Why Higher Oil Prices Are Likely Here To Stay (USO)

Image of an oil derrick with blue sky

From Invesco: The last week has seen a flurry of geopolitical events — from US sanctions on Russia to missile strikes on Syria — that have affected the prices of various commodities as well as some currencies.

Missile strikes in the Middle East

First of all, there are growing problems in the Middle East. Yemen’s Iranian-backed Houthi rebels are conducting missile attacks against Saudi Arabia. While thus far the missiles have been intercepted, they appear to be targeting oil infrastructure in the country. This, in addition to rising tensions in Syria, caused an increase in oil prices of more than 7% last week.1

After markets closed in the US on Friday, the US, France and the UK launched a missile strike against specific targets in Syria in response to reports that the Syrian government launched a chemical attack on its own people. This has the potential to draw those three countries into a more direct conflict with Russia, which supports the Syrian government, and inflame current tensions. While Syria is not a major producer of oil, neighboring countries are, and there is the potential they could be pulled into the conflict. In addition, it seems more likely that the US may dissolve its nuclear deal with Iran given the recent addition of key members of President Donald Trump’s administration who have opposed the deal. This would lead to the re-imposition of sanctions on Iran, which would curtail its ability to sell its oil. All these events are likely to place more upward pressure on the price of oil and add to the volatility we are seeing in some emerging markets currencies.

Sanctions on Russia

Then there is the imposition of US sanctions on various Russian entities. One specific sanction was against Rusal, the second-largest producer of aluminum in the world. This drove up the price of aluminum about 15% in the last week on concerns that supply would fall.1 In addition, the sanctions against Russia have led to a recent rise in prices for both platinum and palladium. That’s because Nornickel, the world’s largest producer of palladium, is linked to Rusal as well as to an oligarch who is being sanctioned by the US. While sanctions haven’t been announced against Nornickel, there is concern that the company will be affected. Sanctions against Russia also placed downward pressure on the ruble.

My view is that neither the crises in the Middle East nor the sanctions against Russia should be of concern over the longer term. Even the most dramatic geopolitical events typically have just a short-term impact on markets. However, it is true that there could be more air strikes on Syria by the US-UK-French coalition, and the situation in Syria could get worse before it gets better. There could also be additional sanctions imposed on Russia. And there is, of course, the likelihood that the US-Iran deal may be killed. In the shorter term, these events would be expected to drive up certain commodity prices such as oil and add to volatility in commodity and currency markets as well as the stock market. (For example, the Indian stock market would likely come under temporary pressure given the economy’s reliance on oil.) But in the medium term, I would not expect these events to have a material effect.

The biggest concern — protectionism

Also driving commodity prices last week were concerns about protectionism, which drove down zinc prices. And since tariffs were announced on aluminum and steel last month, we have seen those prices rise sharply. That’s a great segue into what I am far more worried about than the crisis in Syria or sanctions against Russia: the potential for protectionism to increase. I understand that investors heaved a collective sigh of relief last week at the conciliatory speech given by Chinese President Xi Jinping at the Boao Forum. However, I believe it is erroneous to assume that there will be a dialing down of trade tensions. I still believe Xi will not make material concessions in negotiations with the US. And while many were encouraged by news that the US is contemplating re-joining the Trans Pacific Partnership, I would be surprised if that occurs given that the trade agreement has already been negotiated. There’s little reason to believe the parties would make significant alterations to the agreement in order to make it acceptable to the US without requesting concessions in return.

From my perspective, protectionism remains the big risk markets need to be concerned about — and it seems the US Federal Open Market Committee is in agreement given the minutes from the March meeting. Having said that, it is difficult to assess what could happen, although we know that protectionism can have many investment implications. Because they inject uncertainty into the economic picture, they typically increase volatility in markets. And this particular trade dispute between the US and China could have significant currency implications. Recall that China’s potential weapons are not just tariffs and quotas; it can also devalue the yuan. This would make Chinese goods more attractive to foreign buyers and likely widen the US’ trade deficit with China. In addition, it could impact other Asian currencies.

Where do we go from here?

I must preface my comments by saying that it is very difficult to forecast commodity prices because they are dictated by so many different factors beyond supply and demand, including the strength of the US dollar, government trade policies and speculators.

  • I expect oil prices to continue to rise in the near term, driven by the conflict in Syria and the potential for the US to withdraw from the Iran deal, both of which would curtail oil supply. However, it is likely that production would increase in the US and elsewhere to compensate for depressed supply.
  • I expect aluminum and steel prices to remain at elevated levels in the near term, with other commodity prices also possibly rising. However, industrial demand appears to be softening, and I believe that could persist, placing downward pressure on prices later in the year.
  • My outlook for gold is positive. Greater geopolitical tension, higher inflation and rising protectionism would all be expected to help support demand for gold. And while some believe that gold is being replaced by bitcoin as a go-to, “safe haven” asset, I don’t subscribe to that view.
  • Looking at currencies, I would expect continued volatility in emerging markets currencies given that geopolitical crises don’t appear to be moderating any time soon. I expect a strengthening of the Japanese yen as investors look for safety amidst uncertainty.

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1 Source: Bloomberg, L.P.

Important information

All investing involves risk, including risk of loss.

Safe havens are investments that are expected to hold or increase their value in volatile markets.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

Fluctuations in the price of gold and precious metals may affect the profitability of companies in the gold and precious metals sector. Changes in the political or economic conditions of countries where companies in the gold and precious metals sector are located may have a direct effect on the price of gold and precious metals.

Bitcoins are considered a highly speculative investment due to their lack of guaranteed value and limited track record.  Because of their digital nature, they pose risk from hackers, malware, fraud, and operational glitches.  Bitcoins are not legal tender and are operated by a decentralized authority, unlike government-issued currencies.  Bitcoin exchanges and Bitcoin accounts are not backed or insured by any type of federal or government program or bank.

The opinions referenced above are those of Kristina Hooper as of April 16, 2018. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

The United States Oil Fund LP ETF (USO) rose $0.11 (+0.82%) in premarket trading Wednesday. Year-to-date, USO has gained 11.66%, versus a 1.25% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #35 of 113 ETFs in the Commodity ETFs category.

This article is brought to you courtesy of Invesco.