Indexology^® Blog

After OPEC agreed to an oil output cut in Algiers on Sep. 29, they increased supply by 230 kb/d to a record 33.83 mb/d in October according to the International Energy Agency (IEA).  Supply from Iraq reached the highest level ever and Iran pushed flows to a pre-sanctions rate of 3.72 mb/d. Now OPEC supply has increased by 1.3 mb/d from last year while output has risen for five consecutive months.

It is difficult to see how implementing the cuts will work with the resistance from Iraq and Iran. Even if the OPEC coordination worked, the resulting cuts may be ineffective because there are currently more powerful forces on oil price.  Two possible factors that are more critical to oil price formation, but ones that are even harder to control are the Chinese demand and U.S. production.

The Chinese have been strategic about buying and selling commodities so may buy more oil as the prices drop if OPEC does not cut supply.  China also has the power to heat the competition on the supply side by shopping around.  Conversely if OPEC does cut and oil prices increase, China may use their own reserves – or even worse – might export into the open market, essentially keeping the oil range-bound, which could reach between $25 – $85 dollars before reaching unprecedented levels according to index return history.

The U.S. production is also a key driver that is possibly more important for oil prices than OPEC’s decision. OPEC has the ability to be the swing producer given its large market share, spare capacity, low production costs and capability of acting alone or in a cartel; however, U.S. inventories need to be low for it to matter.  

The U.S. companies act independently and have already cut back production so further output reduction may be limited at today’s price levels.  This is reflected in the magnitude reduction of the large negative roll return seen in the second quarter of this year. The competition between U.S. producers is apparent versus the stability of the state run OPEC in the volatility of the roll return between WTI and Brent where WTI has bigger excesses and shortages than Brent.

The U.S. producers may move quickly to fill the gap if OPEC cuts. The low oil price forced consolidation to improve efficiencies bringing down the cost of production. The race has changed from a race for land to a race for efficiency. The increase in efficiency should bring the oil production back faster than in 1998 or 2009 – it is said to be roughly 9 months.

If OPEC fails to cut output, it will likely lengthen the rebalancing.  One interesting result in the S&P GSCI Brent Crude  is that it’s on the cusp of the longest consecutive monthly contango in history (as measured by the negative roll return of the index since 1999, and greater negative roll returns reflect higher excess inventory and storage costs.)

Also, after the 2008 period, the indices show WTI crude took about 6 years before the excess inventory turned into a shortage. We’re now only two years into the current glut, so the rebalance may take several more years.

• November is the 29^th month in a row in contango, only beaten by a longer streak of 32 months from May 2008 – Nov 2010.
• This Nov. Brent is showing the 2^nd highest contango of any Nov. in history with a -2.4% roll return, only second to Nov, in 2008 when the negative roll return was -2.7%. It is almost 10x the average negative roll return of -0.29% in Nov.
• Brent’s current negative roll of -2.4% has doubled from Oct. and is the highest since Jan. 2016

WTI’s negative roll has also almost doubled from -0.9% in Oct. to -1.5% now, but is only a fraction of Feb’s levels when inventory started to pull back. This shows the relative flexibility in the US production at work.

Other macro factors that may be less direct though still influential include the dollar, interest rates and inflation:

• If the dollar strengthens, oil is one of the most negatively impacted, losing on average about 1.7% for every 1% rise in the USD. If dollar falls it is much more powerful, boosting oil about 4.5% for every 1% drop in the USD.
• Rising interest rates are potentially good for oil futures from the higher margin collateral and interest from storage that push futures price up.
• Energy has a high inflation beta, meaning oil performs well with inflation. If inflation rises 1%, there is about 15% increase in the S&P GSCI (70% energy) and 11% Dow Jones Commodity Index (DJCI about 33% energy)
• This works globally except in countries that regulate price (like Mexico and S. Africa). Oil is most sensitive to Eurozone inflation followed by US CPI and then Australia and Asia.

Last, if OPEC cuts and the price rises in the near-term, it is important to consider the impact of the seasonal demand versus true supply impact. Coming into the winter months, the cold weather generally helps support oil.  In the meantime, for the passive investor that might be long oil through this time of term structure volatility in the sea of excess oil, dynamic and enhanced rolling strategies are known to have added 2-3% in negative months for oil.

MSCI and S&P Dow Jones Indices respect each other, as good rivals should, but we often disagree. We see South Korea as a developed market and MSCI classifies it as emerging; we have 500 companies represented in our leading US index and MSCI has 295; we have our own free float methodology and they have theirs.

However, we agree in at least one respect: in our approach to classifying stocks by sectors and industries. In fact, in this area we are partners. In 1999, together we established a classification system – called the Global Industry Classification Standard (GICS®) – and now we meet regularly to maintain it. How did we get here?

Why We Agreed
It wasn’t a given that MSCI and S&P Dow Jones Indices would work together in this way. As I noted before, we don’t agree on many aspects of index construction. I spoke with Dr. David Blitzer, the head of the S&P 500 Index Committee, who was part of the team that developed GICS, to learn why two rivals decided to link arms. He gave three reasons.

First, the industry was converging to certain best practices. Index providers were watching each other closely. In the game of setting sector and industry classifications, it simply didn’t pay to be an outlier. Though it was difficult to win new business simply because of one’s industry classification system, an index provider could definitely frustrate and potentially lose investors with unconventional classifications.

Second, MSCI and S&P were able to avoid duplicating efforts by collaborating.

