With so many variables at play, it’s notoriously difficult to accurately determine commodity price shifts beyond the near term – the very reason why man has hedged on forward contracts since time immemorial. That even applies to commodities with relatively inelastic demand levels, so it’s all the more surprising that something approaching a consensus seems to have arisen with regard to crude oil prices.
Reuters’ latest monthly poll of analysts gives an average price estimate for Brent crude of $93.70 (£59.71) through next year, rising to $96.00 a barrel in 2016. The October poll represented the largest downgrade to the Reuters forecasts since the global economic crisis – a drop of $9.60 a barrel. Analysts at Goldman Sachs were even more pessimistic, ascribing an average value of $83.80 over the course of 2015. Put in perspective, that represents a 23 per cent discount to the average price of Brent crude over the past three years.
The relegation of supply-side risks
Through much of the third quarter, you would be hard pressed to find any analyst who would have been willing to nail their colours to the mast over these predictions, but headlines in the financial press are currently dominated by bearish sentiment on oil prices. The existing supply/demand balance is obviously weighted to the former, but there is no shortage of external price levers that could come into play. If you look over the horizon, the supply-side of the equation may well be bolstered by the eventual repeal of Iranian sanctions. But then again, if the price of crude was to settle in the $75-$85 range, then some large-scale oil and gas projects – most notably the 10bn barrel Kashagan play in Kazakhstan – could become unprofitable.
For the moment, however, you get the impression that while analysts aren’t oblivious to potential supply-side shocks, they don’t appear to be unduly concerned either. This seeming indifference on the part of analysts seems all the more baffling in light of the re-emergence of political tensions in Libya; let alone what’s playing out in Iraq and Ukraine.
All of the conflicting price catalysts underline why it’s so difficult to plot the trajectory of oil prices. However, it’s predicted that the US will meet only around a fifth of its oil consumption through imports next year – the lowest proportion since the 1970s. That’s got to tell us something. So if, as predicted, a combination of weakening global demand, a US shale oil glut and a resurgent greenback holds sway, then it would probably pay to examine the likely implications derived from a prolonged fall-away in crude prices.
A tax on consumption
Successive academic studies have failed to identify a definitive correlation between the performance of equity markets and the price of crude oil – even with regard to the UK benchmark with its heavy weighting towards oil stocks. However, there’s no doubt that the fortunes of many individual businesses and even entire sectors are intrinsically bound up with the oil price. The overall economic benefit is that high fuel prices act like a tax on consumption, so when petrol prices fall punters have more money to spend. High prices, on the other hand, tend to lead to demand destruction as both corporations and households cut back on fuel use. Put simply, when prices of commodities rise they transfer wealth from consumers to producers but when they fall consumers benefit – and, by extension, consumer stocks.
Economists at the International Monetary Fund (IMF) estimate that a 10 per cent movement in crude oil prices is associated with a 0.2 per cent change in the world’s gross domestic product. The duration, in addition to the scale of price movements, is another key determinant. Assuming the current pullback in prices is maintained well into 2015, we might reasonably expect global growth to be around 0.5 per cent in advance of what it would have been if the status quo had been maintained. There’s no doubt that a fall in energy prices acts as a general economic stimulus, but we shouldn’t kid ourselves that, somehow, cause and effect are interchangeable. The fact is that falling prices stem in large part from slumping economies in Europe and Japan and a slowdown in China. Nevertheless, if we work on the assumption that the price is to remain in the doldrums (if that’s what $85 a barrel now represents) through much of 2015, who stands to benefit and who is likely to lose out?
Producers feel the pinch
On a national basis, a prolonged dip in the price of crude would have a deleterious effect on the major oil producing nations outside the Arabian Peninsula. Countries like Iran, Venezuela and Nigeria are already having trouble meeting their foreign debt and domestic spending commitments, while the African continent as a whole relies on crude oil for 60 per cent of its export income (government spending commitments for a number of emerging market economies should reduce on the back of reduced fuel subsidies – but more of that later).
Meanwhile, Russia’s central bank has dramatically stepped up its purchases of physical bullion, partly to absorb domestic production in the face of Western sanctions, but also to boost liquidity in its foreign reserves – a possible bulwark against rouble depreciation. Russia can at least forestall some of the knock-on effects of cheaper crude as it holds around $460bn in reserves – but for how long is difficult to say.
There are a number of geopolitical theories linked to the seemingly blasé attitude of Saudi Arabia when the price of crude was teetering towards the $75 a barrel mark. One theory runs that the Saudis are willing (and well able) to endure a prolonged price slump as it would price out marginal producers of shale oil in the US. This seems unlikely as only a relatively small number of shale plays in the US are uneconomical above $60 a barrel. Another theory runs that Riyadh’s reluctance to cut back production quotas is linked to the desire to weaken Iran’s influence in the region, while destabilising the Shia theocracy internally. US policymakers certainly wouldn’t have any qualms with these objectives. Until recently, Saudi Arabia had been explicit in its desire to keep crude oil prices above $100 a barrel, so the outcome of the Opec meeting, which was on 27 November, should give us some idea of the Desert Kingdom’s central motivation on this issue.
Fiscal stimulus and subsidies
For economies of other countries, particularly big importers, or those in which fuel is heavily subsidised by government, a weakened price environment equates to a fiscal stimulus. Any country that consumes more oil than it produces gains from economic price transfer – a significant lever in the case of global petroleum, which was worth around $4 trillion last year.
Fossil fuel subsidies cost governments in emerging markets more than $500bn every year. The practice is fairly widespread in the Middle East, north Africa, Asia and parts of Latin America. Ironically, in terms of opportunity cost – because that is what it amounts to – the world’s biggest subsidies are linked to Saudi Arabia, Iran and Russia, all major oil producers.
