Cost of the fall: What opportunities remain after the oil price drop?

Barely three weeks into 2016 the oil price dropped to a 12-year-low, falling to below $28 a barrel, in what has been dubbed the biggest oil counter shock ever seen.

The oil price has been in decline since June 2014, when it was at $115 a barrel. The economic slowdown in China and other emerging markets, which have historically fuelled the demand for oil, and the refusal of oil producers in the Middle East to cut production levels, which would be beneficial to their rivals in the US and Russia, are key factors.

By the middle of January, brent crude had fallen around 75 per cent in 18 months and 39 per cent since November 2015. To the man on the street this was perhaps no bad thing. Petrol prices in the UK were averaging £1.01 a litre, their lowest since 2009, and the RAC speculated we could see the bizarre scenario where petrol becomes cheaper than some brands of bottled water at 86p a litre. That is, if the oil price sinks to $10 a barrel, as predicted by Standard Chartered bank.

However while consumers may be rubbing their hands together at the prospect of falling fuel prices and lower bills, how are other asset classes, countries, companies and investors being affected?

Causes

As an asset that is highly sensitive to supply and demand, oil is prone to boom and bust cycles and has seen several price shocks over the years. It has driven countries to war with each other and is constantly used as a pawn in political agendas.

The oil price was stable between 2011 and mid-2014, but the combined forces of speculation and oversupply prompted the beginning of a downward spiral. The failure of the Organisation of Petroleum Exporting Countries (Opec) to limit production at its meeting in November 2014 put further pressure on the price.

Concerns over the sustainability of oil and the environmental impact of production have been mounting this century, leading to the drafting of a UN climate agreement and a greater focus on alternative fuels. The US, having become the world’s largest oil producer, now imports far less, which means other producer countries are fighting for a share of the Asian markets while demand for oil in Europe has dropped in recent years on the back of weak economies and an increase in energy efficiency. Meanwhile, the wall of money from quantitative easing has aided production, while countries in the Middle East have been using oil in a trade war to damage other oil-producing nations.

As if this wasn’t enough of a perfect storm, over the past few months unseasonably warm weather has dampened the demand for oil in the US and the UK while the anticipation (and execution) of a rise in US interest rates has led to outflows from emerging economies, and a subsequent slowdown in industrial activity, notably in China, quashing oil consumption.

The oil price was further strained last month when the International Atomic Energy Agency lifted economic sanctions on Iran as part of its nuclear weapons deal, leaving the country free to export oil to the West again. Iran, which has the fourth largest proven oil reserves in the world, according to the US Energy Information Agency, now plans to produce an extra 500,000 barrels of oil per day, deputy oil minister Roknoddin Javadi has said.

The obvious solution to the current glut would be for swing producer Saudi Arabia to cut production, but this would be beneficial to rival producers such as the US and Russia, whose profitability is reliant on high oil prices, and with $900bn in reserves Saudi Arabia can easily weather lower oil prices.

Effects

Equity markets have also been in freefall this year as investors fret about sliding oil prices, a concern in itself given that falling oil prices have historically been positive for the world economy. The FTSE 100 dropped 3.46 per cent on 20 January when the International Energy Agency warned that oil prices are likely to slide further this year, which meant the index was officially in a bear market having fallen more than 20 per cent on its previous peak of 7103.98 in April 2015.

John Redwood, chief global investment strategist at Charles Stanley, points out that even though China, Japan and Europe are big importers of oil, the markets are spooked by the main oil companies haemorrhaging income and cancelling capital expenditure plans and fear for the banks who have lent to them.

Royal Dutch Shell, which is set to merge with BG Group in coming weeks, has said it expects fourth quarter profits for 2015 to be down at least 40 per cent year-on-year at between $1.6bn and $1.9bn, although BG’s fourth-quarter update marginally beat expectations. While Shell has announced a dividend of at least $1.88 a share in 2016, it has not committed to paying dividends in 2017. The group plans to further cut capex to $33bn for 2016 and delay share buybacks.

“The combined group could have $35bn of net cash flow in 2016 which is not sufficient to cover its capital spending of $33bn and the $15bn dividend,” Garry White, chief investment commentator at Charles Stanley, says. “This means if the oil price doesn’t recover, the 2017 payment is almost certainly at risk of being cut.”

Meanwhile natural resources company BHP Billiton is likely to scale back oil production to preserve costs.

