Investment Strategy Commentary: Oil Down, Remdesivir Up
See our take on winners and losers from oil's fall and what successful tests of the drug Remdesivir mean for the pandemic and investors.
Countries across the globe are slowly starting the process of loosening public health restrictions in their efforts to restart economic growth. Meanwhile, we received a positive surprise about a COVID-19 treatment that will likely become one part of the building tool kit to combat the virus. Lastly, falling oil prices will have a varying impact on different countries and sectors.
Last week’s report, “Bridge to Reopening”, highlighted the steps that will be necessary to successfully reopen economies to restore economic growth. The past week has brought specifics to this task, as countries (e.g. China and Germany) and states (e.g. Georgia and Alaska) have started to loosen social distancing restrictions. We continue to think that this public health policy approach will be the critical variable to success, but we did receive some positive news this week on the drug Remdesivir. The antiviral drug was shown to reduce recovery time for hospitalized patients by 31%, which could help ease hospital utilization during a second wave of the virus. We discuss Remdesivir more in depth later in the report. We also analyze the impact of the drop in oil prices on different countries and stock markets, showing that many major economies may benefit from the drop in prices. However, the impact of lower oil prices is currently overwhelmed by the economy-wide demand destruction by COVID-19. That said, investor focus may return to this metric once growth regains momentum. The largest net oil exporters tend to be some of the smallest economies (e.g. countries in the Middle East) while some of the largest economies such as China, Europe and Japan are net importers. While the U.S. remains a net importer, it is a net exporter when you include petroleum products, so the impact is more mixed.
OIL SHOULD HEAD HIGHER TOWARD YEAR-END
The near-term price of oil (through the second quarter) is likely to remain depressed ($20/barrel and below) due to the oil demand destruction arising from the impact of COVID-19. Low oil prices and the filling of global storage facilities will force the oil and gas industry to shut in oil wells around the world. The “OPEC++” (OPEC in addition to other large oil-producing countries) agreement to curtail production volumes was supportive of oil prices, but the lack of available global storage capacity will secure well shut-ins from virtually all of the world’s oil producers.
Assuming a dissipation of the negative hit from COVID-19 as the summer progresses and the global economy goes back to work, there should be a pickup in oil demand. However, pricing recovery may be held partially in check by the need to work down storage levels over several quarters. Additionally, many wells around the world have marginal cash breakeven costs near $30/barrel and above. They will not be quickly turned on even if oil prices start to migrate higher — producers will need to have confidence prices will be sustainably higher before investing in bringing wells back on line. As a result, oil prices should gravitate toward $30-35/barrel (West Texas Intermediate) towards the end of 2020 and then potentially rally up to $45/barrel in 2021. This is more or less the consensus view.
Turning to the intermediate term, we believe the outlook is brighter. The move toward capital discipline, particularly in North America, is now likely firmly cemented in the minds of management teams and investors. Capital markets will probably take some time to re-open to the energy industry, so a return of “wild west” days of aggressively drilling and completing wells, especially in U.S. unconventional basins, is likely over. Once inventories have been worked down, we believe many factors will be at play to keep oil supplies at controlled levels. These factors include capital discipline, the exit of potentially many over-leveraged exploration and production companies, a significant downturn in global oil patch investment, the depletion of the new project pipeline which has been delivering a large volume of oil over the past few years, and the potential for ongoing curtailed investment in many financially strapped countries that were struggling to cover their federal budgets at $55/barrel. In addition, we don’t believe that investors are fully considering the risk of oil supply disruptions from a number of these financially stressed countries.
LARGEST ECONOMIES BENEFIT FROM LOWER OIL PRICES
As we mentioned earlier in the report, the traditional impact of lower oil prices is likely overwhelmed in this environment by the sheer scale of demand destruction across all industries. However, we are still asked whether emerging market countries will be hurt by weak oil prices, seemingly based on a presumption that they are net oil producers. The question may also be rooted in the historical positive relationship between oil prices and emerging market equity performance. Exhibit 3 shows the world’s largest economies and oil producers, and illustrates those most hurt and helped by the drop in oil prices. The worst-hit countries are in the frontier and emerging markets – however, their economies are relatively small compared with the global economy. Meanwhile, the largest and fourth-largest emerging markets as a percentage of the MSCI Emerging Markets Index — China and India — are net importers of oil and benefit greatly from lower prices.
