Articles - The Missing Link

The fall in the oil price has affected pension schemes in a number of different ways, relating to both assets and liabilities. But what exactly have the effects been and how should they react? On the liability side, the biggest impact is on inflation. Because oil and its derivatives are an input to a range of items in price indices, a drop to the extent we have seen is bound to have an impact.

 With PAUL SWEETING, Managing Director, Global Pension Solutions & Advisory, J.P. Morgan Asset Management
 Of course, a drop in inflation will affect the level of pensions being paid in any particular year, but will not necessarily have that great an impact on the liabilities. This is because the level of inflation-sensitive liabilities is driven more by the level of implied inflation – that is, the difference between nominal government bond yields and index-linked government bond real yields. And since gilt yields have also been dropping, there is little relief to be seen for liabilities here.
 Can we expect yields to remain depressed? Well, one reason they are where they are is that lower inflation is often linked to lower growth, so there is an expectation rates will stay lower for longer. But how realistic is this?
 The price of oil will have fallen either because the demand for it has dropped, or its supply has risen. On the supply side there are a number of conflicts affecting oil producing countries – and one would expect these to cause oil prices to rise rather than fall. However, the increased use of oil shale – a hard-to-extract oil finding favour in the US – has meant supply has been more than able to cope with any perceived demand problems.
 But there has been a drop in demand. On the face of it, this could be seen as a bad thing – if the price of oil drops because less oil is needed, that may well signify an economic slowdown. This may well be the case, but it does not mean such a drop is occurring everywhere. In particular, it is the easing of demand from Asia, rather than the US and Europe, that is the primary cause of the fall in price.
 This means a fall in the oil price might actually be a good thing for western economies. If demand here is as strong as it was before, a fall in the oil price should result in increased expenditure, on oil and on other goods and services.
 So we might see interest rates – and bond yields – rise, if this increased demand sees inflation actually increase. This would be good for pension schemes on the liability side, but there would be losers. Some of those most at risk are those involved in the oil shale industry. Because margins are thinner here than for traditional extraction, low oil costs are already making life difficult for them. If borrowing costs increase as well, things could become even tougher. As a result, we have seen spreads on the bonds of these firms rise significantly in the last couple of months.
 A fall in the price of oil is also going to have a negative impact on any firm whose business is essentially based on oil extraction. This is an issue for any scheme that holds these stocks, but it is a potentially greater issue for schemes whose sponsors are oil companies: essentially, a drop in the oil price results in a weakening of the sponsor covenant. This problem is even more acute if the fall in the oil price is linked to the performance of other assets in the scheme.
 Other commodities are one example, but some equity sectors may also have structural links to the oil price. Of course, there are also sectors and asset classes that might have the opposite relationship with oil. For example, one would expect infrastructure to perform very strongly when oil struggled, as people and businesses would be more likely to drive, fly, ship and otherwise use infrastructure assets. Similarly, firms for whom oil is an input – such as industrials – might find their profitability increased.

Back to Index

Similar News to this Story

One more year so can we stop thinking about IFRS17 for now
On 14 November 2018, the IASB announced a deferment of the IFRS17 implementation date by a year, with some still calling for a two year delay.You co
Allowing for climate related risks
Allowing for climate related risks when setting long term financial assumptions
Mean Reversion in Equities
A common argument in favour of equity investments is that, even though they go down, they will bounce right back up again. Commentators may advise β€œri

Site Search

Exact   Any  

Latest Actuarial Jobs

Actuarial Login

 Jobseeker    Client
Reminder Logon

APA Sponsors

Actuarial Jobs & News Feeds

Jobs RSS News RSS


Be the first to contribute to our definitive actuarial reference forum. Built by actuaries for actuaries.