Graham Spooner, investment research analyst at the Share Centre, warns: “Investors should brace themselves for the possibility of a dividend cut not just as a result of lower commodity prices but also because of the accident in Brazil.”

Paul Niven, head of multi-asset investment at BMO Global Asset Management for EMEA, is also concerned about dividend sustainability. “We have seen a number of energy and mining-related companies suspend dividend payments and serious questions are being asked on whether some of the highest yielders in the market will succumb to cuts in dividends,” he says.

Niven adds that the falling oil price has also had a “marked impact” on credit markets.

“Spreads in high yield issuers remain under pressure, led by energy-related issuers,” he says.

Defaults in emerging market government bonds and energy companies are also a concern in the credit space, says Chris Iggo, global head of fixed income, AXA Investment Managers.

“The clear danger for credit markets is defaults in either the emerging sovereign space or in the energy or commodity sector and this risk will remain with us for some time until there is some better news from global commodity prices,” Iggo says. “All the more reason to be very disciplined about the individual credit names that one holds in a portfolio and to have a strong view on those businesses and their ability to repay their debt.”

Outlook

The consensus among market commentators is that only a cut in production is going to halt the tumbling oil price. But are the producer countries likely to do this without being strong-armed by Opec?

White does not think so. “The only thing that will reverse this trend is a sharp cut in production somewhere – but this does not appear to be forthcoming from any major industry player,” he says.

However, Scott Jamieson, head of multi-asset investing at Kames Capital, raises the point that a shortage of storage could force the hand of producer countries in reining in production.

“The market rumour mill would now have us believe that all the storage tanks in the world are full. If so, then a lack of storage may exert some – much needed – production discipline that significantly lower prices could not. Temporarily at least, a trough may be at hand.”

An influx of oil from Iran is not proving to be a huge concern to market commentators; not only had Iran’s reprieve been priced into the market, but in the grand scheme of things it seems that Iran’s optimistic output forecast will be a drop in the ocean.

Click here to enlarge

“In general, we don’t think it will be a game-changer for oil prices,” says Jason Tuvey, Middle East economist at Capital Economics. “Even if Iran delivers on its ambitious plans to raise output from around 2.9m barrels per day at present to 3.5m barrels per day later this year, this would be less than half the increase in supply from Iraq over the last year, and it could be offset by the cuts building in non-Opec supply.”

Norbert Ruecker, head of commodities research at Julius Baer, adds: “Iran has excellent oil and gas resources but to reach its full potential, longer-term investments and engagement by international oil companies are prerequisite, for which today’s market environment is not exactly supportive.”

Although the low oil price is playing havoc with the markets, Michael Stanes, investment director at Heartwood Investment Management, points out that in the past when the oil price has halved, such as between 1982 and 1983, 1992 and 1993, and 2001-2002, global growth has consequently increased, according to investment research group Gavekal.

The systemic risk from lower oil prices is also limited and is not comparable to the sub-prime disaster of 2008, Stanes says, while crucially, the adjustments made by commodity-producing companies and countries in response to the falling oil price will prove beneficial in the long term.

“The focus has shifted the cost to the real economy, as commodity-producing companies and countries adjust to lower oil prices, slashing expenditure and unwinding excess capacity,” Stanes says.

“While these developments are painful in the near term, we believe they will be positive over the longer-term by helping to restore the balance sheets and corporate profitability of commodity-related sectors. Stronger jobs growth, low inflation and lower levels of household debt should all help to underpin consumers in developed markets, especially in the US and UK.”

The oil price saw a brief rebound on 22 January on the back of Saudi Arabia commenting that the oil price was “irrational” and a blizzard hitting the east coast of the US, with Brent crude jumping 6.1 per cent to $31.16 per barrel. However these gains were reversed on the following trading day as Brent crude fell 4.07 per cent to $30.92 per barrel. So where are oil prices headed?

Click here to enlarge

Ratings agency Moody’s Investor Services has reduced its 2016 estimates for oil prices, forecasting brent crude to average $33 a barrel, down $10 from its previous estimate of $43, as well as placing the ratings of 120 oil and gas companies on review for downgrade.

John Higgins, chief markets economist at Capital Economics, is more bullish, predicting the oil price could double again by the end of next year.

“Our view is that oil prices will recover – our end-2016 and end-2017 forecasts for brent crude are $45 and $60 a barrel, respectively,” he says.