China and India both stand to benefit from this year’s price falls. China is the world’s second largest net importer of oil. Again, assuming that the current crude oil price is maintained through the first half of next year, China stands to lower its energy imports by around $78bn. Meanwhile, India, which struggles with a structural energy deficit, should witness a sharp reduction in its budget deficit. At the same time, inflation is now more likely to remain within the central bank’s target range. This could underpin a reduction in interest rates, thereby stimulating investment. Delhi commits around 15 per cent of government spending to fuel and agricultural subsidies, so the recent price falls represent a boon for the nation’s coffers.
The point on agricultural subsidies shouldn’t be overlooked either; what’s on the end of your fork owes as much to the petrochemical industry as it does to the farmer. Agricultural processes are more energy-intensive than most forms of manufacturing, while natural gas is the main feedstock for the most commonly used nitrogenous fertilisers – ammonium nitrate, ammonia and urea – and the price of gas is generally correlated to crude oil. So we can also say that input costs for bulk food companies, along with food producing countries, are on the wane. Costs associated with transportation and hydraulic irrigation systems are also significant factors in agricultural production.
Income implications
Of course, the initial concern for investors is whether or not the big oil companies will be able to increase – or perhaps even sustain – their dividend payments. In the UK, the oil and gas sector is traditionally one of the largest conduits of dividend payments, with the lion’s share attributable to Royal Dutch Shell (RDSB) and BP (BP.). The UK heavyweights were the second- and fourth-biggest payers in the UK respectively, according to the latest Capita Dividend Monitor, so it would make a sizeable dent in the UK income profile if either group was struggling to free up enough cash to meet prospective yields.
However, the majority view is that prices would have to dip below $75 a barrel for a sustained period before either group’s ability to increase dividends was jeopardised – BP’s legal wrangles in Louisiana notwithstanding. And at least the strengthening greenback has the effect of boosting receipts for UK-domiciled shareholders, as dividends for both majors are declared in US dollars, so the prevailing sterling-dollar exchange rate is a material factor in determining what UK shareholders are actually paid. (Conversely, a stronger dollar could potentially outweigh the benefits that a softening oil price brings for UK consumers.)
Reduced incentives and wellhead pressures
It follows that oil companies will pull development and exploration projects if their long-term price projections fall below a certain level. For instance, it has been estimated that around a third of Shell’s future energy projects require a minimum oil price of $95 a barrel to be economic. BP and Total have both indicated they will proceed with existing projects even at $80 a barrel, but the Paris-based International Energy Agency estimates that an average price at that level would result in a 10 per cent fall in US oil investment in 2015.
The ability to fund development projects, whether on-market or through bank finance, becomes more problematic if oil prices are depressed. Of course, many subscribe to the theory that oil prices, like those for many other commodities, are essentially self-correcting over time. Ergo a fall-away in direct investment would restrict new production, which would eventually support prices.
Marginal profitability for large integrated oil and gas companies will invariably be impacted by falling prices, but these types of companies can usually see out periods of price volatility because of their financial clout, combined with the benefits of scale. The same cannot be said for overleveraged exploration and production companies plays and – depending on the duration of the price falls – the wider oil service sector.
It stands to reason that when prices fall beyond a certain point, it’s no longer economical to extract. If it’s too expensive to drill, there’s no need to pay an oilfield service specialist. A protracted drop in oil prices, or even expectation of one, could conceivably prompt an increase in merger and acquisition activity as corporations pursue cost synergies. Already we’ve seen a $35bn bid by oilfield services provider Halliburton (US:HAL) for industry rival Baker Hughes (US:BHI), while Technip SA (Fr:TEC), one of Europe’s biggest oil and gas services groups, has made a E1.47bn (£1.63bn) cash offer for French seismic surveyor CGG (Fr:CGG). Logic dictates that when you combine two companies, you get economies of scale. The approaches could herald a period of increased consolidation across the sector – only time will tell.
The sector itself has held up reasonably well thus far; the FTSE 350 oil services index has contracted by a relatively modest 12 per cent since midway through July, against a corresponding fall of 28 per cent for Brent crude. That could indeed point to a speculative element within current valuations (for more on the oil equipment and services sector see this week’s Sector Focus on page 68).
Traders go long on Opec
By the time this article goes to press we will know whether Saudi Arabia, Kuwait and the other Gulf States have acceded to the demands of other Opec members to cut back production quotas. Saudi oil officials are under intense pressure from other member states to take action – and it’s not difficult to appreciate why. For example, Nigeria’s 2014 budget is predicated upon a production rate of 2.39m barrels a day at a price of $77.50 a barrel. Unfortunately, current output is significantly adrift of that target and if the price also remains lower, its budget calculations will quickly unravel – the subsequent political effects for a country already plagued by ethnic and religious conflicts would be wholly unfavourable.
The last time Opec intervened in the market was in December 2008, when it pared back production by 2.46m barrels a day in response to a 72 per cent fall in Brent crude prices from midway through July to the end of the year. Markets are now betting that Opec will trim its sails yet again.
At the time of writing, the latest Commitment of Traders report released by the US Commodity Futures Trading Commission showed that futures market traders and speculators increased their long positions in crude oil futures for a second consecutive week; non-commercial contracts of crude oil futures, traded by large speculators and hedge funds continued this bullish trend, while exchange traded fund (ETF) investors are also trading in expectation of rising prices. However, even if Opec cuts back on production quotas, the implications beyond the near term are far from clear as it’s widely accepted that the cartel now exerts less influence over global pricing than in previous years.
Winners from a low oil price
