appear below in the blue bars. A positive correlation indicates that the asset class has moved in the same direction as oil, while a negative correlation means the opposite. Most notably, U.S. bank loans and high yield, along with emerging-market debt, have shown a high positive correlation to oil prices. As oil rises, these parts of the fixed-income market may perform well. On the flip side, U.S. Treasuries and the Treasury-heavy Bloomberg Barclays U.S. Aggregate Bond Index have experienced low-to-negative correlations with oil.⁶ These parts of the bond market tend to have higher duration and higher credit quality and may come in for sale in an improving global economic backdrop with advancing oil prices.
Global equities (shown in the green bars), in general, have been positively correlated with oil prices. That said, certain areas have gained the most from oil rallies. For example, value and small-cap stocks have tended to be more highly correlated with oil prices than have growth and U.S. large-cap equities. Furthermore, international equities have been more sensitive to oil than domestic ones in general.
We’ve observed one data point that we believe may appear counterintuitive or at least surprising: the similar correlation with oil of both the S&P 500 Index and emerging-market equities. Emerging markets have become far less commodity driven than in the past and are now more leveraged to consumer- and technology-related stocks. Instead of using the old playbook (emerging-market equities) to increase sensitivity to higher oil prices, investors might consider looking to U.S. mid-to-small-cap value stocks and international developed equities.
Historically, oil has been most positively correlated with bank loans, high yield, and EM debt
Source: Morningstar Direct, 1/31/21.
Oil is far from the only input in broad asset allocation decisions, but its recent price increase is likely helping to upend the market regime led by high-quality bonds and U.S. growth stocks. In an environment of rising oil prices, our top choices are bank loans in fixed income and U.S. mid-cap value in equity. These asset classes may be important portfolio additions as investors try to prevent higher oil prices from dragging down returns.
1 cnbc.com, 2/25/21. 2 Macrobond, 2/25/21. 3 cnbc.com, 11/11/20. 4 nytimes.com, 1/5/21. 5 “Short-Term Energy Outlook,” U.S. Energy Information Administration, February 2021. 6 Morningstar Direct, 1/31/21.