Who Wins in EM Debt If Oil Prices Stay Higher for Longer?

Two key themes have been driving emerging market debt and commodities markets in the first half of 2022: faster-than-expected tightening of financial conditions, and the second-order effects of Russia’s invasion of Ukraine. The humanitarian disaster in Ukraine is upending lives both inside and outside the country and having powerful ripple effects across economies and financial markets – most notably through the impact on oil prices.

The oil price rally has led to divergence in bond performance and the economic prospects of different countries and corporate issuers. As active investors, we are tasked with selecting those corporate credits and sovereign issuers that can outperform in this environment.

Swimming with the black swans

Before teasing out the potential winners and losers, we must first get a sense of how long the current elevation in oil prices will last – and this requires exploring the factors driving prices, such as the state of demand, supply, and inventories, and where their trajectories are pointing.

A look to the past may help inform our view to the future. It’s helpful to remember that prior to the invasion of Ukraine, the oil market was recovering from another black swan event: the Covid pandemic. As the world was adding “lockdowns,” “shelter in place,” and “social distancing” to our collective lexicon, oil demand collapsed by an estimated 30%1, and the number of barrels in storage grew by an estimated 8.24%.2 This prompted the Organization of the Petroleum Exporting Countries (OPEC) to react, reaching an agreement in April 2020 to cut their collective oil production by 25%.1 

The measure worked, putting a floor on oil prices and ensuring that inventories were drawn down to historical lows – leaving the oil market in a “tight” state. In July 2021, after a dispute between the United Arab Emirates (UAE) and Saudi Arabia sent oil prices to a six-year high, OPEC agreed to step up production each month by 400,000 barrels per day, to reach pre-pandemic production levels by September 2022.2 The pace of increases was designed to keep the oil market tight, forcing demand and supply to recover at the same pace and thereby keeping inventories low. Prices would thus increase, but not at a runaway pace that could incentivize non-OPEC producers to come into the market.

Oil Inventories Remain Low

Source: Macrobond via Organisation for Economic Cooperation and Development (OECD), February 2022. For illustrative purposes only.

From this tight starting point, the oil market was shocked again by Russia’s invasion of Ukraine and the resulting rapid reduction in Russian export supply. The International Energy Agency estimates that Russian oil supply will have fallen by 1.5 million barrels per day (b/d) in April before dropping another 3 million b/d in May as sanctions and self-imposed bans by would-be buyers kick in. This has forced oil prices to multi-year highs.

Will oil prices stay higher for longer?

We believe oil prices will remain between $95-$105 per barrel throughout 2022 before declining to $85-$95 per barrel at the end of 2023. Our base case assumes that OPEC will continue with its announced 400,000 b/d monthly production increases. Those countries that are undershooting their targets will either overcome their short-term production issues or have their quotas reallocated. Russian exports will remain lower than before the invasion, though steep discounts will entice some buyers back.

OPEC’s Struggles to Meet Their Own Quota, Further Tighten the Market

Source: Macrobond via OECD, February 2022, using country data available at the time of publishing. For illustrative purposes only.

We do not foresee oil demand moving lower unless the global economy moves into a recession. Demand remained steady when prices rose in the late 2000s, when oil was a bigger part of the of the production/consumption basket, and we don’t expect demand destruction this time either – especially as we believe power plants that are able to switch from expensive gas to “cheaper” oil will continue to do so.  

We also do not believe an Iran nuclear deal or a significant uptick in Venezuelan supply are imminent. Oil markets had expected up to 1 million barrels per day of Iranian supply to come online this year2, which we now view as highly unlikely given that any deal would be too politically thorny for the Biden administration leading up to the important midterm elections. Venezuelan production has been suffering from years of chronic underinvestment, and we believe it’s too optimistic to expect a lifting of sanctions and the estimated 0.4 million b/d increase that could result.

Finally, we expect US shale producers to remain disciplined, and that any production increases would be modest. Washington hasn’t yet dangled a big enough carrot to tempt shale producers to abandon their restraint. But even if we’re wrong about that, US oil pipelines will be capacity-constrained, as strategic reserve releases have had crowding-out effects and created bottlenecks.

Who wins and who loses in EM debt?

