Market review: from oil to ESG - the impact of COVID-19

Richard Dunbar

The unprecedented and far-reaching effects of the pandemic are throwing up many new economic, market and social issues for us to deal with. Plus key investment trends that existed before the virus are being further fuelled by its impact.

Richard Dunbar, Head of Multi-Asset Research at Aberdeen Standard Investments, looks at two examples of how the virus is changing the behaviours of individuals and companies, and ultimately the wider economy and society. It’s over to oil, and environmental, social and governance (ESG) factors.

Oil: from bad to worse but what’s next?

Even before the pandemic, the oil price showed signs of stress. This was partly due to an unusually warm winter in the US and Europe, which reduced demand, in combination with increasingly plentiful supply. But few could have predicted what was to follow.

The lockdown measures used to curb the spread of the coronavirus meant demand for oil plummeted at an unprecedented rate. However, this drop in demand was met with an increase rather than a decrease in oil supply, led by Saudi Arabia.

The result: way too much oil, little demand and not enough places to store it – a toxic combination meaning owners of certain types of oil have had to pay to get rid of it and this has led to the most unusual situation of negative prices.

To put this in perspective, during the 2008 global financial crisis – the worst economic downturn since the Great Depression – oil demand dropped 5.6%. At Aberdeen Standard Investments, we forecast (and these are optimistic estimates) that oil demand could drop by 16% in the second quarter of 2020; roughly three times the drop seen during the global financial crisis.

So what could this mean going forward?

Society may be fuelled by very different priorities

The oil price will be determined by the length of the lockdown and, related to this, how quickly oil demand declines. But we shouldn’t expect demand to return to previous levels. Much of the world has realised the benefits of home-working, of a less expensive, commute-free life that allows more time with family. Equally, employers have been forced to improve their remote capabilities and are becoming more comfortable with it.

On the flipside, I suspect that we’re too early to predict the demise of the internal combustion engine. And paradoxically, a lower oil price means it’s more difficult to make the case for fuel-efficient alternatives that may now look relatively expensive.

Only the big and strong will survive

Many energy companies with high levels of debt and lower margins will cease to exist. As smaller companies with high debt levels struggle, it’s likely the major oil companies will buy some of the higher-quality and lower-cost oilfields out of bankruptcy. But they’ll be more cautious about production levels than in the past.

Countries will protect their own needs

Energy security is at the top of most major nations’ priorities. It wouldn’t be a surprise to see new regulations in the US that provide protection for domestic energy companies, effectively a move towards the de-globalisation of energy markets. With the current excess supply, these sorts of policies may have limited impact on the price we pay for our fuel, but over time it may mean a less efficient market and therefore higher prices than we might otherwise have seen.

Low oil prices could unsettle global relationships

In September 2018, Iran earned $160 million a day in oil revenue but today, as a result of sanctions and the oil price decline, they take in $10 million a day – a drop of 94%. This drop in revenue is creating extreme stress domestically amid a devastating coronavirus outbreak. Similarly, Libyan oil production has fallen from 1.1 million barrels per day to 100,000 barrels as General Haftar negotiates a peace agreement while shutting down oil exports. A return of that 1 million of supply would certainly not help the oversupply situation.

These situations highlight the geopolitical issues that abound in the global oil market, particularly in the Middle East – many of which have the potential to impact other parts of the world including the UK.

Environmental, social and governance (ESG) factors: more important than ever before

In simple terms, ESG investing is when investors consider environmental, social and governance factors when they choose what to invest in. The pandemic has brought these factors to the fore.

Companies have never been under more scrutiny; how they treat their staff and customers; how they contribute to the local community; how they interact with their stakeholders. Public and private investors are also under increasing scrutiny; how they’re working with the companies in which they invest in order to help them through this unprecedented period.

These are just some of the issues that have arisen as a result of the virus; others include healthcare spend, the role of the state, and the environment. How we brought the various facets of ESG to bear on investment decisions was important before the virus – it will be even more so after it.

How do we consider ESG factors in investments?

There are different ways that investment managers reflect ESG issues in the investments they choose. One is when investment managers analyse how a company manages its ESG practices and impacts to understand how this may affect its longer-term performance – called ESG integration. It’s not about making a moral judgement, rather it’s thinking about ESG factors in relation to how these may affect a company’s ability to generate sustainable returns.

Secondly, there’s a wide choice of funds that aim to provide a specific ethical, environmental or social outcome alongside a financial return; for instance ethical funds, impact funds and socially responsible funds.

So overall, ESG factors can influence the ways that investment managers aim to create sustainable returns for investors, as well as how they allocate money to investments. In the wake of COVID-19, we expect more investors to demand higher standards of ESG and more solutions that tackle some of the specific challenges that the virus has raised.

ESG is at the heart of company and market performance

The decisions many firms make now and over the next few months will determine their future success or otherwise.

So at Aberdeen Standard Investments, we believe it’s crucial to analyse ESG factors in order to fully evaluate investment risks and opportunities when we build portfolios. We believe that strong ESG attributes enhance performance and resilience over the longer term. That’s why we actively engage with the companies we invest in to influence better conduct on ESG issues – something that’s now more important than ever before.

Find out more

The coronavirus will cause numerous and far-reaching ripples; from how companies, governments, regulators and investors manage climate change, to labour and human rights. We explore some of these issues in the Aberdeen Standard Investments May Global Outlook.

It’s a topic I’ll return to in future market reviews as it affects every financial market, every company, every individual – indeed the successful management of ESG issues will have a big impact on how we all live and finance our lives going forward.

The information in this article should not be regarded as financial advice. Please remember that the value of investments can go down as well as up and may be worth less than was paid in. Information is based on Aberdeen Standard Investments’ understanding in May 2020.