The global oil market has followed a similar trend to other commodities such as iron ore in recent months. Crude oil has fallen into a bear market amid the highest US output in three decades and signs of slowing demand growth. Prices are at levels not seen for five years, with crude oil now down more than 35% from 2014's June peak. At last week’s meeting of the Organisation of Petroleum Exporting Countries (OPEC), the organisation could not agree to the supply caps needed to stabilise the oil price, triggering even further falls.
The question is – how does a falling oil price affect domestic fixed income investors? A falling oil price creates a number of macro and micro themes that are relevant to FIIG bondholders.
From a macro perspective, one of the more noticeable impacts is on the global inflation outlook. A falling oil price is expected to put downward pressure on the inflation levels of the major economies, particularly the US given its heavy reliance on oil and the boom in shale oil production.
Below is a chart comparing the historical 10 year inflation swap curves for Australia, the US and the EU against the crude oil price over this year. An inflation swap is much like an interest rate hedge – it is the fixed rate of inflation which the market is prepared to pay to hedge against future increases in inflation. In Australia, the current mid 10 year CPI swap rate is 2.63%. In simple terms, this means an inflation trader is prepared to pay a fixed rate of inflation equivalent to an Australian CPI rate of 2.63% pa over the next 10 years, in exchange for receiving exposure to ‘floating’ real CPI movements. Note that there are other methods of measuring the market expectation of inflation such as break even inflation, or just comparing nominal versus inflation linked government bond yields, and so an inflation swap is just one method of referencing the ‘market price’ for inflation. Longer term inflation swaps also incorporate a liquidity premium given their longer dated exposure.
Source: Bloomberg
Since the peak crude oil price in June, the US 10 year inflation swap has fallen by about 50 basis points, the EU 10 year inflation swap by about 35 basis points and the AUD 10 year inflation swap by only 15 basis points. This result is interesting for holders of domestic inflation linked bonds. The chart shows that the price of a US or EU 10 year inflation swap has been much more correlated to the falling global oil price than the Australian 10 year inflation swap. The Australian inflation swap rate has not moved as significantly as the US and EU, suggesting the inflation market does not see the falling oil price having as significant an impact on longer term inflation in Australia as it does in the US or EU. In part this is explained by the opposite impact the falling AUD has had on domestic oil prices, with the global oil price being quoted in USD.
In the short term, while lower oil prices may have some impact on lowering CPI growth (lower fuel prices is one example), over a longer term horizon the market is pricing average Australian CPI at a level which is above US and EU inflation, and doesn’t see the recent falls in the crude oil price as having as significant an impact on longer-term Australian inflation. So for holders of domestic inflation linked bonds, it means that the CPI component on their inflation linked returns isn’t expected to be heavily impacted by the falling oil price. This is positive for holders of inflation linked bonds whose returns are linked to the level of inflation, with many of the inflation linked bonds being longer dated. Having said this, if oil prices were to plunge significantly, there may be broader global economic effects which could flow through to the Australian economy and CPI expectations.
While the decline in the oil price will hurt nations which critically depend on oil, overall the world’s economy overall may benefit from the fall. The Organization for Economic Cooperation and Development estimates a $US20 drop in the oil price adds 0.4% to the growth of its members after two years. By lowering inflation over the same period, cheaper oil could also persuade central banks to either keep interest rates low or even add stimulus.
From a ‘micro’ perspective, the following are some of the impacts of a falling oil price for FIIG investors:
- Airlines in particular will benefit from a lower oil price because it will push jet fuel prices down. So a falling oil price, generally speaking, leads to a direct benefit to an airline’s bottom line, and so is broadly a positive for the likes of Qantas, Virgin, and to a lesser extent Sydney Airport. Note that these airlines will have shorter term fuel hedges in place, so the full benefit of a lower oil price will be realised over the medium term. The Qantas 2022 bond and the Virgin 2019 US dollar bond are currently offered to investors at indicative yields of 6.46% and 7.55% respectively. With the recent rallies in share prices of both companies, especially Qantas, we may see a contraction in yields in these bonds in the coming days
- Emeco: the Canadian oil sands player needs a US$70-US$80 oil price to be profitable. If oil prices continue to fall, especially below the US$70 level, we expect that Emeco’s Canadian business will suffer as oil sands work starts to drop off. Canada has been one of the more solid performers for Emeco thus far, offsetting the flagging Australian business, so a falling oil price poses risks for Emeco’s Canadian business. The Emeco 2019 US dollar bond is currently offered at an indicative yield of 11.1%, and we expect continued volatility across the mining services sector given its high risk profile
- Antares: we don’t see major risks to convertible note holders. The Southern Star asset sale has been completed and Antares is buying back the notes on market at par. The company has sufficient liquidity to redeem all of the notes and pay 10% coupons, so we expect it will keep buying back and then redeem what’s left at par at the next reset date next October