In its January market report, Opec said that it expected to see the price of crude begin to rebalance in 2016, as demand continues to increase and output declines. In 2015 the demand for crude is estimated at being 29.9m barrels per day, an increase of 0.2m barrels per day on 2014, while for 2016 the demand is forecast at 31.6m barrels per day, 1.7m barrels per day higher than 2015.

Philippe Ithurbide, global head of research, strategy and analysis, Amundi, says that even though we are seeing a price war, with Opec exporters forcing newcomers to cut their supply, “it will take time to drain the oil glut”.

“That’s why oil prices will remain under pressure,” he says. “In the course of 2016, non conventional oil suppliers are however expected to cut their production. Subsequently, we expect oil prices to rebound and stabilise above $40, but probably not before the end of 2016.”

Roberto Cominotto, fund manager of the JB Energy Transition fund at GAM, counters that supply will be “increasingly scarce” until 2017 as the current oil price will prove prohibitive to new development projects.

“Most people might intuitively feel that the dramatic fall in the oil price would be a negative. In fact, the opposite is true.”

However, he adds that in the long-term producers will need prices to stabilise at $70 per barrel to generate a sufficient yield. “This is the only way they will be able to cover the global oil demand of 93 million barrels per day in the future,” he says.

Investment plays

Are there any investment opportunities to be found in amongst the current turmoil?

Cominotto believes the oversupply of oil has passed its peak and is keen on shale oil producers and renewable energy, but is shying away from the major oil groups.

“Within oil and gas, we prefer North American shale oil and gas producers with low production costs and solid balance sheets that are positioned to grow significantly, even with oil prices at well below $60,” he says. “However, other industries along the entire energy value chain that have also suffered from the collapse in oil prices are also attractive, including renewable energy.

“We are avoiding most major oil groups. Total, Exxon and Shell must pursue three targets: firstly, they must secure dividends, secondly, they must keep production volumes at least constant and thirdly, they must not jeopardise their credit rating. This is hard to imagine with oil prices under $70.”

Lewis Grant, senior portfolio manager on the Hermes Global Equity fund, hasn’t ruled out oil sinking to $20 per barrel, but says this is effectively creating a tax break for US consumers and is therefore buying into US chain stores.

“We believe lower-end consumer outlets such as Dollar Tree can perform strongly in this environment,” he says.

“Following the acquisition of Family Dollar, Dollar Tree has overtaken Dollar General as the number one mass-market retailer by number of locations, with almost 14,000 stores across the US and Canada. While in the short-term we expected these companies to benefit from the increased disposable income among cost-sensitive clientele, there remains the potential for significant expansion.”

Meanwhile Jamie Carter, small-cap European fund manager at SW Mitchell Capital, is taking a different tack by investing in oil tankers, or more specifically product tankers, which are traditionally used to ship refined oil but are now being used to store crude oil in anticipation of oil prices rising.

“Most people might intuitively feel that the dramatic fall in the oil price would be a negative. In fact, the opposite is true,” Carter says. “The forward curve of the oil price is now in contango rather than in backwardation, meaning that you are paying more for oil in the future than for immediate delivery – as the market anticipates a recovery in the future oil price.

“This phenomenon is so extreme that people are buying physical oil, chartering a [very large crude carrier] and using it as floating storage. This in turn is sucking capacity out of the supertanker market and people are now having to turn to product tankers to ship not only refined product, but also crude oil. This is causing an enormous boost to demand for product tanker ships, and day rates are sky-rocketing.”

Carter is invested in d’Amico International Shipping, which has a market cap of €277m, high quality clients and an actively-managed fleet of 52 ships, he says. “We believe they will continue to be adept at adding capacity when it is advantageous to do so, or downsizing as asset values eventually turn in the other direction.”

So while the oil price may be “lower for longer”, there are companies in different sectors benefiting from the current level, certainly in the short term. At some point in 2016 we should see a turnaround in the oil price, but in the meantime the global economy is not quite in the dire straits the markets would suggest.

“The global GDP growth rate remained above 3 per cent throughout 2015 for the fourth year running [and] GDP growth should remain close to 3 per cent in 2016-2017,” Ithurbide says.

Steven Andrew, manager of the M&G Episode Income fund, is similarly sanguine on the outlook for the global economy. “The collapse in the oil price is partly fundamentally driven because Opec is operating at maximum output. We still believe the boost this provides to consumers, businesses and oil-importing countries should be a net positive for the global economy.

“Those predicting that the Chinese slowdown and the oil price decline will trigger a global recession need to provide better evidence and explanation of how this would happen to persuade us that they are right.”