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Global turmoil or a crude stimulus for the economy?

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10 years ago

March 17, 2015

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The fall in oil prices has had a positive impact on Alliance Trust Investments’ Sustainable Future Funds because its holds very little oil and gas exposed companies, explains Chris Foster, a management trainee at the firm.

This article was originally published on Alliance Trust Investments’ Sustainable Future Hub.

The impact of this oil price fall on the Sustainable Future funds has been very positive in terms of performance, as compared to the stock markets; we hold very little oil and gas exposed companies, as we prefer exposure to cleaner energy and energy efficiency.

In July 2014 the International Monetary Fund (IMF) released a report titled ‘An Uneven Global Recovery Continues’. One of the key concerns was that “increased geopolitical risks could lead to sharply higher oil prices.” Having consequently fallen by over 50%, We think the IMF would probably agree that predicting the future price of oil is no easy task. We have seen the oil price fall to as low as $47 per barrel already in 2015 – the last time oil prices were this low was early 2009, in the heart of the most recent financial crisis.

Source: Bloomberg data

The reason the price of oil is so difficult to predict is that the dynamics governing what is essentially just a supply and demand relationship are both abundant and complex. We would however argue that there are currently three main factors determining the price of oil:

– The Organisation of Petroleum Exporting Countries (OPEC) have decided not to reduce supply – in the past, Saudi Arabia has led the way on artificially supporting the oil price by curbing supply, however this time, it has decided not to do so. Out of all the oil exporting countries Saudi Arabia has the lowest costs when it comes to extracting oil from the ground; consequently it is comparatively well-placed to tolerate a period of lower oil prices.

– The US shale revolution – in 2014 the US overtook Saudi Arabia to become the world’s biggest oil producer. In the week leading up to the 9th January alone, US crude output surged to 9.19million barrels a day – the fastest pace in weekly records dating back to 1983. That’s amid a global supply surplus of around two million barrels a day and although America does not currently export crude oil, it now imports significantly less.

– Low demand – the combination of weak global economic activity, efficiency gains in both oil extraction and in the products in which oil is consumed, and a growing trend towards other fuel sources, have depressed global demand for oil.

If you combine the above with the fact that Libya and Iraq, despite heavy conflict, continue to produce oil, the supply and demand relationship between the producers of oil and those who consume it, has re-balanced in favour of the consumer.

The global economy – good, or bad?

The IMF estimate that a 10% movement in crude oil prices is associated with a 0.2% change in the world’s Gross Domestic Product (GDP), whilst Oxford Economics estimates that for every $20 fall in the oil price, global growth increases by 0.4%, within 2-3 years. The general consensus is that a low oil price will have a net-positive effect on the global economy. The chart below shows UBS’ calculations of the impact on GDP after one year from a $10 fall in the price of oil.

An obvious consequence of a low oil price is that economic benefits will be re-allocated away from those that produce it, to those that consume it. Countries that import more oil than they export are set to benefit, particularly those that are “battling high inflation and large oil subsidy bills, such as Indonesia and India”, according to Moody’s, the credit rating agency. The big losers include Saudi Arabia, Venezuela, Russia, and Nigeria, whose net exports of oil and oil-related products counted for 43%, 36%, 13.5%, and 12.5% of GDP, respectively.

North America – consumers are the biggest beneficiary

The biggest beneficiaries of a low oil price in the US will be consumers, as the consequent fall in gasoline prices will effectively act as a tax cut to the American motorist. According to the US Energy Information Administration (EIA), 70% of the retail price of petrol or ‘gasoline’ is determined by the crude oil price. Average regular gasoline prices in the U.S. averaged $2.12 per gallon in January – the lowest monthly average since April 2009.

