The Return Of Volatility Is The Key Market Risk For 2018

We are living in a strange world. As in 2007 through 2008, financial news continues to be euphoric, yet the general news is increasingly gloomy. As Nobel Prizewinner Richard Thaler, has warned, “We seem to be living in the riskiest moment of our lives, and yet the stock market seems to be napping.” Both views can’t continue to exist alongside each other forever. Whichever scenario comes out on top in 2018 will have major implications for investors and companies.

It therefore seems prudent to start building scenarios around some of the key risk areas – increased volatility in oil and interest rates, protectionism and the threat to free trade (including Brexit), and political disorder. One key issue is that the range of potential outcomes is widening.

Last year, for example, it was reasonable to use $50/bbl as a base case forecast for oil prices, and then develop Upside and Downside cases using a $5/bbl swing either way. But today’s rising levels of uncertainty suggests such narrow ranges should instead be regarded as sensitivities rather than scenarios. In 2018, the risks to a $50/bbl Base case appear much larger:

On the Downside, US output is now rising very fast given today’s higher prices. The key issue with fracking is that the capital cost is paid upfront, and once the money has been spent, the focus is on variable cost – where most published data suggests actual operating cost is less than $10/bbl. US oil and product exports have already reached 7Mbd, so it is not hard to see a situation where over-supplied energy markets cause prices to crash below $40/bbl at some point in 2018

On the Upside, instability is clearly rising in the Middle East. Saudi Arabia’s young Crown Prince, Mohammad bin Salman, is already engaged in proxy wars with Iran in Yemen, Syria, Iraq and Lebanon. He has also arrested hundreds of leading Saudis, and fined them hundreds of billions of dollars in exchange for their release. If he proves to have overextended himself, the resulting political confusion could impact the whole Middle East, and easily take prices above $75/bbl