Most oil exporting countries on the far right of Exhibit 3 are tightly tied to the fortunes of oil and natural gas output (mainly liquefied natural gas) and the accompanying commodity prices. In simple terms, they do not have diversified economies and are beholden to the volume and price of commodities. To make matters worse, many of these countries have quasi-socialist governance systems and economies. Their governments provide a number of products and services such as transportation fuels (gasoline and diesel) at low subsidized prices. When times were good and oil was roughly $100/barrel, there were funds to support both liberal social spending and government programs. Things took a turn for the worse when oil prices dropped from highs and stabilized in the mid-$50/barrel range (WTI) because there was no longer enough money to go around. Governments cut social programs where possible, and many citizens were not happy as demonstrated with the recent domestic unrest in Iraq. Funding for oil and gas developments was also pared back. These two points are part of our concern about the future supplies of oil. In addition, reducing investment may not lead to a quick collapse in production, particularly if projects underway move to completion and temporarily boost output. However, over the intermediate-to-long term, the fact that this is a depletion-based business means you have to keep developing and investing or ultimately production declines. Also, if the population can no longer make ends meet due to lower government subsidies, people will likely end up protesting. In this case, supply disruptions are not a given, but highly possible. Countries most at-risk of this include Iran, Iraq, Libya, Algeria, Nigeria and Venezuela.
INVESTING IN COMPANIES, NOT COUNTRIES
While the economic data is interesting, we invest in companies, not countries. As such, we wanted to analyze the sector composition of the major regions’ equity markets and how those sectors are impacted by the unprecedented fall in oil prices. Below, we grouped the 11 Global Industry Classification Standard (GICS) sectors into those that are helped by, hurt by or experience an insignificant impact from falling oil prices (with a quick explanation as to why for the “helped” and “hurt” categories).
Helped: Consumer Staples (transport costs); Industrials (input costs); Real Estate (general associated fall in interest rates); Materials (oil as an input for chemical companies, which make up the bulk of the sector).
Insignificant: Consumer Discretionary; Health Care; Information Technology; Communication Services, Utilities (energy costs generally passed through).
Hurt: Financials (credit exposure, associated fall in interest rates); Energy (obvious reasons).
Exhibit 4 looks at the sector weights across the U.S., Europe, Japan and emerging markets equity indexes with the sectors ranked by the degree to which lower energy prices help the sector (per the above). Europe and Japan have greatest exposure to the “helped” sectors at 38% and 40%, respectively, followed by the U.S. at 22%. However, Europe also has greater exposure vis-à-vis the U.S. to the “hurt” sectors (20% versus 14%, respectively). Emerging markets is the only region with a greater share of companies hurt by lower oil prices than helped — perhaps explaining some of the negative price response these stocks have to falling oil prices.
We recognize that at present investors are currently more focused on the demand destruction caused by COVID-19 (cheap fuel costs mean nothing for an airline that doesn’t have any passengers). However, it does serve as a helpful reminder of the various regions’ sector compositions and the different sensitivities to oil prices — and should prove useful when economic growth starts to resume.
PROGRESS ON THE COVID-19 TREATMENT FRONT
We’ve been consistent in our view that there would not be a “silver bullet” over the next 6-12 months on the medicinal front that would significantly reduce the risks around COVID-19. We did get a positive surprise this week with the released trial data for Gilead Sciences’ antiviral drug, Remdesivir, but it isn’t a silver bullet. As a reminder, Remdesivir is an intravenous drug administered to patients already suffering from COVID-19, so it is a treatment as opposed to a preventative (vaccine). Some key conclusions from the Remdesivir trial data are as follows:
- The primary endpoint is statistically significant, so we can be confident there is some benefit.
- On this key primary endpoint, treated patients had a 31% improvement: time to recovery was 11 days with Remdesivir versus 15 days for a placebo.
- The secondary endpoint of mortality did not quite meet statistical significance, but shows a positive trend of ~22% reduction in chance of death, from 11.6% to 8%.
We think that Remdesivir should be approved soon by the Food and Drug Administration under the Emergency Use Authorization, and most hospitalized patients should receive it. Press reports indicate that Gilead may have 1.5 million doses ready by the end of May. If the treatment regimen includes five doses per patient, this immediate inventory would cover 300,000 patients. While this development is clearly a positive, the scope of its impact is not very broad since its use will be limited to hospitalized patients and it is not a preventative medicine. It is also not a cure — its benefit is fairly modest. It could, however, accelerate the timelines to recovery, making the hospitalization intensity more manageable for healthcare workers. With a 31% improvement in time to recovery, patients can be discharged more quickly, freeing up capacity that may be strained during another outbreak. We will still rely on public health measures for the bulk of the path to recovery.
CONCLUSION: FAST ACTION, FAST RESPONSE
Everything has happened at an extremely rapid pace since COVID-19 started to spread earlier this year. After stocks declined 35% in a month’s time, policymakers responded with massive monetary and fiscal stimulus. This has led to a rapid rebound in stocks over the last five weeks, leaving the S&P 500 at levels reached last September, but still down 14% from its highs in February. The rebound in risk markets over the last month started with the exhaustion of selling and the start of rebalancing through the purchases of equities and sales of bonds. Next, some new confidence developed through the strength of the monetary and fiscal policy response at a time of peaking of new COVID-19 cases across Western Europe and the U.S. The rebound is not a bet that everything is going to turn out rosy, but more likely a result of investors concluding that the intermediate-to-long term return outlook for risk assets is superior to fixed income. We expect
Special thanks to Tom O’Shea and Colin Cheesman, Investment Analysts, for data research.
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