Over a barrel

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Mitchell Fraser-Jones 31 October 2014 Est. reading: 6 min read

Having averaged around $108 per barrel in the first half of 2014, hitting a high of $115 per barrel in June, the price of Brent Oil has slumped in recent months to around $85 dollars per barrel currently. Here, we look at the fundamental reasons why and some of the implications for the stock market and the macroeconomy.

Economics 1-0-1 — supply & demand matter

In recent years, the supply of oil has been steadily rising. The “Shale Revolution” in the US has been significant with substantial new supplies of natural gas and ‘tight oil’ coming on stream, drastically reducing US dependence on imported energy. Buoyed by the high price of oil which has improved the economics of shale, US companies have been ramping up production, with 1.3m barrels per day being added so far this year1.

Elsewhere, growth in output from Iraq, Libya and Nigeria, plus a steady production performance from Saudi Arabia and other Gulf producers, has led to this steady but meaningful increase in oil supply.

At the same time, however, the global economy has started to disappoint what we have long believed to be overly optimistic growth expectations. This is already having a noticeable impact on crude oil demand, particularly from Europe and Japan, but also in China, where oil demand growth has slowed dramatically in recent months. The overall demand picture looks poor and continues to deteriorate.

So the oil market looks like it has been flooded with new supply at a time when demand is faltering – a dangerous economic cocktail which inevitably means lower prices. But shouldn’t the market have seen this coming and adjusted the price more gradually? We suspect it probably did see it coming but the oil price is of course particularly prone to being influenced by other factors such as geo-political risk. Tensions in the Middle East and Russia, both key oil producing regions, may have held the price higher than fundamentals justified for much of the spring and summer but ultimately, fundamentals have a habit of reasserting themselves – in commodity markets as well as stock markets.

The timing of the most recent leg down in the oil price is also to do with Saudi Arabia’s historic role as ‘swing producer’ in the oil market. Many commodity market specialists had expected the Saudi’s to respond to the lower oil price by cutting production to maintain the market equilibrium at a higher price. It’s refusal to do so has alarmed the market, but can be explained by the high cost of production embedded in the US Shale industry – about a third of US shale oil production is uneconomic at $80 per barrel2, so the Saudi’s refusal to ‘swing’ is likely to force others to do so.

Although a supply-side response seems inevitable, as the highest cost producers are priced out of the market, oil prices may continue to be influenced by faltering demand. As things currently stand, however, Goldman Sachs estimates suggest that supply will exceed demand through to at least 2016.

Infographic showing various aspects of global oil's deteriorating fundamentals

What does this mean for the stock market?

As usual, there will be winners and losers. The key losers, in our view, are clearly the oil majors. Mainstays of the UK stock market, BP and Royal Dutch Shell are heavyweights in the FTSE All Share Index, accounting for over 11% of the index between them. The Oil & Gas sector in total represents 14.6% of the FTSE All Share Index3. In terms of their contribution to the dividend income delivered by the index, they are considerably more important. Herein lies a ‘major’ problem.

Jefferies International estimates that the oil majors need an average oil price of $110 per barrel to break even in 2015 (i.e. for operating cash flow to cover capital expenditure and dividends). Some oil companies are already sustaining their dividends by using their balance sheet or by selling assets but this is not sustainable. If the oil price remains below $110 for a prolonged period, something eventually has to give. Either they cut capex or they cut the dividend – neither option looks particularly good news for shareholders.

Of course, this isn’t a risk unless you are exposed to these stocks. An integral feature of our investment approach is our focus on ‘absolute risk’ – the risk of a permanent loss of capital or indeed income. Viewed through our lens, the oil majors clearly look like very risky propositions. Our portfolio has no exposure to BP or Royal Dutch Shell. The falling oil price simply reinforces our long-held view that there are better opportunities to be found elsewhere. Our only exposure to the Oil & Gas sector is through our holding in Velocys, a small, early-stage but very promising technology business developing a product which creates synthetic oil from waste gas and biomass.

But our investment approach is distinct from most of our peers. Most UK funds do have exposure to the oil majors. For example, within the UK Equity Income sector, the average combined exposure to BP and Royal Dutch Shell is 7.6%4.

But what about the winners? Well, any company for whom oil is an input cost might be pleased to see its price fall. This includes manufacturers of all sorts, travel companies and retailers, by example. For some, these lower input costs will immediately be passed on to their customers, although they may benefit from a positive volume effect. For others with more pricing power, there ought to be improved margins.

The last of these, retailers, should also benefit from a wider economic implication of the lower oil price.

A rare piece of good news for consumers

Lower oil prices are great news for the average household’s disposable income, albeit with a lag. Even taking into account the decline in sterling versus the dollar, a fall in the price of Brent crude oil from $110 to $85 per barrel, effectively puts £3.3bn into consumer’s pockets, purely as a result of the reduced amount that we would spend on fuel.

Adding utility bills into the equation as well, the total boon for UK consumers from the fall in oil prices is estimated at over £6.6bn.

Whilst this may appear to be good news for individuals, at the macroeconomic level it poses two significant challenges. Firstly, it means that the UK’s fragile and unbalanced recovery may become even more dependent on consumption going forward. And secondly, the decline in oil and indeed other commodity prices adds to the deflationary forces that are already evident across the developed world. The risk that these deflationary pressures become even more entrenched is therefore exacerbated. Ultimately, as David McWilliams pointed out, this may mean that consumers choose not to spend their increased disposable income but use it to save or pay down debt instead.

A peer into the future

In the near term, it is difficult to forecast what will happen to the oil price. An escalation of tensions in the Middle East or Russia could lead to a spike higher in the oil price but on the basis of fundamentals, we would argue that the risks to the oil price lie to the downside. The lower price of oil will inevitably lead to a supply-side reaction but our cautious view of the global economy would suggest that global energy demand could continue to falter.

Looking longer term, the risk of some form of disruptive technological breakthrough which significantly reduces our dependence on fossil fuels is too important to completely ignore. It may be many years away, but it would completely undermine the ‘scarcity economics’ upon which the oil industry relies and have many other profound implications for the global economic landscape. This, coupled with our fundamental concerns about oil market supply and demand, plus the associated risk to oil company dividends and capital values, means we are very happy to maintain a zero exposure to the oil majors. In our view, there are many other less risky and therefore more attractive, long-term investment opportunities in other parts of the market.

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address: 27 Old Gloucester Street, London, WC1N 3AX.

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