Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

In any other time, news that the oil price has fallen to the lowest level for more than 20 years would dominate the financial headlines - yet in the midst of a pandemic, it’s relegated to an also-ran.

The US benchmark for oil, West Texas Intermediate, dipped as low as $14.47 a barrel in trading overnight, the lowest level since 1999. Buyers are apparently worried that we will soon reach the point when newly pumped oil cannot be stored, making it near worthless. This supply glut is the result of a price war among oil producing countries, which has now been exacerbated by a collapse in demand driven by the Covid-19 pandemic.

The motivations of oil-dependent nations can be difficult to decipher at the best of times but the past few months have been especially baffling. A digested version is that Saudi Arabia and Russia - the most important Opec and non-Opec producers, respectively - have not been able to agree on an appropriate price for oil in the face of competition from US shale drillers - a relatively recent rival to their dominance.

Both would benefit from prices being high, yet they also have an incentive to drive the price lower because this means US fields become uneconomical and are forced to close. Having failed to reach an agreed course of action, Saudi Arabia announced price cuts and a race to the bottom ensued. Now that Covid-19 has decimated oil demand, there is a tremendous overhang of oil supply - which is how we got here.

It’s not always obvious how dramatic swings in financial asset prices affect us in the real world. In the case of oil, the effect can be seen in lower price inflation in the long term because cheaper oil reduces the price of almost everything as transportation and manufacturing costs fall. That can be a good thing for consumers.

It’s not all positive, however. The low oil price reflects the hit to economic activity expected from the pandemic, which will also adversely impact wages and job security. Investments linked to the oil price are also likely to take a hit. BP and Shell are large contributors to the UK stock market and are likely to be held in significant weightings by most investors. Their share prices fell by around 50% after the pandemic struck, but have recovered some ground since then. A sustained period where oil is uneconomical to produce clearly puts the oil majors under stress and makes the giant dividends they pay less secure.

At time of writing, the dividend yields for both BP and Shell are above 10%. This is superficially very attractive but comes with a health warning - yields are this high because plenty of people still see sense in avoiding the shares. Others will see it as a screaming buy, on the ground that even hefty dividend cuts would still leave a healthy income - and the upside could be much better than that if dividends are maintained.

As with everything right now, it is the pandemic which will dictate which thesis turns out to be correct.

Five year performance

(%) As at 31 March 2015-2016 2016-2017 2017-2018 2018-2019 2019-2020
Brent Crude Oil -27.9 33.8 32.6 -1.6 -78.1

Past performance is not a reliable indicator of future returns

Source: Refinitiv, as at 31.3.20, total returns in local currency

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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