Given our base case of higher oil prices for longer, the question then becomes, who is likely to come out on top?

Among emerging market sovereign debt issuers, the Gulf Cooperation Council countries stand out as the biggest benefactors of higher oil prices. Kuwait and the UAE both have fiscal breakeven oil prices below $70 per barrel, so our oil forecast augurs for sizable fiscal surpluses and associated improvements in credit metrics for the next few years. In Sub-Saharan Africa, we believe Angola – where higher oil prices helped the country return to economic growth in 2021 after five years of decline – will be the biggest winner. Angola’s improved credit metrics allowed the country to become one of the few high yield names to issue new US dollar debt in 2022. 

Oil importers, on the other hand, will now have to fund wider current-account deficits in an environment of tightening financial conditions. Turkey and Morocco are two of the larger importers that will bear close watching.

Among corporate issuers, it’s helpful to break down the impact by sector and region. We believe the clear winners in this environment will likely be the Central and Eastern Europe, Middle East and Africa (CEEMEA) ex Russia oil and gas names. These range from certain key vertically integrated investment grade names to high yield exploration and production companies. Within the financial sector, banks in countries with higher lending exposure to the oil sector, such as Nigeria, should see an improvement in their nonperforming loan ratios and thus their own credit quality. Across all regions, those in the metals and mining sector will likely see increases in the cost of energy. As price takers, they will be unable to pass these increased costs on. Those that have been able to diversify their power supply toward renewables will be least affected and be better able to better protect their margins.

We expect the oil markets to remain volatile and sensitive to surprises in the economic data, and heightened vigilance will be warranted in the weeks and months ahead. We will continue to monitor developments and risks that could challenge our thesis of higher-for-longer oil prices and adjust our portfolio positioning accordingly.

LONDON, 30th January 2023, PineBridge Investments (’PineBridge’), a private, global asset manager focused on active, high-conviction investing has upgraded the Global Emerging Markets Corporate Bond Fund to an Article 9 compliant fund under the European Union’s Sustainable Finance Disclosure Regulation (‘SFDR’) protocol. The Fund will subsequently be named the PineBridge GEM SDG Corporate Bond Fund (‘The Fund’).

The Fund seeks to achieve long-term, capital appreciation through investment in bonds issued primarily by corporate entities and financial institutions located in Emerging Markets (EM). Such securities may be denominated in the local currency of any of the OECD member countries or the local currency of the emerging countries in which the Fund is permitted to invest as per investment guidelines

Sustainable investing is central to the team’s investment process. The Fund will only invest in assets that have been assessed as positive contributors (and that ‘do no harm’) to four United Nations Sustainable Development Goals (‘SDGs’): Decent Work & Economic Growth, Industry Innovation & Infrastructure, Responsible Consumption, and Production & Climate Action.

The Fund will deploy proprietary, forward-looking sustainability scoring aiming to manage sustainability risks, promote a more sustainable investable universe, and capitalize on sustainability driven change. Alongside a rigorous bottom-up approach to credit selection, the team will prioritize engagement with issuers to drive improved sustainability practices.

Managed by Chris Perryman, Portfolio Manager, Head of Trading at PineBridge Investments, the strategy is supported by established portfolio management, research, and trading teams based in London, New York, Santiago, Hong Kong, and Singapore. The team is managed by a senior leadership team that averages 32 years’ experience^[1].

Chris Perryman, Portfolio Manager, Head of Trading, Emerging Markets Fixed Income, PineBridge Investments, said: “As capital allocators, we are committed to using our power to not only influence the way the companies we invest in do business, but to raise the bar for such change. Upgrading to Article 9 status reflects the team’s careful considerations of how best to use the strength and depth of our credit market capabilities to enact change.”

“Emerging markets represent approximately 40% of the world’s economy in terms of GDP as well as a majority of both the world’s population and carbon emissions. Focusing on sustainability risks can reduce downside volatility within EM debt markets, while identifying improving sustainability credits can enhance total returns of active emerging market debt portfolios.”

The Fund is a Dublin-domiciled UCITs vehicle, registered for sale in Austria, Denmark, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, and the United Kingdom.

For more information on PineBridge’s range of solutions, visit www.pinebridge.com