Third and most usefully, S&P Dow Jones Indices and MSCI and were able to set a standard that would make U.S. and international markets comparable. This was crucial, particularly in the year GICS launched.

The Euro and GICS
That GICS was established in 1999 wasn’t an accident. Investors were in great need of a standard that would allow them to compare markets across continents. Why? The investment world was both excited and worried about the introduction of the euro.

The euro was far from the only reason S&P Dow Jones Indices and MSCI created GICS, but it did highlight a need. Journals were filled with articles like this one, speculating about how the world would change because of this development. To see what industries in which countries would come out on top, securities had to be grouped in useful, comparable ways. It wasn’t enough to compare company groups within individual regions. They needed to be comparable across regions.

In 1999, S&P Dow Jones Indices – which was just “S&P” then – did not own a full set of international indices. To my knowledge, MSCI did not publish U.S. indices. And because both S&P and MSCI maintained their own industry classification systems, investors were forced to reconcile the differences between the two index families themselves.

When GICS was finally introduced in 1999, a portfolio manager told Dr. Blitzer that he was very happy – he could now go golfing on Thursdays! He had been liberated from the many hours he had spent each week mapping European companies according to the S&P classification system so he could compare the two regions. At last, investors could prepare for big events like the launch of the euro without first reclassifying companies one by one.

A Leading Standard
Both MSCI and S&P Dow Jones Indices now offer equity indices that cover every developed, emerging, and frontier market. If this were the case in 1999 – and if the euro hadn’t come along to put some stress on the investment world – we might not have a single standard across the two major index providers. But that standard is now set and life is easier for everyone because of the Global Industry Classification Standard.

Green bonds are bonds created to fund projects with positive outcomes that are directly related to the environment.

They include the following.

• “Use of proceeds” bonds and revenue bonds, which are designated for green projects.
• Green project bonds, the proceeds of which are earmarked for specific projects with positive environmental outcomes.
• Green securitized bonds, which are designated for green projects (specific or otherwise).[1]

As depicted in Exhibit 1, green bond issuance has grown significantly in recent years.

Additionally, as of the end of September 2016, green bond issuances already totaled USD 50 billion—illustrating that this rapid growth shows no signs of stopping.  This upward trajectory is likely due to a few key factors.

• Green bonds are relatively simple and contain traditional debt—there are no specialized cash flows and no financial engineering.
• Multiple coalitions began surrounding the green bond market in 2014, including the Green Bond Principles and three different green bond index launches (including that of S&P Dow Jones Indices). These movements helped spur the green bond market further into the spotlight and spread awareness to market participants.

Another prime example of the growth of this market is the increasing constituent count of the S&P Green Bond Index.

The S&P Green Bond Index includes any green-labeled bond, as flagged by Reuters and the Climate Bonds Initiative (CBI), which makes it a superb indicator of the green bond marketplace.

As depicted in Exhibit 2, there were 31 bonds in the index in 2010.  As of September 2016, there were 1,320.

Even with this considerable expansion, the green bond marketplace is still flawed.  As with many areas of sustainable finance, it still lacks standardization.  The CBI has standards in place, but they are non-binding and typically viewed in the marketplace as guidelines rather than hard-line standards.

However, we expect the green bond market to continue to grow.  It’s a relatively easy way for market participants to tango with green finance—a prospect even more desirable after the COP 21 “two degree” investment initiative, the G20 Summit goals, and increasing regulations surrounding divestment.

As more and more market participants engage with green bonds, it’s reasonable to expect that regulation will come naturally, as a means to standardize a fast-growing market.  After all, the first “climate awareness” bond was only launched in 2007.

[1]   “Explaining Green Bonds,” Climate Bonds Initiative.  https://www.climatebonds.net/market/explaining-green-bonds

South African equity markets have once again performed poorly, especially in comparison with global equity markets.  One reason for this drab performance was that its GDP contracted 1.2% in the first quarter, although the price of gold—one of the country’s key exports—increased and the South African rand recovered somewhat with respect to other currencies.

Poor economic news, both domestic and international, led to bouts of heightened volatility in the first half of the year, but active equity managers did not seem to be able to take advantage of this.  Across all time horizons studied, both domestic and international active equity funds underperformed their respective benchmarks (see Exhibit 1).

The results regarding fixed income were less clear.  Over the five-year horizon, active managers beat their respective benchmark in the short-term bond category but not in the diversified/aggregate bond category.

To access the full report, please click here.

It’s been a roller coaster week in the aftermath of the startling conclusion to the U.S. Presidential election on November 8, 2016.   As recently as a week before the election, equity markets were quite calm, although volatility levels recognized the possibility of a surprise Trump victory.  When that victory occurred, U.S. futures declined significantly before markets opened on November 9, only to close the day with significant gains.  But the market’s returns were not evenly distributed.  Industries thought to benefit from Trump policies were revalued upward, while those that would have benefited more from a Clinton administration went in the opposite direction.

We can view this adjustment through the lens of equity market dispersion.  S&P 500 dispersion, which measures how individual stock returns deviate from average, peaked this month on November 9 for the S&P 500. It has since leveled off and is currently almost back to its pre-election levels. It has similarly declined in Europe and Asia.  As the Trump administration begins to take shape and we learn more about its priorities and legislative agenda, future surprises are possible, and we’ve learned in the last week how rapidly market conditions can change.  For now, however, narrowing dispersion signals an end to the initial adjustment to a new market consensus.