The oil price began to drop during the summer of 2014 as US production boomed and economic growth slowed in Europe and China.
Fast forward to the present day, and the oil price has now fallen to its lowest level in a decade, which provides some welcome relief at the petrol pumps, but not in the oil company boardrooms.
Returns on capital investment have been declining for some time with many exploration projects that were undertaken when oil was north of $100 (£70) per barrel no longer viable at today’s prices. Indeed, according to international drilling contractor, Noble, daily hire rates for shallow-water drilling rigs in the Gulf and elsewhere have fallen to half the peak levels reached in September 2008.
The falling oil price has had a predictable effect on energy stocks. The initial reaction is to sell investments linked to energy production. However, it is worth recalling that the oil price fell by more than 70 per cent in 2008, bottoming at $35, only to trade at $100 per barrel some 25 months later. This is not lost on deep value recovery fund managers, many of whom have identified the sector as unloved, oversold and cheap.
In the short term, the falling oil price can be likened to a tax cut for oil-importing nations, and it provides a boost to consumer spending, particularly in the US. It also provides a shot in the arm to high consumption sectors such as airlines, cruise operators and shipping companies. But while this may benefit the US, Europe and Japan, the economies of Russia, Venezuela, and much of the Middle East have all seen their revenues fall.
Careful country, sector, and security selection is key to being successful in this environment. One region that seems well set to benefit is Asia. Asian economies are, by and large, net oil importers and exporters of manufactured goods to economies whose consumers are feeling wealthier.
Careful country, sector, and security selection is key to being successful in this environmentThere are a number of fundamental and geopolitical considerations that factor into the oil price, and that will impact on the geographic, sectoral and stock specific opportunities. Uncertainties continue about future demand with growth waning in China and the potential for Western economies to remain stuck in lost decades of long-term slump.
Vehicles themselves are also becoming more energy-efficient, although it seems that we are particularly short-sighted in our buying decisions. Evidence from the University of Minnesota’s Energy Transition Laboratory suggests that there is a paradox in cheap oil: despite a typical 15-year or so vehicle life, sales of ‘gas guzzlers’ increase rapidly when petrol prices are cheap.
Other factors that affect the oil price remain in play – the break-even price of US shale oil is unclear as is the viability of access to reserves in Iran, Mexico and Venezuela. As one analyst put it “do not count your wells before they pump”.
From a geopolitical perspective, there are tangible threats to oil supplies in Libya, Iraq and Nigeria while other countries such as Iran, Algeria and Venezuela are also, arguably to a lesser extent, unstable.@Image-4e2a7271-088c-49ca-aeae-9ace30649882@
On the other hand, it is entirely possible that Iran, which is emerging from 30 plus years of sanctions, will add significant capacity to the market and, notwithstanding the ongoing threat from Isis/Daish, there is potential for Iraq (and Kurdistan) to meet as much as one-third of global production requirements. Even a moderately optimistic outlook for supply will increase pressure on other Organization of the Petroleum Exporting Countries members to reduce production.
With all of these considerations, it is easy to see that there is a recipe for the supply glut continuing throughout this year. Where the oil price gets to in the short term is anyone’s guess, but, in the long run, oil analysts predict that, politics aside, the sustainable oil price is around $50-$60.
While oil companies might remain under pressure, lower fuel prices will reduce costs across many other industries, freeing up capital and increasing profits. Many firms where oil costs dominate will hedge against price changes, so the benefits may not be apparent immediately. However, the effects of hedging should be beginning to wear off.
Oil costs money to extract and there is evidence that new oil projects are being cancelled or shelved – any under-investment could ultimately impact upon supplies. Share prices provide an instant barometer of sentiment and these sectors, where pressure may lead to increased merger and acquisition activity, are particularly unloved.
It is just such market conditions that prove most enticing to contrarians (and the brave) attracted to direct investments in oil producers or collective funds that specialise in commodities. This year might well provide a real buying opportunity, but timing, as is so often the case, could prove to be beyond all but the most fortunate.
Andrew Miles is head of research at Ascot Lloyd
Key points
The oil price has fallen to its lowest level in a decade.
The break-even price of US shale oil is unclear as is the viability of access to reserves in Iran, Mexico and Venezuela.
Lower fuel prices will reduce costs across many other industries, freeing up capital and increasing profits.
