UBS Asset Management

After over two years OPEC has finally done the economically and indeed politically rational thing. Sentiment was supportive of a deal for most of the period since the initial Algerian meeting when such a cut was proposed. However, from last weekend the language from the main participants was reminiscent of the exchanges before previous failed gatherings. While OPEC members previously behaved like football teams more interested in physically hurting their opposition (taking share), they are now focused on winning the game (growing revenues). The outcome of yesterday's meeting was more comprehensive that even hopeful bulls could have expected, although severe action was required after the previous damaging strategy. A maximum cut, country specific quotas, independent monitoring, and potential non-OPEC (mainly Russian) involvement on top, is huge.

US shale will return, and besides the revenues thrown away, another unintended consequence of OPEC's share war has been forcing this emerging competitor to become more efficient and therefore sustainable. There are also projects sanctioned at US$100/b being delivered into the market. However, OPEC's agreement together with Russian co-operation will send the market straight into deficit, and in late 2017 and into 2018 the three successive years of CapEx cuts will result in supply being further challenged.

While the portfolios are materially overweight direct oil exposure, the leverage is lower than it was for most of the last 24 months as the more speculative names were replaced with the higher quality Oil Search and Woodside. The stocks exited disappointed either around hedging strategy (which limits upside leverage) and succession, and developments around asset quality. Besides the direct energy positions, other portfolio exposures should also benefit from the flow on effects of oil normalisation.

The miners who have been bailed out by Chinese policy which stimulated demand and tightened supply and then by speculators jumping on the momentum to inflate commodity prices further will face a sharp increase in energy expenditure which represents about 15% of total costs. Indeed, this rise in the oil price should NOT be perceived as a risk-on indicator (although trading may ignore this in the short term) as it is supply not demand driven and therefore not symptomatic of a broad recovery. Rather the oil price increase is a material tax increase on activity and a headwind for all cyclicals, where we don't think valuations generally capture this risk.

Inflationary expectations that are already rising should be added to by rising energy prices. This could sustain the normalisation in interest rates and the ongoing de-rate of pure bond proxies that we believe remain overvalued and risky given their indebtedness. Genuine defensives with reliable cash flows (like AGL and Telstra) without the interest rate leverage should continue to deliver. Rising rates, however, should accelerate the normalisation in the insurance cycles by removing liquidity and supporting premiums, and increase investment returns. We continue to see share prices in this sector extrapolating the current cyclically weak environment.

Written by Jakov Males, Head of Equities, UBS Australia: (VIEW LINK)


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