Source: Daily Fuel Gauge Report

Despite the recent shale revolution, the US is still a net-importer of oil and analysts expect that the economic benefits of increased consumer spending and falling input costs will outweigh the negative effects that a low oil price will have on the shale industry. UBS estimate that “lower for longer” oil is set to positively affect US GDP in 2015 and calculates that for each $10 drop in oil prices, US GDP rises by 0.1%. A recent article by The Economist explains that a typical American motorist, who spent $3,000 in 2013 on petrol, might save $800 a year – equivalent to a 2% pay rise – from a $40 fall in the oil price. Visa Inc (electronic payments) is an example of a company held in the Sustainable Future funds which is exposed to the US consumer having more money, and has performed strongly since the move in oil price.

The flip side is that the shale drillers in the US will lose out significantly, as the oil price is now lower than the marginal cost of drilling. BHP Billiton for example, is cutting back its operating US shale oil rigs by 40% following the recent slump in the oil price and the total number of rigs drilling for oil has fallen to its lowest since 2011.

The Sustainable Future funds have benefitted from being underweight the energy sector and by not having exposure to shale companies, so the negative impact that this low oil price has had on shale companies, hasn’t affected our performance.

Europe – consumers win again

Inflation in Europe, or rather the lack of it, has been attracting all the attention of late and the depressed oil price turned the inflation rate negative for the first time since 2009. Consumer prices fell 0.2% year on year in December, raising concerns that the single currency region will enter a prolonged period of deflation.

The European Central Bank (ECB) has responded by agreeing to pump money into the economy by buying government bonds in a process known as quantitative easing. The ultimate aim being that by further suppressing borrowing rates, consumers and businesses will be encouraged to stop saving and start to spend and borrow more. Such actions could continue to devalue the Euro, which is already at a nine year low against the dollar. A weaker Euro should increase the competitiveness of European products internationally and Germany in particular, is expected to benefit from this.

The graph above shows how different sectors have performed relative to the oil price since 1995 and here are some of the stand out sectors that should benefit in a low oil price environment:

– Beverages: should benefit both from lower packaging costs and a positive impact resulting from improved consumer disposable income.

– Transportation: airlines and cruise ships should benefit from significantly lower running costs and from an increase in consumer spending.

– Pharma and Biotechnology: pharmaceuticals have performed well historically during times of falling oil prices, typically as a result of sector rotation as portfolio managers sell oil stocks and move into defensive sectors.

Asia

Lower oil prices could increase current account surpluses as well as reduce subsidy pressures on government budgets for countries who are big importers of oil. Japan and India’s net imports of oil and oil-related products equate to around 5% of the respective countries’ GDP. According to research by the Financial Times, a 30% fall in the oil price should hand back as much cash as was raised by the Japanese government in 2014 – when it put consumption tax up by 3%.

Any industry in which oil is a significant input should benefit from falling costs from a lower oil price, such as airlines. UBS estimates that fuel constitutes around one-third of airlines’ operating costs per available seat mile. The Sustainable Future funds do not invest in airlines due to their significant contribution to global carbon dioxide emissions.

Challenged sectors

The following are a selection of industries that will be under pressure from a sustained fall in the price of oil:

– Oil services, oil & gas exploration and production: low oil prices will put pressure on capital expenditure of exploration and production, which are the sole drivers of global oilfield service and drilling activity. A low oil price reduces the profitability and likelihood of projects going through.

– Aerospace: a lower oil price shifts the balance towards older aircraft as the cost benefits of buying more efficient planes is materially reduced.

– Chemicals: despite falling input costs, any industry where companies have limited pricing power tend to suffer in the long term from a lower oil price as they face significant pressure to pass these savings through to their customers.

We also see a possible tail risk in banks that have funded oil and gas companies. At current prices some oil and gas companies, those that are especially leveraged and require high oil prices to get an investment return on their assets, may struggle to repay their loans.

How the markets have reacted

The charts below show the ten biggest winners and losers since the oil price started to fall at the start of July 2014. Unsurprisingly, the Energy Equipment and Oil & Gas industries have been hit the hardest, with Airlines and Biotechnology the clear winners, having returned 31% and 27% over the six month period.